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 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.
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 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.
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.