25 Oct 2011

Follow-Up on Rothbard and Consumption Taxes

Economics, Rothbard 31 Comments

Incidentally, Bob Wenzel and I have been exchanging emails that are as chummy as the bounds of heterosexuality permit. I think we are in 99% agreement on Rothbard’s views towards a consumption tax. So this isn’t me “attacking” anybody, just making sure people don’t draw erroneous inferences from some of Rothbard’s arguments.

In this piece Rothbard says:

Having challenged the merits of the goal of taxing only consumption and freeing savings from taxation, we now proceed to deny the very possibility of achieving that goal, i.e., we maintain that a consumption tax will devolve, willy-nilly, into a tax on income and therefore on savings as well. In short, that even if, for the sake of argument, we should want to tax only consumption and not income, we should not be able to do so.

[T]he general assumption that a sales tax can be readily shifted forward to the consumer is totally fallacious. In fact, the sales tax cannot be shifted forward at all!

Consider: all prices are determined by the interaction of supply, the stock of goods available to be sold, and by the demand schedule for that good. If the government levies a general 20 percent tax on all retail sales, it is true that retailers will now incur an additional 20 percent cost on all sales. But how can they raise prices to cover these costs? Prices, at all times, tend to be set at the maximum net revenue point for each seller. If the sellers can simply pass the 20 percent increase in costs onto the consumers, why did they have to wait until a sales tax to raise prices? Prices are already at highest net income levels for each firm. Any increase in cost, therefore, will have to be absorbed by the firm; it cannot be passed forward to the consumers. Put another way, the levy of a sales tax has not changed the stock already available to the consumers; that stock has already been produced. Demand curves have not changed, and there is no reason for them to do so. Since supply and demand have not changed, neither will price. Or, looking at the situation from the point of the demand and supply of money, which help determine general price levels, the supply of money has remained as given, and there is also no reason to assume a change in the demand for cash balances either. Hence, prices will remain the same.

Now some people in the comments–and to repeat, Wenzel and I are in 99% agreement on this stuff, so I’m not cheekily referring to him in a vague way or something–took these arguments to mean that consumer prices won’t budge, period.

But that’s not right, and it’s not what Rothbard is saying. Look: By the same token, I could say, “It’s impossible for retailers to pass the tax backwards. If the retailers could get away with cutting the wages they pay to workers or the rents they pay to landowners, they already would have done so. Or, the prices for factors are determined by the supply and demand for money. Those haven’t changed.”

So what Rothbard is getting at here, is that you have be more careful in thinking through the mechanism through which the imposition of a sales tax may (ultimately) lead to the consumers paying higher out-of-pocket prices.

It’s easiest to first consider a really narrow and steep tax, like a 1000% surcharge on cigarettes at the retail level. Retailers can’t automatically just jack up prices 1000%; consumers won’t buy as many cigarettes at that price.

What happens is that in the new equilibrium, the official pre-tax price is lower, meaning the retailer earns less from selling a pack of cigarettes. But, the pre-tax price hasn’t fallen enough, so that when you slap on the 1000% surcharge, the consumer has to pay (way) more at the register to get a pack of cigarettes.

Now it’s true, the imposition of a cigarette tax per se doesn’t change the demand curves for cigarettes. The reason the consumers are willing to pay more per pack in the new equilibrium, is that we’ve moved to a lower equilibrium quantity of cigarette packs produced. Specifically, because they’re earning less per pack, retailers now lower their demand for wholesale cartons of cigarettes. This drop in (derived) demand moves up the chain of production, so that ultimately the price of tobacco drops and farmers switch some of their land into other crops.

Thus, in the new equilibrium, there is less tobacco harvested and fewer cigarette packs sold (at least legally at stores).

Rothbard understands all of this. His point is that if you think you are narrowly targeting consumption, while leaving “productive” areas of the economy unharmed, you’re fooling yourself. It’s all intertwined.

What’s more, Rothbard says that the more general you make a so-called consumption tax, the more this effect will end up falling on every productive factor. When we’re trying to figure out which side of the market–producers or consumers–bear a broad-based consumption tax, Rothbard says the only way the producers can escape it (and leave some of it for the consumers to bear, in the form of higher out-of-pocket unit prices) is if workers engage in more leisure and other factors remain idle (because of the lower rents).

So to repeat, neither Rothbard nor Wenzel is saying that the imposition of a consumption tax will have no effect on consumers. Rather, the point is that you can’t limit the impact of a consumption tax on just consumption; it will spill over onto factor incomes, which in turn will have deleterious consequences for consumers.

