The Limits of Optimal Tax Theory

July 11, 2005

One of the criticisms of optimal tax theory—which among other things prescribes that each good in an economy should be taxed at a separate rate, higher for necessities and lower for things with good substitutes—is that it ignores the administrative costs of tax systems.

While optimal tax theorists can safely ignore tax compliance costs, actors in the marketplace have no such luxury. From the Chicago Sun-Times, a vivid example of retail sales tax complexity in action:

When two Sun-Times reporters went shopping at a number of retail outlets, they discovered the costs didn’t quite add up. Some products such as Aveeno Baby Soothing Bath Treatment or SpongeBob Band-Aids — indispensable in households with accident-prone toddlers — were overtaxed. Other items such as Equaline 100 percent Pure Petroleum Jelly Lip Treatment and Tropicana grape-flavored juice beverage were undertaxed.

The problem is not the merchants but the complex and confusing state sales tax. If a product is considered a medicine it’s taxed at a different rate, 1 percent, compared with 6.25 percent for other items. But what constitutes a medicine? Sometimes it’s hard to figure that out. For instance, Medicated Noxzema shaving cream is taxed by the state at the 1 percent rate. Barbasol shaving cream is taxed at 6.25 percent. The difference is the word medicated. Chapstick Disney Princess Lip Balm has a lower tax than Equaline petroleum lip treatment because it uses the word “balm.”

On top of this, retailers don’t always seem to know how to apply the tax properly… “Merchants say Illinois is viewed as, hands down, the most complicated sales tax system in the country,” says Robb Carr, of the Illinois Retail Merchants Association.

Setting myriad selective tax rates for different goods in the economy might make sense in a short-run theoretical setting devoid of political institutions and limits on human cognition. But once we account for the costs of tax administration, tax complexity, and the political incentives and constraints actually facing tax policymakers, economist James Buchanan’s famous argument that uniform general taxation is efficient starts to look much more attractive.

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