What tax plan is best for the people of Mississippi? What kinds of taxes are best for job growth and the economy? Why is tax policy important, in the first place?

Dr. Jameson Taylor recently interviewed two Mississippi economists for the answers. Dr. Joshua R. Hendrickson and Dr. Ronald Mau have studied the real-life effects of the Mississippi Tax Freedom Act (HB 1439) and produced a timely report on how the Tax Freedom Act would grow Mississippi’s economy.

Dr. Hendrickson holds a Ph.D. from Wayne State University and is an associate professor of economics at the University of Mississippi. Dr. Mau holds a Ph.D. from the University of Notre Dame and is an assistant professor of economics at the University of Mississippi.   

Dr. Taylor: It seems like the income tax is not something most people think about. People see this money taken out of their paycheck, but don’t realize it’s actually part of their tax bill from the state and federal government. Why is tax policy important for the average Mississippian?

Drs. Hendrickson and Mau: Tax policy is important to the average Mississippian because it affects how much money they really bring home in their paycheck. It also affects the costs of the things that they buy. In addition to other taxes in the economy, these income and consumption taxes reduce household resources available to save or spend.

On a more macro level, tax policy is important because it affects economic activity in the state, a key measure being the total amount invested in the state. When investment income is taxed, investment returns are lower, and investment resources may flow elsewhere. Tax policy can also affect whether businesses want to locate here or workers want to live here. 

Dr. Taylor: Tax policy differs quite a bit from state to state. Nine states essentially have no income tax. Five states have no state sales tax. Mississippi is in the middle of the pack in terms of its overall tax burden. How much does tax policy affect where people choose to move?

Drs. Hendrickson and Mau: Tax policy is important. While tax policy might not always be the most important determinant of where a firm or a particular person decides to move, it does matter at the margin. In other words, when a particular person or company is choosing between moving to one state or another, the taxes that one has to pay in each of those states will play a role in that decision.

Dr. Taylor: The Tax Freedom Act essentially eliminates the income tax in exchange for raising the sales tax, excepting a cut to the grocery sales tax. What does the research show is the best way to levy taxes and what are the tradeoffs between taxing income and taxing consumption/sales?

Drs. Hendrickson and Mau: In general, research shows that a consumption-based tax system is preferred to an income-based tax system on efficiency grounds. People have no doubt heard the phrase, “when you tax something, you get less of it.” This is what economists mean by inefficiency. The tax prevents economic activity that would have taken place without the tax. 

All taxes create distortions in economic activity, but not all taxes create the same magnitude of inefficiency. When designing a tax system, one would like to generate as much revenue as possible with the smallest distortions possible.

Consumption-based tax systems are preferred to income-based tax systems because the former create fewer distortions—income taxes not only tax labor income but also tax income that comes from savings. A tax on savings income lowers the after-tax rate of return on savings. Due to the nature of compound interest, the costs of taxation increase with the duration of savings.

Think about why people save. They might save to buy a new car, to have money for a rainy day, or for their retirement. Thus, we can think of savings as a way to pay for future consumption. Since the cost of taxation increases with the duration of savings, taxing income from savings is like having a tax on future consumption where the tax rate is higher every subsequent year in the future.

As we said, the goal of tax policy is to raise as much revenue as possible while also trying to minimize the distortions in economic activity that come from taxes. A higher and higher tax rate on future consumption not only creates a distortion, but the distortion gets larger with time. People not only have the incentive to save less, but they have an incentive to save for shorter durations of time.

A consumption-based tax system also creates distortions. However, in contrast to a tax on income, a consumption-based tax system taxes consumption in each period equally. As a result, you get fewer distortions.

Dr. Taylor: Your study finds that the Mississippi Tax Freedom Act (HB 1439) would increase incomes and economic activity in Mississippi. Why is this the case? How would it affect incomes in Mississippi?

Drs. Hendrickson and Mau: Our analysis really highlights the benefits of a more efficient tax system. When it comes to tax reform, what policymakers would like to do is increase economic activity without reducing the amount of tax revenue that they bring in. Of course, that is not easy to do. When you eliminate a particular tax, you eliminate the distortions and increase economic activity. However, you also lose the revenue that tax generates. To make up for that lost revenue, you have to create a new tax or increase another existing tax. Doing so generates revenue but also creates new or bigger distortions. For tax reform to be successful by the terms we just described, the new tax regime would have to be more efficient than the existing regime.

Our analysis shows that eliminating the income tax and replacing the revenue with a higher sales tax increases economic efficiency. This is because the distortions of the sales tax are smaller than the distortions from the income tax. The reason is what we described in answer to the last question. Income taxes tend to discourage savings and investment. As a result, shifting away from the income tax provides greater incentives to save and invest. This is where the economic benefits come in. This increase in investment leads to more production, higher marginal productivity of workers, and higher labor income. Furthermore, as a sign that a more efficient tax system drives this, we find that consumption would increase, despite a higher sales tax. This demonstrates that the economic effects of eliminating inefficiencies more than offset the cost of the tax increases.