31 Responses to “Follow-Up on Rothbard and Consumption Taxes”

  1. Joseph Fetz says:

    Aww, you guys are having a bromance? How sweet.

  2. Creighton says:

    I’m confused so will the effect of tax, say the day it is levied, raise the price at all? Because this part sounds like it will:

    “What happens is that in the new equilibrium, the official pre-tax price is lower, meaning the retailer earns less from selling a pack of cigarettes. But, the pre-tax price hasn’t fallen enough, so that when you slap on the 1000% surcharge, the consumer has to pay (way) more at the register to get a pack of cigarettes.”

    Isn’t rothbard saying that the only way prices go up because of a tax, unless demand curves change, is because the producers produce less? So, maybe I’m asking is why specifically do sales taxes have no instantaneous effect at raising prices.

    • Dan says:

      Yes, the price will rise because production will go down. He’s just saying that the prices aren’t rising from the tax because if a company could just raise their prices they would’ve already did that. So the tax causes a decrease in production so that the prices will rise. Unless I’m missing something here.

      • Creighton says:

        So, just to be clear, if tomorrow a national sales tax were to pass in the middle of the night and it was like 50%, then producers, with no previous knowledge of it at all, would not raise prices (this is before they alter their production)

        • Bob Murphy says:

          Well it depends how it is levied probably. If the tax statutorily falls on the consumer–like you take the sticker price then at the register add 50% and this is what the consumer is asked to pay–then who knows what will happen? Some stores will adjust their sticker prices more quickly than others. Gasoline prices are really flexible, so the pre-tax gas price would probably fall pretty quickly.

          It’s not that there would actually need to be a sequence of events. Speculators (or regular producers acting as speculators) can look ahead and see where the new fundamentals are pushing the equilibrium price. E.g. if one retailer realizes that in a month, everybody selling shoes is going to have to post a sticker price that is 30% less (and then is getting hit with a 50% sales tax, remember), but right now none of the other retailers is changing his price, then the first retailer would be smart to cut his prices by 10% (say) and try to dump his inventory before prices plummet.

          • Creighton says:

            But doesn’t rothbard argue that there isn’t a reason for those prices to change (before production is altered). They have the stock, the consumers value the product the same. So, regardless of a tax, wouldn’t the price necessarily have to stay the same if the total demand to hold is the same? Am I misreading Rothbard?

            • Bob Murphy says:

              Creighton, well, Gene is going to say, “No you’re not, Rothbard was wrong.” But if you read the whole piece (not just the part I excerpted), you’ll see Rothbard explicitly deals with the complications I bring up about supply reductions etc.

              I can’t prove this, but I am quite confident that if he were alive and I said, “Prof. Rothbard, if people know the new equilibrium–after adjustments–will be a higher price, is it possible some people will react to this without waiting around?” then Rothbard would agree.

              You are right that he does say the price can’t move at first because the demand is unchanged, but I think that’s really only correct in terms of the logical progression of ultimate causes. The demand curves really will change, because consumers expectations about future prices will change. E.g. let’s say you are used to paying $5 a pack. If you thought that would forever be the stable “trend” price, then a temporary blip up to $6 might make you cut purchases by 50%.

              But, if you thought the new, stable price for cigarettes would be $10 per pack after the farmers stopped planting so much tobacco, then if the price were $8/pack you might load up, buying as many cartons as you could afford after emptying out your bank account. So it would weirdly look like your demand curve shifted to the right. It’s not actually because your taste for smoking increased, but rather your expectations about future prices.

              Rothbard handles this kind of stuff generically in his treatment of demand curves. So I think he would endorse it, and just say he didn’t want to include everything in his handling of the consumption vs. income tax. Again, his main moral here is to show that even a narrowly targeted “consumption tax” ends up hurting income and even saving, contrary to the claims of some of its boosters.

              • Creighton says:

                Ok, yeah, that makes sense. Thanks for the help. I knew that the taxes would change the equilibrium price, I just got caught up on whether or not that would happen before demand and supply curves moved. I know Rothbard would be the first to tell you that demand curves move around all the time in the real world and there is no reason to assume that a tax would not affect peoples value scales.

        • Joseph Fetz says:

          Creighton, you must keep in mind that this is basically an ERE analysis. In the real world there are going to be many unforeseen actions that take place and there is no way to know what these will be or to what extent, or how these will interact with other areas. In an ERE analysis we are looking at the structure of production itself, and how the tax effects ultimately play out, how it shifts the equilibrium in an all things being equal situation.

