An Excise State of Mind

As the economic crisis driven by the pandemic has continued, a troubling trend 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 discussions has arisen. It is common these days to hear finance ministers refer to tax increases that would be narrowly targeted at a particular business model or industry simply based on the fact that those businesses appear to be succeeding in the midst of the crisis.

Political leaders say things like, “If digital businesses are succeeding in the pandemic, then we should have a tax that is specific to digital companies.” Or, “Healthcare and pharmaceutical businesses stand to profit significantly from the health crisis, we should ensure they pay their fair share with a minimum tax.”

Policies that have popped up reflect a (continued) focus on digital services taxes, financial transaction taxes, excess profits taxes, and minimum taxes.

These suggestions result from what I like to call an “Excise State of Mind.” Excise taxes are often used to target an activity or industry with the intent of diminishing incentives for that activity to take place in the future. Taxes on gross revenues operate with similar impact. Minimum taxes and excess profits taxes can fall into a similar vein, though not quite to the same extent.

In each case, the policies shift from a broad tax framework for taxing final consumption or income to an approach with significant problems. In some cases, the policy is designed without regard for income, essentially an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. , as is the case with digital services taxes and financial transaction taxes.

In the case of excess profits taxes and minimum taxes, the policies create separate tax bases that are usually made broader than a standard income tax by essentially clawing back otherwise deductible expenses or allowable credits.

Moving away from taxing net income, either to a broader base or all the way to gross revenues, damages investment and production incentives.

An Example

To give an example of how these taxes compare, assume a business has $1,000 in sales and $200 in profits after spending $800 in deductible inventory, capital costs, and wages. The business has a healthy 20 percent profit margin.

A 20 percent corporate income tax would have that business pay $40 in taxes.

A minimum tax that claws back $200 of deductible expenses and applies a 15 percent rate to the redefined tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. of $400, would result in a tax payment of $60.

An excess profits tax of 30 percent that applies (in addition to the standard corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. ) on profits over a 10 percent margin would generate a tax bill of $30 by itself.

A 5 percent tax on the $1,000 in gross revenue from sales would have that business pay $50, a 25 percent effective tax rate.

At each departure from the corporate income tax, new tax costs are incurred and the effective tax rate changes in ways that reduce incentives to invest and grow a business.

Four Taxes, Four Different Results

20 Percent Corporate Income Tax			15 Percent Minimum Tax
Revenues from Sales	$1,000		Revenues from Sales	$1,000
Deductible Expenses for Inventory, Capital Costs, and Wages	$800		Deductible Expenses for Inventory, Capital Costs, and Wages (Limited)	$600
Profits	$200		Taxable Base	$400
Corporate Income Tax (20% x $200)	$40		Minimum Tax (15% x $400)	$60
30 Percent Excess Profits Tax (on profit margins above 10%)			5 Percent Tax on Gross Revenues
Revenues from Sales	$1,000		Revenues from Sales	$1,000
Deductible Expenses for Inventory, Capital Costs, and Wages	$800		Taxable Base	$1,000
Profit Margin	20%		Gross Revenue Tax (5% x $1,000)	$50
Taxable Base (20% – 10% = 10%; 10% x $1000 = $100)	$100
Excess Profits Tax (30% x $100)	$30
Source: Author Calculations

What About the Principles?

There are justifications for excise taxes in some policy areas, including addressing externalities, but the trouble with the current thinking is that it treats success as an externalityAn externality, in economics terms, is a side effect or consequence of an activity that is not reflected in the cost of that activity, and not primarily borne by those directly involved in said activity. Externalities can be caused by either production or consumption of a good or service and can be positive or negative. – adopting a new tax simply because it could raise additional revenue from profitable businesses. In this way, the excise state of mind has the potential to seriously undermine a principled approach to tax policy.

Tax Foundation relies on four principles for sound tax policy – neutrality, stability, simplicity, and transparency.

An excise state of mind, if taken to its full effect, undermines each of the principles.

Industry specific taxes are, by definition, non-neutral. Designing tax systems around temporary events creates instability and uncertainty, and a tax code that becomes riddled with taxes tailored for certain business models will be incredibly complex. Finally, taxes on gross revenue can lead to hidden costs within the system, as the statutory tax rate is always lower than the effective tax rate.

A tax system that devolves into special sectoral taxes will create all sorts of new barriers to investment, costs of compliance, and challenges for administration and auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. . If policymakers are interested in a tax system that promotes economic dynamism and raises sufficient revenue for spending programs, then an excise state of mind moves entirely in the wrong direction.

A Real Problem

Imagine for a moment, a tax system that has a relatively standard corporate income tax, as most countries do. Then imagine that the system also has a set of special taxes on gross revenues, some of which have industry-specific thresholds and application. Then consider the potential for the revenue collected from those special taxes to be so significant that it overtakes the revenue collected from the corporate income tax.

This country exists today, and its name is France.

In France, corporate income tax revenues are dwarfed by revenues from so-called production taxes. The French Council of Economic Analysis found that in 2016, production taxes brought in €72 billion while corporate income taxes raised just €30 billion.

Of the three main production taxes, two are particularly insidious. One taxes revenues directly and the other has a progressive rate structure where the higher rates are tied to gross revenues. The Council provides clear analysis showing that these taxes are bad for the French economy.

The French government has recognized the need for reform and has pledged significant cuts to those taxes. In the next two years that will amount to €20 billion in tax relief.

And yet, even as the production taxes will diminish, France is fully engaged in the excise state of mind when it comes to digital companies. The French digital services tax is a tax on gross revenue that is sector-specific and will thus result in much higher effective tax rates than the 3 percent rate in law.

The European Union is also enthralled by the excise state of mind when it comes to digital taxes. The European Parliament voted this week in support of using a digital tax and a financial transaction tax to support EU budget plans.

Conclusion

Tax policy can be a powerful tool to either set the stage for an economy to grow and flourish, or it can be used to destroy incentives to invest, produce, and make a profit. The excise state of mind ignores the principles behind sound tax policy and instead opts for narrow, targeted, and distortionary taxes.

Even during a crisis when budgets are squeezed, policymakers should put their efforts into serious reforms of existing income and consumption taxes rather than leaving good tax policy behind for an excise state of mind.

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