The Sin Tax Paradox

– March 1, 2021 Reading Time: 4 minutes

All taxes are “bad” in the sense that they distort economic activity. This suggests that to maximize human happiness, a.k.a prosperity, governments should remain as small as possible and tax in the least distortionary way possible. As governments grow (rightly or not), the quest for the LBT or “Least Bad Tax” (a subset of Optimal Tax Theory) becomes all the more important. One putative LBT candidate, taxes on “sin” levied to ameliorate social problems like “excessive” consumption of X, promise more than it has delivered.

First, many people who consume X really, really like X, so they find creative but economically costly ways to decrease their tax burden rather than decrease their consumption of X. That causes distortions like underground markets, bribery of tax officials, exploitation of loopholes, and so forth (much as with banned goods or activities as recently described by AIER’s Peter C. Earle).

Second, governments can become addicted to their own sin taxes. For example, after the War of 1812 the city of New York, then with a population of about 120,000, became addicted to the sale of liquor licenses. It received $10,000 per year from the sale of licenses “to persons to retail liquors, which are not to be drunk on the premises of the retailer.” With that market saturated but the political need for cash unquenchable, the city started to sell licenses to retail liquors “which are to be drunk on the premises of the retailer.” The result, according to the Society for the Prevention of Pauperism anyway, was a jump in alcohol consumption as retailers pushed harder for sales in order to cover their licensing fees.

Worse, more alcohol consumption increased crime, and hence government expenditures, “for it is a fact, that three-fourths of the assaults and batteries committed in the city and county of New-York, and brought before the court of sessions, proceed from the degrading use of ardent spirits.” The result of taxing alcohol retailers, the Society concluded, was not a reduction in drinking but rather “a contradictory and clashing system of municipal regulations of the most injudicious tendency, fostering guilt and moral abandonment” [Anon., The Second Annual Report of the Managers of the Society for the Prevention of Pauperism, in the City of New-York (New York: E. Conrad, 1820), 9].

That was not the first time, nor the last, that a government sinned due to its own sin tax. Taxes do decrease consumption of the taxed commodity or activity, pretty much in proportion to the size of the levy and the effectiveness of its enforcement, but that produces a paradox. Instead of increasing the tax until it has extirpated the unwanted behavior or product, governments often find themselves dependent on the revenue to the point that they are careful not to discourage, and may even begin to encourage, the putative sin. It has happened with alcohol, gambling, prostitution, tobacco, and other Xs, and we may soon see it with firearms if the Biden administration gets its way with a $200 tax on “assault” weapons, whatever that term means.

A $200 tax on the transfer of fully automatic weapons, commonly called “machine guns,” has been in place since passage of the National Firearms Act of 1934. Nevertheless, in April 2020 Americans legally owned almost 727,000 such weapons. Two hundred bucks was a nice chunk of change in 1934 but the tax obviously did not dissuade all legal ownership (and of course encouraged illegal ownership, especially of relatively cheap and concealable automatic weapons like UZIs and TEC-9s). After the Great Inflation of the 1970s, though, $200 wasn’t so much anymore, so the government could bring itself to ban the sale of new machine guns in 1986 (unconstitutionally in my view, but that for another time). In fact, bloated government bureaucracy had by then reduced the net revenue produced by the 1934 tax to almost nil.

A $200 tax on the transfer of the 400 million non-automatic firearms currently in the country, though, especially if indexed to the inflation that may hit soon, would make government bean counters tipsy. Gun sales by one careful estimate topped 20 million in 2020, which was a crazy year in many ways, so let’s take 2019 sales of 14 million as a base instead and shave off 4 million in sales that will not occur or that will go underground due to the tax. Ten million times $200 is $2 billion, a drop in the bucket as they say, but big enough to fund a lot of gender studies programs in Pakistan. A $200 per year tax on the entire stock of firearms that some fear may be coming would garner an intoxicating $80 billion per year if held constitutional.

Marijuana taxes are another emerging area of addiction at the state level. In an interesting twist, the Federal government rakes in an estimated $5 billion in extra taxes by keeping weed illegal because that makes pot businesses ineligible for various federal tax breaks.

Finally, if you really believe that earthlings need to reduce greenhouse gas emissions, encouraging an emissions tax may well doom the planet. Note, for example, how a Brookings report suggests that carbon taxes could be “part of the fiscal solution.” The only way that labeling carbon emission a sin can help to reduce budget deficits, though, is if people continue to emit carbon, as they have in countries like Denmark, Finland, and Sweden that implemented carbon taxes over the last few decades.

In short, it is time to jettison the notion of taxing sin and think hard again about the LBT advocated by Milton Friedman and Henry George, a tax on the unimproved value of land. It’s a tax, and hence bad, but it’s less distortionary than taxing income or sin and it doesn’t have to be high if government would only stick to its core functions.

Robert E. Wright is the (co)author or (co)editor of over two dozen major books, book series, and edited collections, including AIER’s The Best of Thomas Paine (2021) and Financial Exclusion (2019). He has also (co)authored numerous articles for important journals, including the American Economic Review, Business History Review, Independent Review, Journal of Private Enterprise, Review of Finance, and Southern Economic Review. Robert has taught business, economics, and policy courses at Augustana University, NYU’s Stern School of Business, Temple University, the University of Virginia, and elsewhere since taking his Ph.D. in History from SUNY Buffalo in 1997. Robert E. Wright was formerly a Senior Research Faculty at the American Institute for Economic Research.