DRI-280 for week of 7-7-13: Unintended Consequences and Distortions of Government Action

An Access Advertising EconBrief:

Unintended Consequences and Distortions of Government Action

The most important cultural evolution of 20th-century America was the emergence of government as the problem-solver of first resort. One of the most oft-uttered phrases of broadcast news reports was “this market is not subject to government regulation” – as if this automatically bred misfortune. The identification of a problem called for a government program tailored to its solution. Our sensitivity, compassion and nobility were measured by the dollar expenditure allocated to these problems, rather than by their actual solution.

This trend has increasingly frustrated economists, who associate government action with unintended consequences and distortions of markets. Since voluntary exchange in markets is mutually beneficial, distortions of the market and consequences other than mutual benefit are bad things. Economists have had a hard time getting their arguments across to the public.

One reason for this failure is the public unwillingness to associate a cause with an effect other than that intended. We live our lives striving to achieve our ends. When we fail, we don’t just shrug and forget it – we demand to know why. Government seems like a tool made to order for our purposes; it wields the power and command over resources that we lack as individuals. Our education has taught us that democracy gives us the right and even the duty to order government around. So why can’t we get it to work the way we want it to?

The short answer to that is that we know what we want but we don’t know how government or markets work, so we don’t know how to get what we want. In order to appreciate this, we need to understand the nature of government’s failures and of the market’s successes. To that end, here are various examples of unintended consequences and distortions.

Excise Taxation

One of the simplest cases of unintended, distortive consequences is excise taxation. An excise tax is a tax on a good, either on its production or its consumption. Although few people realize it, the meaningful economic effects of the tax are the same regardless of whether the tax is collected from the buyer of the good or from the seller. In practice, excise taxes are usually collected from sellers.

Consider a real-world example with purely hypothetical numbers used for expository purposes. Automotive gasoline is subject to excise taxation levied at the pump; e.g., collected from sellers but explicitly incorporated into the price consumers pay. Assume that the price of gas net of tax is $2.00 per gallon and the combination of local, state and federal excuse taxes adds up to $1.00 per gallon. That means that the consumer pays $3.00 per gallon but the retail gasoline seller pockets only $2.00 per gallon.

Consider, for computational ease, a price decrease of $.30 per gallon. How likely is the gasoline seller to take this action? Well, he would be more likely to take it if his total revenue were larger after the price decrease than before. But with the excise tax in force, a big roadblock exists to price reductions by the seller. The $.30 price decrease subtracts 15% from the price (the net revenue per unit) the seller receives, but only 10% from the price per unit that the buyer pays. And it is the reduction in price per unit paid by the buyer that will induce purchase of more units, which is the only reason the seller would have to want to reduce price in the first place. The fact that net revenue per unit falls by a larger percentage than price per unit paid by consumers is a big disincentive to lowering price.

Consider the kind of case that is most favorable to price reductions, in which demand is price-elastic. That is, the percentage increase in consumer purchases exceeds the percentage decrease in price (net revenue). Assume that purchases were originally 10,000 gallons per week and increased to 11,200 (an increase of 12%, which exceeds the percentage decrease in price). The original total revenue was 10,000 x $2.00 = $20,000. Now total revenue is 11,200 x $1.70 = $19,040, nearly $1,000 less. Since the total costs of producing 1,200 more units of output are greater than before, the gasoline seller will not want to lower price if he correctly anticipates this result. Despite the fact that consumer demand responds favorably (in a price-elastic manner) to the price decrease, the seller won’t initiate it.

Without the excise taxation, consumers and seller would face the same price. If demand were price-elastic, the seller would expect to increase total revenue by lowering price and selling more units than before. If the increase in total revenue were more than enough to cover the additional costs of producing the added output, the seller would lower price.

Excise taxation can reduce the incentive for sellers to lower price when it is imposed in specific form – a fixed amount per unit of output. When the excise tax is levied ad valorem, as a percentage of value rather than a fixed amount per unit, that disincentive is no longer present. In fact, the specific tax is the more popular form of excise taxation.

The irony of this unintended consequence is felt most keenly in times of rising gasoline prices. Demagogues hold sway with talk about price conspiracies and monopoly power exerted by “big corporations” and oil companies. Talk-show callers expound at length on the disparity between price increases and price decreases and the relative reluctance of sellers to lower price. Yet the straightforward logic of excise taxation is never broached. The callers are right, but for entirely the wrong reason. The culprit is not monopoly or conspiracy. It is excise taxation.

