Luxury Taxes

A luxury tax is an excise levy on goods or services considered to be luxuries rather than necessities. If luxuries are consumed conspicuously with the intention to gain social status by distinction, one can call them status goods. The taxation of status goods has a long tradition. Historical examples are taxes on servants, drapes, hair powder, or windows in the late-eighteenth and early nineteenth century in England or Holland. Modern examples can be found in the United States, where luxury taxes were introduced on expensive cars, boats, aircrafts, jewelry, and furs in the late-twentieth century.

[Page 878]Generally, goods can be taxed for several reasons: taxes are levied on goods for fiscal reasons to finance governmental activities, such as defense, infrastructure, and social redistribution. This is not without problems because taxes on goods other than lump-sum taxes distort behavior away from goods (and activities) that are taxed toward goods (and activities) that are not taxed. As a result of the tax, individuals reduce their economic activities, which causes an economic loss over the revenue collected on a societal level. This loss of welfare is known as the excess burden or deadweight loss of taxation.

Initiated by the seminal work of Frank P. Ramsey (1927) and carried on by Peter A. Diamond and James A. Mirrlees (1971), the optimal taxation literature identifies tax systems that minimize the distortion of behavior and with this the excess burden of taxation, subject to a certain amount of governmental revenue. The main question in this stream of literature is, How can a certain budget be raised through commodity taxes with minimal distortions and therefore with a minimum excess burden?

Corrective taxes have a totally other intention. The work of Arthur C. Pigou (1920) analyzes the use of taxes to correct for externalities associated with imperfect private markets. With corrective taxes, the state tries to internalize the negative external effects of a certain kind of destructive or harmful behavior. Examples are pollution of the environment or behavior that negatively affects health, such as the use of cigarettes or alcohol. Here the question to be answered is, How can a certain kind of behavior be changed by taxes to maximize welfare?

Also, the taxation of status goods and luxuries has a long tradition in economic theory and thinking and often implies strong normative statements. From a mercantilist perspective, ostentatious consumption of luxuries diminishes capital accumulation, reduces economic growth, and is to be seen as immoral and condemnable. Therefore, conspicuous consumption was often tried to inhibit by sumptuary laws but with little success.

Bernard de Mandeville offers a contrary view, however, in his poem “The Grumbling Hive: or, Knaves Turn'd Honest” published first in 1705 and again in 1714 in his seminal work The Fable of the Bees: or, Private Vices, Publick Benefits. He states that any selfish economic activity and thus also the conspicuous consumption of luxuries generates economic growth and increases welfare. In other words, from Mandeville's perspective, status seeking is a socially desirable motive.

With the actual development of trade and economic prosperity, the mercantilist thesis that high levels of consumption were incompatible with sustainable economic growth was disproved.

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