Luxury taxes – a workable idea? (econ HW)

Are luxury taxes (taxes on expensive luxury goods) a good way to raise government revenue? If so, how can we make them work? If not, why not? Consider the elasticity of demand of luxury goods in your answer.

While luxury taxes have been largely scorned in recent decades, they began in the United States since 1898. In that year, the Congress passed a “luxury tax” on long-distance calls, then an amenity off limits to nearly all but the rich. The tax of 1 cent on any telephone call costing more than 15 cents was levied to help fund the cost of the Spanish-American War, at a time when there were fewer than 700,000 phones in the US. At a time when the US population was about 7.5 million, the telephone was a fairly exclusive item, primarily a new plaything of the wealthy. This tax proved amazingly resilient over time, being revoked in 1902, but revived and raised to 5 cents to help fund WWI in 1917. In 1919 it was turned into a graduated tax (increasing to 10 cents for calls costing more than 50 cents), revoked again in 1924 and introduced again in 1932 to help raise revenue from the wealthy during the depression. Extended indefinitely after the end of WWII, it was only finally revoked in 2006.

The more recent experiments in the 1990s with luxury taxes on cars, yachts and private airplanes all drew the ire of an increasingly anti-tax media, punditry and perhaps even general public, fueled by the outcry of the affected industries and their associated lobbying organizations. These taxes were virtually all repealed by the early 2000s. President Obama has recently floated an idea for a tax on corporate jets, considered by most as little more than a symbolic sop to voters, part of his nascent reelection campaign (and in direct contradiction to his inclusion of increased depreciation allowances in the stimulus bill, a direct attempt to boost sales of such high dollar goods in the corporate sector).

In general, taxation of luxury goods, according to the textbook law of demand, appears to be a poor way to raise government revenue. Since such expensive goods would typically have a highly elastic demand curve, increasing prices on these goods through taxation would be expected to result in a decrease in overall revenue from such goods, leading to a decrease in taxes collected over time and a net negative impact on the economy as jobs and associated spending power are lost by workers in affected industries. Some evidence shows that in the case of the yacht tax of the 1990s, this did occur as buyers purchased boats from non-US dealers or simply shifted their spending to other untaxed luxury goods.

However, to take this simplistic view of the relative merits or pitfalls of luxury taxation is to miss key elements related to both the feasibility and the desirability of such a scheme. Below are a few things that ought to be considered in any such analysis.

1)   One exception to the law of demand widely accepted by microeconomists is the existence of “Veblen goods” (so named for the economist Thorstein Veblen who first described this phenomenon and also coined the term “conspicuous consumption”). This term refers to goods that defy the law of demand, in that their desirability increases with an increase in price. This phenomenon is associated with the concept of price signaling, in which consumers desire goods known to others to be prohibitively expensive. Jewelry, designer clothing and handbags, electronic accessories, wine, automobiles and many other goods can be considered Veblen goods to varying degrees. Distinguishing normal goods with elastic demand curves from Veblen goods is a critical part of creating a workable luxury tax that would be more resilient to the normal behavior of goods on an elastic demand curve, and would assure that most of the tax burden falls on consumers of such products rather than falling on the producers, a common past complaint against the efficacy of such taxes.

2)   Another key to acceptance of a luxury tax is to target the revenues to address externalities which can be linked to the good in question. For instance, if you want to tax luxury automobiles, target the revenues to address improved public transportation through state grants earmarked for mass transit system capital projects. This approach has three important benefits. First, such targeting can provide much needed support for the tax through provision of socially desirable benefits covering large segments of the population, helping to ameliorate complaints that the money is just going to disappear into government coffers. Secondly, such a tax is Pigovian in nature and can be used to signal, in a relatively transparent way, the current priorities that a society has decided to focus on. Finally, the very nature of such a transfer tax is such that arguments that it is a job killer and the like are much harder to make when it is demonstrable that X funds have gone to the purchase of Y new train systems and employed Z workers, etc. In this light, a “luxury tax” can be seen as a progressive Pigovian tax, likely to enjoy much more widespread support among economists, politicians and general public than a poorly targeted and easily avoidable luxury tax taken into general revenues.

