Concededly, a good deal of tax law is exceedingly technical and abstruse. But no one claims that voters can be magically transformed into tax experts in several easy lessons. The question rather is whether they would grasp the basic essential of tax policy if the issues were adequately presented to them. The real difficulty, I suspect, is they might understand too well.
L. Eisenstein – The Ideologies of Taxation (1961)
Taxes have been in the news more than usual of late and that is saying something. Whatever governments spend they must pay for with money they get from the public. Leaving aside fees charged for some government services, governments acquire that money by taxing people (citizens, residents, foreigners, etc) even if they temporarily borrow some of it. Which people they tax, which activities of those people they tax, and how that burden is distributed among different people and activities have very important consequences for what people do (economic efficiency) and how fair the public judges the burden of the financing of government to be.
Whatever collection and level of activities governments undertake, hopefully reflecting the wishes of the public they serve, should be paid for with taxes that do the least damage to the economy and that are viewed as fair. This article reviews the broadly held principles for judging tax systems by these criteria.
Who and what to tax
Whenever the government collects taxes, someone’s income is reduced regardless of the intended sources of the tax. This is as true of corporate taxes, tariffs, sales taxes, etc, as it is of the personal income tax. This suggests the individual (or the household) as the reference point for establishing concepts of tax fairness.
There are two major camps on this issue, which have provided economic literature with a long, flowery and often heated debate. The newer of the two positions asserts that taxes should be levied against individuals in proportion to the benefits they derive from government. The “benefit principle” is a natural outgrowth of social contract philosophy, and was supported by men like Locke, Hume, Hobbes and Rousseau. The other camp asserts that taxes should be divided among individuals according to their respective abilities to pay. The ability-to-pay principle found support from men like Mill, Sismondi, Say, Marshall and Pigou. Support for both positions can be found in Adam Smith.
Each of these principles has its place. In general, free markets assume that people pay for what they get. This is a key factor in determining how the economy’s scarce resources are to be employed. Likewise, in taxation, if people pay for the benefits they receive from government (that is, are taxed in accordance with the benefit principle), we can have greater confidence that the government will supply the “right” amount of services. This principle leads to the taxation of gasoline to finance highway construction, to the selling of stamps for postal service (if the word service can possibly be applied here), rather than complete “general fund” financing, and to the taxation of property to finance those municipal services that tend to benefit citizens in relation to the property they own, such as fire and police protection, roads, sidewalks and waste disposal.
However, many necessary government services confer benefits that cannot be attributed to specific individuals or that, by their very nature, should not be paid for by the beneficiaries. National defence is an example of the first type. One person’s consumption of it does not reduce its benefits to others. Welfare is an example of the second type. Any programme whose very purpose is to transfer income, say from the wealthy to the poor, obviously cannot tax the poor according to the benefit they receive. At this point we must have recourse to the ability-to-pay principle.
Ideally all government activities that can be financed through direct charges or benefit-related taxes should be (user fees). That would still leave us with the problem of financing those government activities, such as national defence, for which no exclusive individual benefit can be established or for which a benefit-related tax would be inappropriate. The generally accepted standards for designing and collecting taxes for such purposes is that they should allocate the financing burden fairly, should distort the efficient allocation of resources the least possible, and should not cost too much to enforce and collect. The balance of this article broadly reviews and illustrates these principle of “good” tax systems.
Ability to pay
Most people consider the ability-to-pay doctrine an appropriate standard of fairness for government services of the nature we are considering here. A person’s ability to pay is related to his income or wealth. But wealth is the source of income (both human and physical wealth or capital) and thus income itself is generally taken as the more appropriate tax base. Real estate or property taxes are an exception because they are easy to evaluate and collect and relatively neutral (see below and the Henry George movement).
Equal treatment of equals
If income, then, is to be the tax base, what is a fair way of taxing incomes in order to raise the required amount of revenue? One of the most widely held standards of tax fairness is the principle of equal treatment of equals. If income is the basic measure of ability to pay, the principle requires that two individuals with the same income should pay the same tax.
A commonsense application of ability to pay suggests only one modification: since we generally tax households (or family units) rather than individuals, an adjustment should be made for the size of the household being supported by the income in question. The first criterion of an ideal tax system can then be restated to say that all households of the same size with the same income should pay the same tax. Bear in mind that this refers to taxes in excess of the benefit-related taxes households may pay.
The ability to pay reflects total economic gain, regardless of type or source (dividends, interest, wages), less all costs incurred in generating it. A farmer, for example, would deduct the cost of his seeds, fertiliser, land rent, etc. It is this concept of income as the tax base that best satisfies most people’s sense of fairness in taxation and which is most consistent with the second major principle of good taxation: “neutrality”.