        • Joseph Fetz says:

          Also, one of the bigger takeaways from this entire debate is that ultimately everybody is paying more due to less supply caused by the actual cost of the tax being born by the original factors of production. Price is really a relative thing, but it is kind of like saying you’re paying the same price, but now there is less availability (the good is now more scarce). The economy is regressing, not progressing, we are producing less goods, not more goods. Obviously, the entire purpose of production is for consumption, and the purpose of consumption is to satisfy our wants/needs, so stifling production hurts everybody.

          Bob, feel free to call me out if I am not understanding this correctly.

  3. Gene Callahan says:

    You’re analysis is correct, but only because it fixes what is obviously wrong in Rothbard! You are being kind.

  4. Major_Freedom says:

    Murphy, your analysis, and Rothbard’s analysis, seems to make the erroneous Keynesian inspired assumption that consumption spending is what finances all the spending up the productive structure, when in reality, or in the Austrian inspired conception if you will, spending is first made in the initial stages, then in the subsequent stages, and so on down the line until consumption.

    Compared to the current tax scheme, reducing taxes on saving and investment, and taxing only consumption, will only have deleterious effects on consumers in the short run, but in the long run it will be better off for consumers if consumers value more consumption in the future versus less consumption in the present.

    For if only consumption is taxed, then people can avoid paying taxes in the present by postponing more of their nominal consumption to the future, and by saving and investing more in the present. This will generate higher incomes in the capital stages, stimulate production of capital goods, and lengthen the productive structure of the economy “tax free” so to speak. Once the productive structure is lengthened, it becomes more productive, and the nominal spending on consumer goods that does take place, while getting taxed at a higher rate, will be in greater supply.

    Your cigarette example seems to be correct in my mind, because capital that used to get invested in selling cigarettes is now being devoted to other lines of production, on account of the lower final payoff to producing cigarettes as opposed to other things, *including producing tobacco*. But does that mean this can be generalized to the whole economy if all consumer goods were taxed more? I don’t see how. People can just save and invest and generate incomes in the capital goods industry in the present, which will make the economy more capital intensive, and when people do spend money on consumption, taxation will occur, but there will be more supply being sold.

    If all we focus on is production relative to labor hours, eliminating taxes on capital and only taxing consumption will have the long term effect of raising productivity.

    I will devote more of my time to very long term projects, that have the net effect of increasing consumer goods output in the distant future. Once that future arrives, sure, the state can tax 20% of those goods, but there will be more and more goods produced over time, not only because of the initial saving and investment, but because the new capital goods brought about by the initial saving and investment can be used to produce even more capital goods and consumer goods in the future just by virtue of being available.

    Imagine Friday and Crusoe on some deserted island. Suppose Friday tells Crusoe that he will stop stealing his fishing nets and boats (eliminate taxes on capital) and 5% of the fish he catches (consumption tax), and he will instead only steal 20% of the fish Crusoe catches (consumption tax). Wouldn’t this be better off for Crusoe in the long run, if Crusoe values more consumption in the future relative to the present? Crusoe can devote more of his time making better and better fish nets and boats, and he’ll be able to keep them for use in his fishing. Sure, Friday will be stealing a larger percentage of fish from Crusoe, but Crusoe’s actual consumption for himself will increase because he has more fish nets and boats with which to work.

    Did I make a mistake here?

    • Bob Murphy says:

      MF, you might be right if we go from an income tax to a consumption tax; in fact I’d agree (in principle, assuming govt takes same $$ in revenue etc.). But I think Rothbard is saying, start from zero, then impose a consumption tax, and it will hit producer incomes.

      • Major_Freedom says:

        This passage:

        “Since future consumption will be taxed, we assume, at the same rate as consumption at present, we cannot conclude that savings in the long run receives any tax exemption or special encouragement. There will therefore be no shift by Jones in favor of savings-and-investment due to a consumption tax.”

        reminds me of the way Shostak considers real savings. He considers consumer goods to be real savings which sustain workers who move from consumer industries to capital industries and thus sustain a lengthened productive structure. Only if there are more consumer goods produced per unit of labor can more and more workers go into capital production and be sustained. In other words, only saving and investment can beget more consumption. More consumption will just reduce a given supply of consumer goods that is made possible by the prevailing saving and investment.

        So this starting from scratch, taxation of consumer goods only business, is like a sudden removal of real savings from the economy, which makes the remaining real savings insufficient in sustaining all the workers in their present jobs, which means that labor will have to move away from capital industries and towards the consumption industry asap, in order to make up for the loss. This will reduce the productivity and real incomes of capital industry producers.