This unintended consequence was apparently first noticed by Richard Caves of Harvard University in his 1964 text American Industry: Structure, Conduct, Performance.

ObamaCare: The 29’ers and 49’ers

The recent decision to delay implementation of the Affordable Care Act – more familiarly known as ObamaCare – has interrupted two of the most profound and remarkable unintended consequences in American legislative history. The centerpiece of ObamaCare is its health mandates: the requirement that individuals who lack health insurance acquire it or pay a sizable fine and the requirement that businesses of significant size provide health plans for their employees or, once again, pay fines.

It is the business mandate, scheduled for implementation in 2014, which was delayed in a recent online announcement by the Obama administration. The provisions of the law had already produced dramatic effects on employment in American business. It seems likely that these effects, along with the logistical difficulties in implementing the plan, were behind the decision to delay the law’s application to businesses.

The law requires businesses with 50 or more “full-time equivalent” employees to make a health-care plan available to employees. A “full-time-equivalent” employee is defined as any combination of employees whose employment adds up to the full-employment quotient of hours. Full-time employment is defined as 30 hours per week, in contradiction to the longtime definition of 40 hours. Presumably this change was made in order to broaden the scope of the law, but it is clearly having the opposite effect – a locus classicus of unintended consequences at work.

Because the “measurement period” during which each firm’s number of full-time equivalent number of employees is calculated began in January 2013, firms reacted to the provisions of ObamaCare at the start of this year, even though the business mandate itself was not scheduled to begin until 2014. No sooner did the New Year unfold than observers noticed changes in fast-food industry employment. The changes took two basic forms.

First, firms – that is, individual fast-food franchises – cut off their number of full-time employees at no more than 49. Thus, they became known as “49’ers.” This practice was obviously intended to stop the firm short of the 50-employee minimum threshold for application of the health-insurance requirement under ObamaCare. At first thought, this may seem trivial if highly arbitrary. Further thought alters that snap judgment. Even more than foods, fast-food firms sell service. This service is highly labor-intensive. An arbitrary limitation on full-time employment is a serious matter, since it means that any slack must be taken up by part-timers.

And that is part two of the one-two punch delivered to employment by ObamaCare. Those same fast-food firms – McDonald’s, Burger King, Wendy’s, et al – began limiting their part-time work force to 20 hours per week, thereby holding them below the 30-hour threshold as well. But, since many of those employees were previously working 30 hours or more, the firms began sharing employees – encouraging their employees to work 20-hour shifts for rival firms and logging shift workers from those firms on their own books. Of course, two 20-hour shifts still comprises (more than) a full-time-equivalent worker, but as long as the total worker hours does not exceed the 1500-hour weekly total of 50 workers at 30 hours, the firm will still escape the health-insurance requirement. Thus were born the “29’ers” – those firms who held part-time workers below the 30-hour threshold for full-time-equivalent employment.

Are the requirements of ObamaCare really that onerous? Politicians and left-wing commentators commonly act as if health-insurance were the least that any self-respecting employer could provide any employee, on a par with providing a roof to keep out the rain and heat to ward off freezing cold in winter. Fast-food entrepreneurs are striving to avoid penalties associated with hiring that 50th full-time-equivalent employee. The penalty for failing to provide health insurance is $2,000 per employee beginning with 30. That is, the hiring of the 50th employee means incurring a penalty on the previous 20 employees, a total penalty of $40,000. Hiring (say) 60 employees would raise the penalty to $60,000.

A 2011 study by the Hudson Institute found that the average fast-food franchise makes a profit of $50,000-100,000 per year. Thus, ObamaCare penalties could eat up most or all of a year’s profit. The study’s authors foresaw an annual cost to the industry of $6.4 billion from implementation of ObamaCare. 3.2 million jobs were estimated to be “at risk.” All this comes at a time when employment is painfully slow to recover from the Great Recession of 2007-2009 and the exodus of workers from the labor force continues apace. Indeed, it is just this exodus that keeps the official unemployment rate from reaching double-digit heights reminiscent of the Great Depression of the 1930s.

Our first distortion was an excise tax. The ObamaCare mandates can also be viewed as a tax. The business mandates are equivalent to a tax on employment, since their implementation and penalties are geared to the level of employment. The Hudson study calculated that, assuming a hypothetical wage of $12 per hour, employing the 50th person would cost the firm $52 per hour, of which only $12 was paid out in wages to the employee. The difference between what the firm must pay out and what the employee receives is called “the wedge” by economists, since it reduces the incentive to hire and to work. The wider the wedge, the greater the disincentive. Presumably, this is yet another unintended consequence at work.

