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Proper Framework for Evaluating Changes in Tax Policy

By: Gerald Prante

When analyzing whether a proposed change in taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy is good or bad, there must be a solid framework imbedded in the analysis. Without such a framework, one can resort to defending anything (like the extreme positions that any tax cut is good or any tax hike is good).

The proper framework for analyzing whether or not a tax cut is good tax policy is the question “Do the expected benefits from the tax cut exceed the expected costs?” The costs include the loss in social well-being coming from higher taxes elsewhere or lower government spending, both of which are possibilities. This is not a liberal framework. This is not a conservative framework. It is a public interest framework.

Suppose we have a state proposing to exclude automobiles from its sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. . Ignoring possible externalities and administrative cost concerns, would such a measure improve societal well-being? The answer depends upon how it is financed. Here are three scenarios:

(1) Exclude automobiles from sales tax and cut a wasteful government spending program — social well-being improved

(2) Exclude automobiles from sales tax and cut a valuable government spending program — social well-being decreased

(3) Exclude automobiles from sales tax and raise the general sales tax rate — social well-being decreased

In other words, in order for the targeted tax cut to have a positive expected value for societal well-being, the probability that the targeted tax cut actually leads to a cut in wasteful government spending must be sufficiently high. In a sense then, this is mostly a political question about what a legislature is likely to do in response to the tax cut.