It is widely held that income taxes have a negative effect
on saving. By taxing both labor income (wages and salaries) and investment
income (interest on savings, dividends, etc.) personal income taxes subject
savers to double taxation, forcing them to pay taxes first on their salary and
then again on the investment income earned by the portion of their salary which
they save. This double taxation makes saving less financially rewarding.
Acting as rational economic agents, individuals respond to
the incentives of income taxes by saving less of their income than they would in
the absence of an income tax. This artificially low level of saving causes the
capital stock to be smaller than it otherwise would be. In the long run, this
leads to slower productivity growth, which causes living standards to rise less
rapidly and reduces corporate profitability, thus making it more difficult for
firms to expand and hire new workers. In sum, income taxes place a major burden
on economic growth.
Consumption taxes, on the other hand, do not directly
punish saving. Since a given level of income can only be consumed once, using
consumption as the tax base avoids the problem of double taxation present under
an income tax. As a result, consumption taxes do not discourage saving.
Therefore, the growth-inhibiting effects of the income tax are not present with
a sales tax. Given the choice between a higher income tax and a higher sales
tax, the sales tax wins hands down with respect to minimizing the harm to