ObamaCare is a law that was advertised as the solution to a burgeoning, decades-old problem that threatened to engulf the federal budget. Instead, the law itself now threatens to bring first the government, then the private economy to a standstill. In time, ObamaCare may come to lead the league in unintended consequences – a competition in government ineptitude that can truly be called a battle of the all-stars.

The Food Stamp Program: An Excise Subsidy

In contrast to the first two examples of distortion, the food-stamp program is not a tax but rather its opposite number – a subsidy. Because food stamps are a subsidy given in-kind instead of in cash – a subsidy on a good in contrast to a tax on a good – they are an excise subsidy.

Food stamps began in the 1940s as a supplement to agricultural price supports. Their primary purpose was to dispose of agricultural surpluses, which were already becoming a costly nuisance to the federal government. Their value to the poor was seen as a coincidental, though convenient, byproduct. Although farmers and the poor have long since exchanged places in the hierarchy of beneficiaries, vestiges of the program’s lineage remain in its residence in the Agriculture Department and the source of its annual appropriations in the farm bill. (Roughly 80% of this year’s farm bill was given over to monies for the food-stamp program, which now reaches some 47.3 million Americans, or 15% of the population.)

The fact that agricultural programs help people other than their supposed beneficiaries is not really an example of unintended consequences, since we have known from the outset that price supports, acreage quotas, target prices and other government measures harm the general public and help large-scale farmers much more than small family farmers. The unintended consequences of the food-stamp program are vast, but they are unrelated to its tenuous link to agriculture.

Taxes take real income away from taxpayers, but – at least in principle – they fund projects that ostensibly provide compensating benefits. The unambiguous harm caused by taxes results from the distortions they create, which cause deadweight losses, or pure waste of time, effort and resources. Subsidies, the opposite number of taxes, create similar distortions. The food stamp program illustrates these distortions vividly.

For many years, program recipients received stamp-like vouchers entitling them to acquire specified categories of foodstuffs from participating sellers (mostly groceries). The recipient exchanged the stamps for food at a rate of exchange governed by the stamps’ face value. Certain foods and beverages, notably beverage alcohol, could not be purchased using food stamps.

Any economist could have predicted the outcome of this arrangement. A thriving black market arose in which food stamps could be sold at a discount to face value in exchange for cash. The amount of the discount represented the market price paid by the recipient and received by the broker; it fluctuated with market conditions but often hovered in the vicinity of 50% (!). This transaction allowed recipients to directly purchase proscribed goods and/or non-food items using cash. The black-market broker exchanged the food stamps (quasi-) legally at face value in a grocery in exchange for food or illegally at a small discount with a grocery in exchange for cash. (In recent years, bureaucrats have sought to kill off the black market by substituting a debit card for the stamp/vouchers.)

The size of the discount represents the magnitude of the economic distortion created by giving poor people a subsidy in excise form rather than in cash. Remarkably, large numbers of poor people preferred cash subsidies to markedly that $.50 in cash was preferred to $1.00 worth of (government-approved) foodstuffs. This suggests that a program of cash subsidies could have made recipients better off while spending around half as much more money on subsidies and dispensing with most of the large administrative costs of the actual food-stamp program.

Inefficiency has been the focus of various studies of the overall welfare system. Their common conclusion has been that the U.S. could lift every man, woman and child above the arbitrary poverty line for a fraction of our actual expenditures on welfare programs simply by giving cash to recipients and forgoing all other forms of administrative endeavor.

Of course, the presumption behind all this analysis is that the purpose of welfare programs like food stamps is to improve the well-being of recipients. In reality, the history of the food-stamp program and everyday experience suggests otherwise – that the true purpose of welfare programs is to improve the well-being of donors (i.e., taxpayers) by alleviating guilt they would otherwise feel.

The legitimate objections to cash subsidy welfare programs focus on the harm done to work incentives and the danger of dependency. The welfare reform crafted by the Republican Congress in 1994 and reluctantly signed by President Clinton was guided by this attitude, hence its emphasis on work requirements. But the opposition to cash subsidies from the general public, all too familiar to working economists from the classroom and the speaking platform, arises from other sources. The most vocal opposition to cash subsidies is expressed by those who claim that recipients will use cash to buy drugs, alcohol and other “undesirable” consumption goods – undesirable as gauged by the speaker, not by the welfare recipient. The clear implication is that the food-stamp format is a necessary prophylactic against this undesirable consumption behavior by welfare recipients, the corollary implication being that taxpayers have the moral right to control the behavior of welfare recipients.