3)   In terms of the construction of such taxes, two properties would help to make them both easier to accept and harder to game: relatively low amounts per good/transaction and gradation of the tax when applicable. For certain goods, such as cars, a graded tax beginning at a level shy of what would normally be considered a “luxury” price is an important safeguard against arbitrage. Say cars starting at $15,000 had a $300 tax (if this resulted in an increase in cars under $15,000, then a positive externality for less affluent buyers would be gained as well), then at $20,000 it increased to $500; at $25,000 the tax was $800, at $30,000 it was $1,200, at $40,000, $1800 and so on. A schedule which began with a small tax at lower prices and with a slowly graduating rate would be much more likely to draw ire, much as the telephone tax disappeared into the background of the life of every American consumer for several decades. As another example, charging a 3% tax on first-class airline seats might not sound like much, but a quick conservative calculation* shows that such a tax could yield around $2.6 billion per year. For the approximately 43.8 million annual flyers going first class, these seats are a likely candidate to be considered a Veblen good and tacking on $60 per flight is not likely to dissuade such consumers tremendously (or current baggage fees, which often add 30% or more to the cost of a flight, would have emptied out coach seats a few years ago on the flights of all legacy carriers. Such a tax as this could be used to help fund high-speed rail service, a much less carbon intensive and energy efficient means of transportation.)

4)   Lastly, a strong normative case can be made for such a tax as well. Economists as a group seem relatively fond of consumption taxes (insomuch as they are fond of taxation at all) as a way to incentivize saving and to make taxation a measure of ones use of resources. Luxury taxes, through this lens, are best viewed as a form of progressive consumption tax. We currently live in era where Americans in the top 1% of the income distribution capture an astonishing 2/3rds of each dollar of economic activity generated by the economy. Looking at the cost of this sort of income distribution to society as a whole, it takes $3 of economic activity, with the associated use of scarce (and very often completely finite) resources, to move $1 of wealth into the pockets of 99% of Americans (even within this figure, much of that $1 is captured by the rest of the top 10%). One can make an easy argument, then, that the ability to consumer luxury goods reflects magnified costs to the nation in the form of a requirement to generate greatly accelerated economic activity simply to provide a fractional level of increasing wealth to the vast majority of the population (in comparison to conditions that prevailed under historical income distribution from the 1940s through the 1990s). As such, a program of consumption taxes carefully targeted at Veblen goods is a reasonable way for society at large to recapture some of that massively asymmetrical spending power, in effect deflating the purchasing power of the wealthiest for certain goods a very small part of the way back down towards US historical norms. This overall goal can also be viewed as Pigovian in nature if demand fails to prove inelastic for the taxed goods. In such a case, investment or other uses are likely to be slightly favored by a rational actor. If such taxes succeed in targeting goods that have high inelasticity, then designated societal goals (as discussed earlier) would be served and an overall slight disinclination towards extremes of income disparity would be the other likely long-run outcome.

* Calculation is as follows – 20,000 flights (out of 28,000 average commercial passenger flights per day in US airspace to allow for discount airlines) x 6 average first/business class seats per flight (assuming miles upgrade passengers would still have to pay fees as with existing air travel taxes) x 365 days/yr at an assumed “list” price of $2000 per seat.

Sources:

“Luxury tax under attack” (AP – May 10th, 1991)

http://www.nytimes.com/1991/05/11/business/luxury-tax-under-attack.html?scp=6&sq=luxury%20car%20tax&st=cse

“When a luxury tax paid the way for war” (Walter Pincus/Washington Post – August 18th, 2011)

http://www.washingtonpost.com/blogs/checkpoint-washington/post/when-a-luxury-tax-paid-the-way-for-war/2011/08/18/gIQA9clHNJ_blog.html

“Taxes: Tempest in a Yacht” (Time Magazine – July 1, 1990)

http://www.time.com/time/magazine/article/0,9171,973305,00.html

“Sources: Air Marshalls missing from almost all flights” (Drew Griffin, Kathleen Johnston and Todd Schwarzchild/CNN Travel – March 25, 2008)

http://articles.cnn.com/2008-03-25/travel/siu.air.marshals_1_air-marshals-federal-air-flights?_s=PM:TRAVEL

“U.S. Losing Money As Tax Stalls Luxury Car Sales, Dealers Say” (Julie Jolin/Chicago Tribune – May 24, 1991)

http://articles.chicagotribune.com/1991-05-24/business/9102160364_1_tax-luxury-items-car-dealers

“President Gets Flak for Jet-Tax Idea” (John D McKinnon/Wall Street Journal – July 1, 2011)

http://online.wsj.com/article/SB10001424052702303763404576418132383750882.html

“Can the Middle Class Be Saved?” (Don Peck/The Atlantic Magazine – September 2011)

http://www.theatlantic.com/magazine/archive/2011/09/can-the-middle-class-be-saved/8600/

“Striking it Richer: The Evolution of Top Incomes in the United States” (Emanuel Saez/UC Berkeley 2009)

elsa.berkeley.edu/~saez/saez-UStopincomes-2008.pdf

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About theunlikelyeconomist

theunlikelyeconomist is in the midst of the long slog to attain a PhD in economics.
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