Not a Sales TaxI recently spent a few days in Hawaii, teaching some classes and giving a talk at the Iolani school. In the process, I learned something interesting about the Hawaiian tax system. A major source of state income is the general excise tax, a tax, in most cases of 4% (4.5% on Oahu), on the gross revenue of firms. At first glance that looks like a sales tax, but it has rather different implications.Consider the taxation of bread. A farmer grows wheat, sells it to a miller, pays 4% tax on the money he receives. The miller converts the wheat into flour, sells it to the baker, pays 4% tax on the money he receives. The baker sells the bread to customers, pays 4% tax on what they pay him. The wheat has been taxed three times, for a total tax of (because of compounding–taxes on taxes) 12.5%. The miller's contribution, the value added to the wheat by milling it, has been taxed twice. The contribution of the baker has been taxed once. Depending on the relative amounts of value added at each stage, the total tax on the bread is between 4% and 12.5%.Suppose, however, that the bakery is a vertically integrated firm, owns its own farm and mill. That makes the transfer of wheat from farm to mill and of flour from mill to bakery internal to the firm. Only the final stage, the sale of the bread, produces revenue to be taxed. Now the total tax on the bread is only four percent.Which means that one effect of the excise tax is an artificial incentive for vertical integration, making firms in Hawaii larger than they would otherwise be.A Theory of Exploitative TaxationWhile on the subject of taxation in Hawaii, an interesting conjecture occurred to me, which I thought someone else might be interested in pursuing. Consider two adjacent states that are equally attractive in terms of climate, culture, and the like. They compete for taxpayers. If one of them has higher taxes and does not use them to produce a correspondingly better level of services, it will lose citizens, and taxes, to the other.Consider the same story, with one change—one of the states is, for reasons independent of taxes and government services, a pleasanter place to live in than the other. It can collect taxes and use them in ways that produce no benefit to the taxpayers—to buy the votes of state employees, say, with generous wages and pension benefits. As long as the cost of the higher taxes is lower than the value to taxpayers of the state's natural advantages, they have no incentive to move. Hawaii has unusually high state taxes per capita. It is also a very pleasant place to live—comfortable climate, lots of beaches. To turn my conjecture into a research project, you need data of two sorts. One is some measure of the level of exploitative taxation in each state—tax collected minus value of services to the marginal taxpayer/resident. The other is some measure of each state's natural advantages. If the theory—think of it as an elaboration of the Tiebout hypothesis—is correct, the two should be positively correlated.
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