Cost-Benefit Analysis of Sales Tax Holidays

July 23, 2009

Sales tax holidays are temporary tax cuts, thereby temporarily reducing one distortion: the wedge between the price a consumer pays and the amount a seller receives. Relative to other possible tax cuts that forgo the same amount of revenue, however, a sales tax holiday has the distortion of encouraging consumption of one product over another and in one time period over another. A sales tax holiday likely has no positive externality effects, but it does impose transactions costs on both business and government, thereby reducing its benefit. Finally, it could even induce possible irrational behavior on the part of consumers, thereby reducing its benefit.

So the question is then: if given the choice between a sales tax holiday and nothing, should it be done? The answer depends upon both the level of net benefit described above (could be negative) and how the foregone revenue will be financed. Will it reduce wasteful spending or will it reduce some spending that actually has value to society? Or will it just force other taxes to be higher in the future (such as higher rates), thereby almost assuredly making society worse off? Simply put, here’s the condition for a sales tax holiday to be welfare-enhancing:

(Benefit of Tax Cut – Administrative Costs, etc.) > Expected Costs,

where expected costs equals the sum of the values of the various financing mechanisms that are possible weighted by their respective probabilities.

It’s a simple cost-benefit calculation that could in theory go either way. In my view, given their administrative costs and that a sales tax holiday’s economic value as a tax cut is much smaller than the value of a revenue-neutral sales tax rate decrease combined with the fact that there is a high probability that such a tax cut would be financed by a sales tax rate increase down the road, the chances that a sales tax holiday improves societal well-being is small.

One final point on this overall issue. There are those who argue that $1 raised in revenue by government in one way is the same as $1 raised in revenue by government in any other way. To put it bluntly, those arguments are economically ignorant. If the federal government passed fundamental tax reform that eliminated many exclusions, deductions, etc., yet it raised $1 more in revenue that was spent by government, it would still actually reduce the total burden of taxation (i.e. revenue + excess burden + administrative costs). That may be a revenue increase, but not a true tax burden increase. To illustrate the lunacy of this argument, suppose we were in the rare position of being on the right side of the Laffer Curve (where the excess burden is huge) — a tax rate cut would actually be classified as a tax increase because revenue went up (and government would have more money to spend).

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