There is less agreement on the amount by which a household’s ability to pay increases with income. The base line would be that a household with twice the income has the ability to pay twice the tax. This is part of the case for a flat tax (same tax rate whatever the level of income). The other is the simplicity and neutrality of a flat tax rate. However, some argue that the ability to pay rises more rapidly than income, because of decreasing marginal utility of income, which supports the idea of rising (progressive) tax rates with income. However, it provides no guidance as to how rapidly rates should rise, which thus becomes arbitrary, at least with regard to the ability to pay principle and can lead to the abuse by majorities (average income) of minorities (the wealthy).
The second important criterion of an ideal tax system is neutrality. A tax is neutral if it does not alter the relative prices of goods and services – that is, the price of one good relative to the price of another. In a free-enterprise economy prices are the indicators of value. Prices tell firms how badly consumers want one good relative to another. Taking the cost of producing various goods into account, firms are encouraged by profit to produce that collection of goods that in aggregate are most highly valued. A neutral tax does not interfere with the price system’s task of directing firms into the provision of the “optimal” quantities of the “right” goods and services. A neutral tax is one “that affects the prices of all goods and services equally, thereby leaving their relative prices unchanged.
An excise tax (a tax on one good or a small number of goods) is not a neutral tax. It causes the selected good to appear artificially expensive relative to other goods to consumers and artificially unprofitable to producers, with the result that less of the good will be produced and in its place more of other less valued goods will be produced. Thus an excise tax causes a misallocation of resources; it causes the economy to function less efficiently. However, “sin” taxes (alcohol, tobacco, etc) are sometimes justified on the grounds that their free market prices do not reflect non-production (social) costs to society of their consumption and therefore such taxes can close the gap between private and social cost and thus improve the allocation of resources.
Income and neutrality
An income tax is most neutral when it is universal, ie without deductions (other than the costs of producing it). Deductions from income such as for the interest on home mortgage payments, taxes for state and local government, charitable contributions, provide economic subsidies (so called tax expenditures) that make each of these activities more attractive than does the free market itself. Economists almost universally consider these subsidies undesirable (except maybe for charitable deductions). However, even if the public wishes to subsidise certain activities, economists generally prefer to do so more transparently through budgetary expenditures rather than via tax deductions.
Thus in the UTaxes have been in the news more than usual of late and that is saying something. Whatever governments spend they must pay for with money they get from the public. Leaving aside fees charged for some government services, governments acquire that money by taxing people (citizens, residents, foreigners, etc) even if they temporarily borrow some of it. Which people they tax, which activities of those people they tax, and how that burden is distributed among different people and activities have very important consequences for what people do (economic efficiency) and how fair the public judges the burden of the financing of government to be.
Is there is broad support for “closing deductions or tax loopholes, as they are often called” in order to broaden the income tax base, which would allow lowering the tax rate that would raise the same revenue or as a way to increase revenue without raising rates. However, those affected by individual deductions, eg the housing construction and banking industries, have successfully fought to preserve tax subsidy that benefit them and the deductions live on.
Some have argued that it is fairer to tax on the basis of what people take from the economy (ie consume) rather than what they give it (income from producing). Moreover, a consumption tax is clearly superior to an income tax by the criteria of neutrality, because the latter taxes saving (investment) while the former does not. Saving (investment) generates future income. Taxing saving changes the relative benefit of consuming now or in the future in favour of consuming now and thus reduces economic growth. See my earlier discussion of the merits of replacing all non-benefit (user fee) taxes with a comprehensive sales tax (or Value Added Tax–VAT):
Corporate income tax
Most of the discussion of taxation and tax avoidance in the US in recent years concerns the corporate income tax. This tax is one of the worst by almost all criteria. It double-taxes income, first at the corporate level, then again at the personal income level when corporate profits are distributed as dividends or share price appreciations. This reduces investment and the job creation that accompanies it. It is also very complex and filled with many loopholes that further distort resource allocation. It is very difficult to define and collect when companies operate (produce and sell) all over the world. While most countries tax on the basis of territory (only income of a company generated within their territory is taxed within that territory), the US taxes the worldwide income of its companies when repatriated to the US.
The corporate income tax rate in the US is the highest in the world. These features further distort the allocation of investment globally. The number of Fortune Global 500 headquarters in the United States decreased from 179 to 133 from 2000 to 2011. For all of these distortions, high collection costs, and ease of moving income from high to low tax jurisdictions, corporate income taxes raise “barely more than 2 per cent of GDP (8.5 per cent of tax revenue) in America and 2.7 per cent in Britain.” (The Economist, 16 February, 2012, page 13). The corporate income tax should be abolished.
Even the income tax raises challenging definitional problems when income is earned from work and investments in various places around the world. Trade is distorted as well when goods produced abroad receive different tax treatments, and thus incur different tax costs, than those produced and sold in the home country. Adopting the territorial system of taxation in the US would be an improvement, but the full replacement of all income, wealth and wage taxes with a consumption tax as discussed above (a VAT is a territorial consumption tax) would best fulfil all of the criteria of “good” taxation.