        The capital industries people depend on the consumer goods people to sell enough consumer goods to sustain all the workers in the capital industry, and the consumer industry people depend on the capital industries people to sell enough real capital to sustain the production of consumer goods.

        If all of a sudden a portion of consumer goods revenues are taken away, then Rothbard’s vital assumption is that time preferences will not necessarily change. He assumes that the previous split between nominal consumer spending and nominal capital spending (saving and investment), will go unchanged. If that’s the case, then wouldn’t the profitability of consumer goods sellers decrease relative to capital goods sellers? Wouldn’t that mean scarce capital will be removed from consumer goods sellers where the profitability is relatively lower, and towards capital goods sellers where the profitability is relatively higher? Wouldn’t that increase capital goods incomes relative to consumer goods incomes? Wouldn’t that have the long term effect of increasing real productivity and consumer goods output?

        My thinking is that the assumption of unchanged time preference must be relaxed if we are going to account for producer’s loss of incomes. If we relax this assumption, then should there be a sudden slap of 20% tax on consumption, then people will decrease their saving and investment, and increase their consumer spending, in order to maintain their standard of living, which I think is a dominating assumption rather than unchanged time preference. As this happens, then incomes in capital goods will decrease relative to incomes in consumer goods, and the economy will become less productive.

        I mean, how many of us will not change our time preference at all if the government all of a sudden slapped a draconian 90% tax on consumer goods? Who among us will keep spending the same nominal amount in consumption and the same nominal amount in saving and investment, which results in a drastically lower quantity of consumption and standard of living? I am sure most of us would not choose to live at 10% of our current lifestyles in order to make a point about unchanged time preference. Most of us would choose selling at least SOME of our investments and increasing our consumer spending SOMEWHAT in nominal terms, so that we can live at say 20 or 30% of our former lifestyles, rather than 10%.

        I think that’s where the loss of producer incomes will come from. Yes, the taxation caused it, but I don’t think it caused it in the way Rothbard suggested.

        Then there is the fact that we haven’t even considered where the government spends the tax money, which will further complicate things. I mean, suppose that the government taxed consumer goods 20%, but then turned around and spent that money on the government’s own consumption? It will be like stealing money from you only to then buy what you sell using that same money. Your nominal income will be unchanged, but your standard of living will decrease because you’ll have a smaller inventory. So a 20% tax on consumption that is then spent by government on its own consumption will keep nominal incomes the same for both consumer goods and capital goods, but it will change the nature of which consumer goods are produced and which are profitable, and it will decrease the standard of living of everyone who now has to produce for productionless consumers.

  5. Matthew Murphy says:

    Some of this stuff is still going over my head; but one question I haven’t seen answered: are the consumption/sales tax and the income taxes equally evil? If you had to choose one over the other, which would it be?

    • Joseph Fetz says:

      Yes, this is a really complex subject, especially when thinking it all the way through the structure of production. Rothbard’s theory of production is quite difficult for many to understand unless they have studied it. Shoot, I had to read those chapters more than once, and they are not easy reading and they are long.

      As for your question, I would personally still go with a consumption tax merely on the principle that I see the income tax as theft. A consumption tax will still burden all production, but at least there is some hopes of reaching a new equilibrium and all that that entails. I mean, utility would still be less than it otherwise would have been, but future increases in productivity and efficiency are still bound to occur.

      Ultimately, I would prefer a capitation tax over either if a tax HAD to be levied.

      • skylien says:

        A capitation tax cannot be avoided. Isn’t that a bit of a problem? What happens with people who cannot pay that? I mean there are always people who cannot pay. Of course you can exempt children and the disabled etc.. But wouldn’t that make it quite bureaucratic again, and translate into some sort of income tax if it finally would mean to exempt nearly all without income?

        • Bob Murphy says:

          I think you decapitate them if they can’t pay.

          • MamMoTh says:

            Oh yeah!!!

          • Joseph Fetz says:


    • Bob Murphy says:

      MM, hands down the income tax is way way worse, because of the invasion of privacy. If we could actually be assured of blowing up the IRS and replacing an income tax with a national sales tax, I would much rather live in that world. But, Cain isn’t getting rid of the income tax.

      • Matthew Murphy says:

        Other than privacy invasion, though, the two are roughly equal in economic harm?

        It’s surprising Schiff doesn’t seem to have a much problem with the extra pipeline in Cain’s plan. Even though he knows better.

        • Bob Murphy says:

          No, an income tax imposes a double-whammy on individuals. They take the given amount of money (which we assume is fixed for the sake of apples-to-apples), and they make future consumption artificially more expensive. So they’re hurting you in two ways, whereas a consumption tax just hurts you in the first way but then lets you distribute the blow optimally.