Taxpayers may or may not be morally justified in asserting the right to control the behavior of welfare recipients whose consumption is taxpayer-subsidized. But this insistence on control is surely quixotic if the purpose of the program is to improve the welfare of recipients. And, after all, isn’t that what a “welfare” program is – by definition? The word “welfare” cannot very well refer to the welfare of taxpayers, for then the program would be a totalitarian program of forced consumption run for the primary benefit of taxpayers and the secondary benefit of welfare recipients.

The clinching point against the excise subsidy format of the food-stamp program is that it does not prevent recipients from increasing their purchases of drugs, alcohol or other forbidden substances. A recipient of (say) $500 in monthly food stamps who spends $1,000 per month on (approved) foodstuffs can simply use the food stamps to displace $500 in cash spending on food, leaving them with $500 more in cash to spend on drugs or booze. In practice, a recipient of a subsidy will normally prefer to increase consumption of all normal goods (that is, goods whose consumption he or she increases when real income rises). Any excise subsidy, including food stamps, will therefore be inferior to a cash subsidy for this reason. In terms of economic logic, an excise subsidy starts out with three strikes against it as a means of improving a recipient’s welfare.

So why do multitudes of people insist on wasting vast sums of money in order to make people worse off, when they could save that money by making them better off? The paradox is magnified by the fact that most of these money-wasters are politically conservative people who abhor government waste. The only explanation that suggests itself readily is that by wasting money conspicuously, these people relieve themselves of guilt. They are no longer troubled by images of poor, hungry downtrodden souls. They need feel no responsibility for enabling misbehavior through their tax payments. They have lifted a heavy burden from their minds.

The Rule, Not the Exception

These common themes developed by these examples are distortion of otherwise-efficient markets by government action and unintended consequences resulting from the government-caused distortions. By its very nature, government acts through compulsion and coercion rather than mutually beneficial voluntary exchange. Consequently, distortions are the normal case rather than the exception. Examples such as those above are not exceptions. They are the normal case.

DRI-313 for week of 3-24-13: The Power to Tax

An Access Advertising EconBrief:

The Power to Tax

The long-running economics news story of 2013 has been the budgetary battle between the Obama Administration and Congressional Republicans. The most recent skirmish featured a clash between Senate- and House-approved budgets – that is, between Democrat and Republican pretenses to reform.

Both sides are pretending because neither side really wants to abandon big government and out-of-control spending. The Republicans are harder pressed because they have long given lip service to concepts of limited government and budgetary control. But both sides want to make a political show of deficit reduction. The Democrats are wedded to their political constituencies unto death and must fund the spending that supports them.

The Republican approach is to cut spending in order to lower government expenditures closer to revenue. The Democrat philosophy is to raise taxes to raise revenue to meet expenditures. The failure of either side to change their position significantly is presumably what the public means when it charges individual legislators with deliberately promoting gridlock and refusing to compromise.

Republicans are adamant in their unwillingness to raise taxes. This attitude has won them a public reputation for being unwilling to compromise. In recent years, the Republican reaction to public disapproval has been to retreat in confusion and dismay. This time, though, they remain intractable. Why are they so unwilling to raise taxes? What is the overarching purpose of a tax, anyway? How do taxes affect economic welfare and growth?

Taxation

Taxation is as old as civilization. Before democratic government, monarchs used it to extract wealth and income from their subjects. It has taken numerous forms, but the underlying principle invariably requires an involuntary levy or exaction paid to government by the governed.

One traditional form is a tax on either the production or consumption of a good or service. This is called an excise tax. This tax may consist of a fixed amount per-unit (a specific tax) or an amount expressed as a percentage of the selling price (an ad valorem tax, where the Latin phrase means “to the value”). It is a good place to start looking at taxes because its simplicity gives us a good look at the general principles of taxation.

The basic economic effect of a tax is to drive a wedge between the price paid by the buyer of the good and the price received by the seller. The result applies regardless of whether the tax is levied on the buyer or the seller. In fact, the resulting market price and quantity are the same regardless of who bears the nominal impact of the tax. This is referred to as the equivalence theorem; it is a fundamental principle of Public Finance, the economic sub-discipline under which taxation is studied.

