How to think smarter about taxes

Hold revenue constant and ask whether a structural change makes things better or worse

I’ve been thinking lately about both Donald Trump’s proposal to exempt tips from income tax and Joe Biden’s somewhat complicated proposal to tax unrealized capital gains.

I think the debate over both of these issues could be improved if everyone adopted the heuristic of thinking about tax structure questions independently from thinking about how much revenue they are hoping to raise.

Of course, I understand that’s not how Congress works.

In practice, Trump’s proposal will increase the budget deficit, and Democrats are going to pay for new programs. And it’s totally fine to say that’s the reason you favor or oppose a particular piece of legislation. But it’s still the case that when thinking about the design of the tax system, it’s useful to try to separate the question of how taxes should work from the question of whether the government has too much money. Otherwise, I think a lot of people end up confusing themselves.

As a basic example, a retail sales tax is a major source of revenue for most states, but groceries and large categories of services are generally exempted from this tax.

So if you buy some vegetables, you don’t pay tax on that. And if you hire a nutritionist to tell you to eat vegetables, you also don’t pay a tax on that. But if you buy some socks, you do pay a tax on the socks. Does this system make sense?

The way I think about this question is to start by holding revenue constant. Taxing groceries would allow a state to lower its sales tax rate, but ultimately, this switch is bad for people for whom groceries are an above-average share of their household consumption bundle, which is to say it’s bad (on average) for poor people. Taxing professional services would also allow you to lower your sales tax rate. And ultimately that switch is bad for people for whom professional services are an above-average share of their household consumption bundle, which is to say it’s bad (on average) for rich people. So I would advise states to continue to exempt groceries from taxation, but to try to convert retail sales taxes into something more like a comprehensive consumption tax — what they call Goods and Services Tax in Canada or Value Added Tax in Europe.