  6. eduardo says:

    There is yet another way to see the imposition of a consumption tax, from the point of view of the consumer it may look as if the producers succesfully colluded to raise prices, a situation previously not attainable due to issues of credibility, fear of defection, low entry costs (you know all those incentives good old markets provide benefitting the consumer). A new equilibrium may form where pre-tax prices do not change and levels of consumption do not change either, the levels of private savings and investment will be lower and government spending/deficit are indeterminate (tax revenues will be higher but who knows the evil that lurches in the heart of men?).

  7. Cody S says:

    It seems like if a politician ever really wanted to levy a tax that was based on the notion that the “rich” and the “fat cats” aren’t paying their fair share, but also one which would “not hurt the economy”, then they should propose a tax on accumulated wealth rather than income.

    I’m not saying I would; just that it seems like taxing cash balances rather than compensation would have more anti-fat cat muscle on the surface. Basically, tax accumulation rather than flow.

    And yet, I don’t see this sort of proposal floating around much. The “fat cats” or “millionaires”, when a politician is speaking, are always people who make more salary than me, instead of people with enough real assets to avoid needing a salary at all.

    Is there some good reason other than campaign donations that wealth redistribution folks like Reid or the president don’t suggest this sort of thing?

  8. kavram says:

    I think the best explanation is that prices for the current inventory of cigarettes won’t change, since retailers (assuming they’re rational) will see this as a “sunk cost,” and therefore will just try to salvage whatever revenue they can out of them. But once that inventory is cleared, less cigarettes will be produced/purchased, and the post-tax price will rise. It’s probably more complex than this, but you get the gist.

    • Bob Murphy says:

      Kavram wrote:

      I think the best explanation is that prices for the current inventory of cigarettes won’t change, since retailers (assuming they’re rational) will see this as a “sunk cost,” and therefore will just try to salvage whatever revenue they can out of them. But once that inventory is cleared, less cigarettes will be produced/purchased, and the post-tax price will rise.

      Right, I think that’s the kind of logic Rothbard is walking the reader through.

      But now I’m tweaking it by bringing in a complication: Let’s say you’re a retailer, and you’re sitting on 100 packs of cigarettes that used to sell for $5 each. You know that a month from now, in the new equilibrium, you will be charging $10/each because your wholesale price will go up, some of your competitors will stop carrying cigarettes altogether, etc. etc. So right now, are you going to keep selling your current inventory at $5/each? Why not just wait a month and sell them for twice as much? Or, why not start selling them now at $9/each if that makes sense, and eventually the price rises to $10 by the time we reach the new equilibrium. Etc.

      To repeat, this is immune to Rothbard saying “if the supply/demand curves don’t move, the price has to stay the same.” The actual supply/demand curves have moved, because of speculation. Both retailers and consumers look ahead and realize the new equilibrium price is going way up, so that affects what they do now, even though their underlying preferences haven’t changed.

  9. RG says:

    I believe the elimination of all taxes outside of consumption tax for a long enough period of time would give rise to a wave of black market activity that would eventually kill fiat money, taxes, and government altogether.

  10. Evan says:

    I’m not sure why, but I find this whole debate absolutely fascinating.

    I can’t see how Rothbard is wrong, though. Austrian Economics seems to emphasize that production is a process. Since the taxes being compared (income versus consumption) are purportedly “revenue neutral”, how could it be possible that government could simply shift taxation from one step of the process to another step in a way that leaves MORE wealth in the private economy? Wouldn’t that be analagous to saying that if we draw water out of the east side of a bucket rather than the west side, the water level of the bucket won’t fall as fast?

    I sort of get the logic that, by incentivizing savings against consumption, people will defer consumption, but since all savings is eventually directed at future consumption, won’t this shift only amout to a brief adjustment period? Is the magic surplus somehow a result of people being tricked by the tax structure into forgoing leisure, yielding more wealth on paper?

    • Bob Murphy says:

      Evan, no, you’re missing the original point I was trying to make about an income tax giving a double-whammy. If you are having trouble with this, probably hundreds of other readers are too, so I’ll try to post something in the next day or two to clarify.

      • Evan says:

        Thank you Dr. Murphy. I look forward to it.

        I went back and re-read some of your posts on the debate and noticed your point that an advantage of the consumption tax is that the consumer is able to choose the period in which he is hit with the tax (presumably by deferring consumption to a future period.)

        But if that’s the case, couldn’t I just as easily say that the worker can choose which period he gets hit with the income tax by deferring his income to a later period? What exactly makes the first statement correct and the last statement incorrect?