The words “nominal impact” imply that the people who pay the tax may not necessarily be the ones who bear its real economic burden. This is correct. The ultimate end-in-view behind all economic activity is consumption, now or in the future. Only human beings can consume in this meaningful economic sense. Only human beings can suffer a loss of current or future consumption (e.g., savings). While a non-human entity like a corporation – recognized by law as a “fictitious person” – may pay a tax in the legal sense, it cannot bear the true economic burden or incidence of the tax.

Because both short- and medium-term market demand and market supply are each a function of price, an excise tax affects both the quantity buyers wish to purchase and the quantity producers wish to produce and sell. This means that the incidence of the tax is shared by consumers and business owners.

Consider first the case in which buyers pay the tax. If the tax is (say) $2 per unit of the good, the market price (net of tax) that buyers are willing to pay for every quantity of the good is now $2 less, since their total outgo will include the market price plus the tax. That is, their demand for the good will fall. This will lower the market price, forcing producers to produce and sell a lesser quantity. Alternatively, suppose that producers are liable for the tax. Now their costs will rise by $2 per unit, decreasing supply and increasing price. Consumers will pay a higher price for the decreased quantity.

In either case, consumers will pay more than before the tax – in the first case, a lower market price plus the tax; in the second case, a higher market price inclusive of the tax as reflected in producers’ costs. In either case, producers will receive less than before the tax- in the first case, a lower market price; in the second case, a higher market price whose value is reduced by their higher costs due to the tax they owe. The equivalence theorem states that the buyer and seller pay and receive, respectively, exactly the same in the two cases no matter who “pays” the tax.

In the long run, there is sufficient time for business firms to enter and (in this case) leave the market. Exit of firms tends to increase price by the full amount of the tax and drive profit toward the so-called “normal” level, at which owners receive a return just equal to what they could earn in the best alternative investment of equal risk. Thus, the long-run incidence of the tax may be shared by consumers and suppliers of inputs to the industry, or it may be borne by consumers alone.

Our excise-tax example illustrates general principles applicable to all taxes. Taxes discourage economic activity. They harm people on both sides of the market. Over and above this harm, they distort the prices faced by buyers and sellers, creating what public-finance economists call the “excess burden” of a tax.

Because taxes have these adverse effects, economic textbooks deem them a tool of limited resort. Some goods and services, such as national defense, cannot be produced and sold in private markets. These “public goods” must be produced and administered by government. To finance this activity, taxes are considered expedient.

In practice, however, public goods are very few in number, while government is pervasive. Taxes are numerous and lucrative sources of government revenue. Instead of a necessary evil, taxes have become a threat to our well-being. America today has become a locus classicus of the aphorism “the power to tax is the power to destroy.”

In the United States, the most familiar excise taxes have long been specific taxes on gasoline, cigarettes and alcohol. At the federal level, gas tax proceeds are devoted to maintenance of federal highways. Or rather, that was the original intention; today, about 40% of proceeds are diverted to general revenue for earmarked programs. Meanwhile, our roads and (especially) bridges have deteriorated markedly.

Maintaining vital infrastructure with a funding mechanism that is both ineffective and harmful to growth and prosperity seems quixotic. Recently, some state legislatures have begun to make long-term lease contracts with private firms who operate and maintain roads in exchange for the right to charge tolls and book the revenue. The companies have the strongest possible incentive to keep the roads in good condition and maximize their use. Other countries have already seized this chance to improve their transportation network by relieving government of a responsibility it handles badly.

We now shift from general principles of taxation to evaluation of particular types of tax.

Excise vs. Ad-valorem Taxation

A longstanding source of periodic irritation to Americans is the retail price of gasoline. The usual focus of anger is “the oil companies,” who are popularly supposed to possess monopoly power with which they earn “obscene profits” – modified to read “windfall profits” whenever an increase in gasoline prices accompanies an oil-related event on the national or international scene or “record profits” whenever a quarterly release of income statement date from Exxon Mobil reveals that the company’s total net income has exceeded its previous high.

The complete lack of cogency in these complaints has been demonstrated time and again. Another recurring gripe, however, bears on the issue of taxation. Talk-show callers often gripe that gasoline sellers are quick to raise prices but slow to lower them – even when this appears justified by events. If price increases are merely supply and demand at work, they inquire heatedly, why does the process only work in one direction? Shouldn’t prices be just as quick to fall when supply increases, when costs decrease, when Middle-East tensions dissolve, when demand goes slack?

