Tuesday Blognado: The taxing question of … tax

Day 2 of Blognado is upon us (or upon me anyway, I’m never sure where your day boundaries are relative to mine), so to keep people interested I thought I’d discuss something light and easily relocatable like the intricacies of tax policy.

Now I’ve done one post on taxes before, but that post wasn’t about tax policy per se.  As far as I’m concerned “how much tax revenue should we collect?” isn’t a valid question.  You answered that question when you set the government’s budget (and determined your fiscal policy settings if you’re doing the Keynesian thing).  So for me the magnitude of taxes is a fiscal policy issue, not a tax policy issue.  Tax policy is about how you raise the tax revenue you need: what gets taxed, how progressive rates should be and what breaks or exemptions will be permitted.  In this post I’m going to outline how I think tax policy should be run generally and what implications that has for the US.

Terminology

Before I wade into the details, I want to define a couple of terms that are important to this type of policy.  There are the names I’m familiar with, though you may have other terms you use for similar concepts.

Tax Rates: There are two tax rates any person faces, and each matters for different reasons.  The most obvious one is your average tax rate, which is what % of your income you pay in taxes.  This reflects the effect taxation has on your standard of living.  It’s also the most useful rate to use when examining how progressive or regressive a tax is.  Your marginal tax rate also matters, but for different reasons.  Your marginal tax rate is calculated as the % of your next dollar of income that is taken as taxes.  If your income increased by $1, how many cents richer would you be after tax?  This rates reflects the effect of taxation on your incentives to earn more income, which is why it’s the rate economists care most about.  The negative economic effects of taxes are caused by high marginal tax rates more than high average tax rates.

Purpose of Taxation: There are two main reasons why governments tax.  The first is to raise revenue, which is what I’m talking about in this post.  Government’s don’t tax income because they think people are pathological workaholics who need to be encouraged to take it easy, the do it because they need cash.  The goal with revenue taxation is to change behaviour as little as possible while collecting as much revenue as possible.  Those goals are in tensions, as I’ll explain later.  The other sort of taxation is pigouvian taxation where you’re trying to correct a failure in the market by discouraging  an activity.  The goals in pigouvian taxation are reversed from revenue taxation, the goal is change behaviour and any money raised is incidental.

Incidence of Taxation:  The incidence of taxation is who actually ends up paying a tax, as opposed to the person or party the tax is officially levied against.  For example, corporate taxes could be paid in three ways: the shareholders could accept lower dividends (in which case the owners are bearing the incidence), the company’s employees could end up receiving lower wages over time (this would be the workers bearing the incidence), or the corporation could raise prices (the consumers are bearing the incidence).  How much of each happens will depend on how the labour, goods and financial markets react to prices changes.  Incidence is very important when considering how progressive a tax really is.  If a corporate tax ends up being paid by workers and consumers it’s probably not as progressive as it might appear.

Principles

When designing an ideal tax system the first thing you want emphasize is neutrality.  Neutrality is ensuring that your tax changes people’s behaviour as little as possible.  In the absence of a market failure any change you make to people’s behaviour is impairing allocative efficiency, and so you should do as little of it as possible.  Practical tips for neutral taxation include:

Use taxes that are hard to avoid.  Capitation taxes (i.e. tax everyone $X) are the best for this since you have to be really dedicated to Going Galt in order to commit suicide just to avoid paying taxes.  Of course capitation taxes are problematic for other reasons (I’ll talk about progressivity below), so other good choices are income taxes, consumption taxes and capital value taxes.  Of these land taxes are the best because the incidence of the tax falls entirely on people who owned land at the time the tax is implemented, making avoidance effectively impossible.  But you don’t want to jack the rates on any one tax too high as that gives the tax accountants too much of an incentive to start finding loopholes (and works to not work quite so hard), so the ideal tax regime will consist of several taxes each with modest rates (how modest depends on your budget of course).  Note also that the more complex your tax system is (with multiple rates, deductions and so on) the less neutral it will tend to be.

The second principle is progressivity, which is how the burden of the tax falls on the poor vs. the rich.  Now how progressive taxes should be is a subjective question, so I won’t take a position on this while I have my policy hat on, though I will say that at regressivity should probably be avoided.  When it comes to measuring the progressivity of a tax I recommend using average rates and not marginal (though check to make sure welfare isn’t making marginal rates too high for the poor or you’ll create a poverty trap), account for the incidence of the tax as well as you can and don’t forget to net welfare spending out of the average tax rate so you can compare the net effect of government on the poor vs. the rich.

The third principle is the laffer curve.  Now the laffer curve is one of those subjects where a lot of nonsense gets written, so here’s the short version from someone who’s actually: yes taxation does experience diminishing returns, even to the point where revenue falls as marginal tax rates rise.  But that revenue-maximising rate might be very high and it’s almost certainly not in the 30-40% range.  However, that doesn’t mean the laffer curve doesn’t matter.  For one thing the diminishing returns will feature all all points of the curve so you can’t expect a 10% increase in average tax rates to yield at 10% increase in revenue.  Secondly, different revenue sources have different laffer curves.  The reason most countries tax capital gains less sharply than other sources of income is that it’s much easier to hide your capital overseas than it is to move overseas yourself.  That ease of avoidance makes taxing capital gains trickier than taxing other income.  Third, the shape of the laffer curve is affected by policy.  The simpler your tax system is, the more neutral the taxes are and the less corrupt the tax collection mechanism is the more revenue you can extract without diminishing returns causing you a problem.  Finally, at some point you’re going to hit that laffer peak, and even before tax rates get that high, they can take a significant toll on economic performance.  A government can noly be so big, given the siz eof the economy and it’s worth bearing that in mind, even if the limits are more expansive than some would suggest.

Advice for the US

So how does all of this translate into US tax policy?  Here are some areas I’d suggest as good starting places for tax reform:

1: Simplify!

The key to a better-functioning tax system is to tax many activities a little, instead of a few activities a lot.  That means clearing away exemptions, deductions, tax breaks and other fiscal bric-a-brac as much as possible.  That allows for lower marginal tax rates without affecting average rates, in fact you can even end up with more revenue than you had before.  Those deductions might look good one at a time, but taken together they render your tax system unmanageable.  Think of all those tax accountants who will be freed up to apply their intellects to more positive-sum activities.

2: Take a second look at corporate taxes

The general opinion is that corporate taxes are paid by the 1% for the benefit of the 99%, but I think that assumption merits testing.  I’d like to see some research done on the actual incidence of corporate taxes, and whether it actually makes sense to tax corporations at all.  Corporate taxes add a lot of complexity to the tax code, and if that can be avoided I think it’s worth investigating.

3: What does “no tax increases” actually mean?

Many conservatives in the US, the Tea Party in particular, have stated strong opposition to tax increases.  But what does that mean in practice?  Is your opposition to higher marginal rates?  If so, how do you feel about simplifying the tax system which will lower marginal rates even while raising revenue?  Do you oppose average rate increases?  If that’s the case I hope you have a brilliant plan to cut spending.  The answer will be different for everyone, all I ask is that you figure out exactly what you will and will not support, and then state it clearly so any opportunities for cooperation can be identified.  Because something has to change, and the sooner the changes begin the easier things will be for everyone.