Proper Framework for Evaluating Changes in Tax Policy

September 2, 2009

When analyzing whether a proposed change in tax 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 tax. 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.

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