Nearly fifty years ago, the distinguished specialist in international trade and industrial organization, Richard Caves, pointed out the role played by specific excise taxation in pricing. To modify his example using fictitious numbers for convenience, suppose that the retail price of gasoline is $2 per gallon and the excise tax is $1. Now ponder the effects of a 10 cent price reduction by a seller. In actual fact, sellers pay the tax, so the seller’s gross receipts fall by 10% (10 cents as a percentage of $1). But the price faced by buyers falls by only 5% (10 cents as a percentage of $2). Thus, the purchasing response to a price reduction will be depressed by a price reduction, compared to the case where taxation is absent.

Now consider the opposite case, where price is increased. A 10-cent price increase will increase gross margin by 10% while increasing the price faced by buyers by only 5%. It is the opposite situation to the price-decrease case. Specific excise taxation increases the incentive to raise the price of the good while reducing the incentive to lower price. In other words, it tends to create just the short of world complained of by gasoline consumers – one in which sellers are relatively quick to raise price but slow to lower it!

As Caves mentioned, this flaw could be remedied by changing the specific excise tax to an ad-valorem tax, in which the tax is comprised of a fixed percentage of the good’s selling price. But this hasn’t happened in the 49 years since Caves wrote.

The excise taxes on cigarettes and alcohol have created additional problems by encouraging smuggling and illegal production to avoid payment of the taxes. Unlike the fuel tax, those taxes do not have a clear-cut rationale other than the raising of revenue. Lip service is given to the goals of discouraging smoking, but a prohibitive tax would be high enough to persuade all smokers to quit. Since the tax is set well below this point, its purpose is presumably to raise revenue instead. Another oft-stated goal is to use tax proceeds to defray medical expenses attributable to use of the products, such as medical bills of lung cancer sufferers. Again, this ambition has not been fulfilled. The only reasonable explanation for the persistence of these taxes is to support government – not for any productive or valuable purpose, but merely to provide income for officials and employees.

Income Taxation

This year, the federal income tax celebrates its centenary. From its miniscule beginnings, the federal income tax code has grown into a monstrosity fed and cared for by a huge federal bureaucracy, the Internal Revenue Service. The top marginal tax rate began at 7%, has grown as high as 92% and currently resides at 39.6%.

But the most destructive thing about income taxes is not their height but the indirect costs they impose on all of us. These include the impossibility of definition, verification and collection. The continual additions and modifications to the tax code have made it a byzantine nightmare for preparers; it is proverbial that even pre-eminent experts cannot warranty their interpretations of its provisions. Each year, Americans spend a chunk of Gross Domestic Product on federal tax preparation. This calculation includes the time and effort devoted to tax avoidance.

The biggest irony associated with the income tax is that its central logic was developed by a free-market libertarian economist, Henry Simons of the University of Chicago, while working for the federal government during World War II. In particular, it was Simons who developed the definition of “income” that had made the tax code so baffling and infuriating to subsequent generations. In fact, Simons sought to make the income tax consistent with the concept of real income or utility as defined by economic theory. Alas, his efforts demonstrated that the precise theoretical categories beloved of economists all too often lack real-world referents.

The clearest demonstration of the damage done by income taxation may be migration by high individual earners and businesses away from high income-tax rate habitations. Over the years, some of the world’s wealthiest authors, movie stars, athletes and moguls have become tax exiles. Among the historical sufferers of this brain drain have been Great Britain (movie stars Anthony Hopkins and Michael Caine), Italy (movie mogul Carlo Ponti and star Sophia Loren) , France (movie star Gerard Depardieu) and Sweden (tennis great Bjorn Borg).

Apart from revenue, the other claim made in behalf of income taxes is fairness. For over a century, the Left has maintained that progressive income-tax rates are necessary to insure an equitable distribution of income. The most recent rhetorical recurrence accompanied the Occupy Wall Street movement. The counterarguments, marshaled concisely by authors Blum and Kalven in The Uneasy Case for Progressive Taxation, are convincing on a theoretical level. Empirically, the utter failure of regimes such as Soviet Russia and Communist China to achieve distributional equality suggests that government power is either inappropriate or insufficient for the task – even assuming it is worth doing.

