Sales Tax Bias Against Turnover and Jobs

Paper by Mason Gaffney, summarized by Lindy Davies. Read the full paper here.

Mainstream attitudes toward “capital” tend to ignore the variable rates of turnover. “Turnover means replacement, and replacement sustains demand for labor.”

There’s a continuum of turnover: on one end there’s stuff that turns over very quickly, such as pies in a bakery. The shelves and ovens in the bakery turn over less frequently; the building still less. What’s all the way at the other end? The land — which is never replaced at all, and hence has zero turnover.

So, not only do sales taxes penalize production by increasing prices (we knew that), they do so with greater severity on precisely those activities we most want to encourage: high-turnover items, rapidly replaced. Therefore, sales taxes steer investment toward land and long-cycle capital (e.g., buildings) and away from the kind of working capital that creates jobs.

Conventional thinking has it that a general retail sales tax is neutral — because it penalizes all products equally, and hence induces no distortion in markets. This argument is used, for example, by those who want to extend state sales taxes to online commerce.

It simply isn’t true. Different products react to the tax penalty at different rates. This is recognized in the “Ramsey Rule” — taxes distort markets less, to the extent that they’re levied on things that are less elastic in either demand or supply. If the good is completely inelastic (in other words, if its demand or supply is completely unaffected by changes in price), then the tax on it is fully neutral.

Now, some goods are relatively inelastic in demand — such as cigarettes or liquor, which leads to calls for “sin taxes”. In fact, the Ramsey rule is most frequently cited in terms of the demand side of the equation.

Economists frequently — and, Gaffney suggests, conveniently — forget about the supply part of the Ramsey rule, which “leads straight as a guided missile to levying taxes exclusively on the value of land, because its supply is absolutely inelastic.”

(There is a long list of inequitable features of the sales tax. It is regressive, collecting a greater portion from those with less ability to pay. It applies to products — but not to sales of other kinds of property: real estate, licenses, debts, securities, etc. Capital gains taxes do apply to some of these, but they are charged only when assets are sold — and sometimes, as in the case of reinvested gains from real estate, not even then. And of course, capital gains taxes severely limit turnover of capital. William Vickrey argued for decades that capital gains should be taxed as income, as they accrue.)

Gaffney surveys the development of the erroneous mainstream position on sales taxes through the 20th century economics literature. He notes that Austrian economists have long explored the contrast between long-duration and short-duration capital goods — yet, surprisingly, he has found none of them who use this well-established Austrian concept to criticize retail sales taxes.

It’s widely accepted that (because of federal income taxation) states have virtually no alternative but sales taxes. But, before the 1930s, sales taxes were not used at all in the US. And, states that don’t use them (Delaware, Oregon, New Hampshire) prosper at the expense of their neighbor states that do. Also, sales taxes have no effect on absentee owners — who pre-empt valuable local resources, paying nothing for the privilege. Property taxes — which are, in fact, still an option for states — do not have these weaknesses.

This bias toward land and long-duration capital was observed by John Stuart Mill in 1848. He wrote: “…if there were a tax on all commodities, exactly proportioned on their value, there would… be a ‘disturbance’ of values owing to the different durability of the capital employed in different occupations….” Gaffney refers to this “disturbance in the Force” as “The Mill Effect”.

This can be clearly seen if we compare two businesses: a furniture store and a five-and-dime.

The furniture store has greater operating capital, fewer sales, lower gross volume, and higher profit margin per sale.

The five-and-dime has less operating capital much higher sales volume, and lower profit margin per sale.

If each sale is taxed at the same rate, the higher volume of the five-and-dime is penalized far more heavily than the lower volume of the furniture store.

Gaffney illustrates this with two analogies, one from hydraulic physics:

Robert Dorfman, in a 1959 article I cannot praise too highly, whimsically calls it “The Bathtub Theorem”. The average transit time of a molecule of liquid through a reservoir is basically the flow/fund ratio: in economic terms, the sales/capital ratio. For the lady baking pies and selling out daily the annual ratio is 365. For the boreal forester, whose stock of harvestable timber turns over in 70 years, the annual ratio is 1/70 — differing by a factor of 26,000… For doubters and masochists Dorfman provides many equations, but ends them delightfully saying “It is nice that this elaborate calculation is really unnecessary”

the other analogy is from chemistry:

“Land in production is like a chemical “catalyst”: it facilitates a process without disappearing into the product. Its “quantum of value” remains in the land. Working capital is, at the other extreme, like a “reactant”: its corpus and its quantum of value go into the product. That means they get sales-taxed with each turnover….”

Gaffney summarizes some of his colleagues’ observations of these principles in action: “as Dan Sullivan points out, sales taxes penalize high-volume low-markup marketing strategies as against their opposite. Lest one turn up his nose at, say, Walmart, its low prices do not reflect low markup so much as low labor-service per dollar of inventory. It also provides acres of free parking, a service of land, like other big-box stores. Sullivan also notes that sellers in better locations, say Rodeo Drive, can have higher markups, so sales taxation favors better locations over marginal ones. New businesses with high startup costs can deduct them from taxable income, but not from gross sales. Clifford Cobb notes that ghettos have many barber shops and beauty parlors but few shops carrying commodities.”


“We are left with this. Jobs depend on turnover. Turnover is measured by the sales/capital ratio, which varies hugely among different firms, products, locations, stages of the cycle — and tax regimes. Elected officials control the last, and we as economists influence elected officials. Sales taxes, rampant and rising in our times, depress turnover heavily, and so depress demand for labor — both the number of jobs and their pay rates. Property taxes have the opposite effect, and so may some aspects of income taxation. We do not here address how both property and income taxes may be modified for the better, although they may and should be. Our main point here is that sales taxes (and their twin, VAT) are among the worst possible choices when the objective is to make jobs and raise pay rates.

“The U.S.A., with all its faults, has no national VAT. We do not lack for crusading VATsters. They chide us for being behind Europe, where all nations in the EU depend heavily on VATs, the dependence rising fast ever since France introduced it in 1954. As the EU careens to financial crisis, and derivative political crises, while world capital flees for refuge in the U.S.A., the evidence of history is not speaking well for VAT.”


Gaffney describes how consolidation of banking by mega-giants such as JP Morgan-Chase, Bank of America, Citibank and Wells Fargo serves to restrict loans to small businesses, and thus to hinder job-creation, and reinforce this overall bias against capital turnover. Small local banks have a much larger portion of their assets in loans to small businesses. Big banks rely on automation; small business loans demand case-by-case human contact. He concludes:

“We have a financial system that is mismatched to the economic needs of American communities. This mismatch will become more acute as we attempt to transition to a carbon-efficient economy, which, by its very nature, will be the domain of small-scale enterprises: local food producers, community-owned wind and solar electricity, neighborhood stores that provide goods within walking distance of homes, and so on. To take root, these businesses will need a robust array of community-based financial institutions capable of meeting their capital and credit needs.”

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