Property Taxation

Property taxes have long been the primary source of income for local governments and schools in the United States. That constitutes a recommendation only to those employed by governments and schools. The assessments used to determine the property values to which the property-tax rates apply are notoriously inaccurate when compared to actual market values. For years, local politicians used rising property values and the prestige associated with education as levers to ratchet up property taxes and continually increase education funding.

In the late 1970s and early 80s, this gravy train came to a screeching halt. It became clear that continually rising taxes were funding an education system that was failing its customers. Despite fivefold spending increase in real terms over the previous three decades, average test scores were flat or falling. California taxpayers felt so thoroughly victimized that they approved the landmark tax-limitation measure Proposition 13. Other state-level tax limitation measures, such as Missouri’s Hancock Amendment, accomplished the same goals through less direct means.

The concept of property taxation bears at least a family resemblance to the form of taxation most admired by economic students of the subject. Henry George’s “single tax” on land was based on the premise that land is the only resource in completely inelastic supply. Given this, a tax on land cannot discourage its supply. George became the most popular economist of the 19th century by promoting this program of public finance.

Unfortunately, his view was simplistic. While the physical supply of land is indeed in fixed supply, the economically valuable and available supply of land is not. To achieve its goals, the single tax would have to apply only on the undeveloped component of developed land. It is not commonly feasible to sort out this datum and property taxes in reality do not even make the attempt.

Sales Taxes

Just as water seeks its own level, taxation tends to follow the path of least resistance. In recent years, this has been traced out by the sales tax. A tax on retail commercial transactions is easy to implement, verify and collect. This gives it a big advantage over other forms of tax that can be avoided legally, evaded illegally and put off indefinitely.

Ironically, the sales tax has also become popular with the organized anti-tax movement, many of whom have proffered it as a composite replacement for virtually all other forms of taxation. A flat sales tax of X%, where X might be some number between 10 and 25, could substitute for all other taxes by providing government with roughly the same amount of total revenue it currently collects, but without the tremendous costs of collection, verification and monitoring it now incurs. Similarly, citizens would be spared the tremendous burden of preparing, calculating and worrying over the taxes they now pay. And they could fight one single battle against future tax increases rather than having to fight on multiple fronts simultaneously.

One counterargument, perhaps the most telling, is that government cannot be trusted to first pass an omnibus sales tax, then repeal other taxes. We might well be stuck with a vastly higher sales tax on top of our current tax burden. From the Left comes the objection that sales taxes are highly regressive, falling much more heavily on low-income taxpayers whose annual retail transactions form a large part of their incomes and wealth.

Taxes and Economic Growth

In the late 1970s and early 80s, the economic philosophy of “supply-side economics” drew attention to the effect of taxes on economic incentives and growth. Federal tax-rate reductions in the U.S. and Great Britain, followed by the revival of growth and retreat of inflation in both countries, preceded tax-rate reductions in dozens of other countries around the world. To this day, economists argue about the effects of this revolution. The argument centers mainly on the sensitivity of households and business to tax-rate changes, with left-wing economists seeing little reaction and right-wingers finding great responsiveness.

One way to break this logjam would be to examine state-level U.S. data. Policy studies by think tanks like the Heartland Institute, American Legislative Exchange Council, Cato Institute and Heritage Foundation have all found in-migration toward, and higher rates of economic growth in, states with lower tax rates and downward tax-rate trends. These states have also tended to be the so-called “red states,” which have voted Republican in national elections.

The Power to Tax

There is simply no doubt that the incentives created by taxation are perverse; that is, they tend to discourage economic value, welfare and growth. The arguments for taxation are twofold – first, that its undesirable effects are quantitatively small; second, that it is necessary to support activities that would otherwise go begging and needs that would otherwise go unmet.

Both these arguments are remarkably weak. Given the omnipresence of taxes, their aggregate impact can hardly be weak. The case for a tepid reaction by individuals to changes in tax rates does not accord with everyday life or historical experience. And the Left has done nothing at all to convince the public that government programs are necessary, successful and responsive to consumer wants.

It is no wonder that Republicans in Congress are drawing a line in the sand on taxation. The wonder is that they have waited so long. Doubtless their reluctance reflects their unwillingness to face the implications of this decision. The welfare state has come to a dead end. It survives in an artificial atmosphere oxygenated by spending pumped in by government. We can no longer borrow or print the money to spend. Opposition to taxes implies opposition to spending. And that requires a political will that Republicans have not had to summon for many decades.