Recent posts by two of the most prominent New Zealand left wing blogs (the Standard and New Z Blog) lament the fact that the wage people are paid does not necessarily relate to the effort they put into their work. As a policy solution to this inequitable result of the free market both blogs suggest that the government provides tax cuts that give the poor more.
However, no matter how sympathetic I am to the idea that effort and reward aren’t correlated in a way that most people would view as “fair”, I don’t think that adding further progressivity to the tax scale is the appropriate mechanism with which to achieve this social goal. Furthermore, I don’t think the trade-off between production in society and the achievement of our “equity” goals is appropriately mentioned in these posts.
Starting with the issue of an equity-efficiency trade-off we have to realise that for the same level of revenue (in a static sense), a more progressive tax scale will lead to higher “marginal tax rates“. The higher the marginal tax rate – the less incentive people have to work an additional hour. This phenomenon is especially prevalent among secondary income earners – which have become an important part of our labour force. There is also a case for tax-avoidance and as the tax rate rises for those on high incomes it disrupts savings incentives – influencing the accumulation of capital and thereby reducing productivity.
Furthermore, progressive taxes make “skilled” labour relatively more expensive then “unskilled” labour. This implies that firms will move away from productive processes that use skilled labour – which likely implies that potential output in the economy will fall.
Anyway, lets ignore this trade-off for now, even without it I would prefer us to have a flat tax scale but progressive benefit payments. Why? It’s transperant!
One of the most important issues in a democracy is transparency. Income taxes are levied to raise revenue for government spending, ‘welfare’ payments are made in order to increase distributional justice (which is effectively what we want to do in this case). By keeping them separate the public is fully informed about the sort of welfare enhancing policies we have in place, and can express how it feels about them (more welfare or less).
When we mix up the tax and benefit systems, the discussion of distributional justice and efficiency becomes mixed and we end up in a situation where the party with the best rhetoric surrounding either tax cuts or helping the poor will end up taking the day.
The main cost from such a division between taxes and benefits is “churn” – however, I’m not a big proponent of churn anyways, and hopefully a flat tax scale would give sufficient administrative benefits to make up for this churn. Note in efficiency terms both the tax and benefit schemes have a cost – as they both increase effective marginal tax rates.
This isn’t much – do you have anything a bit more convincing?
Ok ok, I have another trick up my sleeve to explain why I think benefits and not tax is the way to go here.
First, tax incidence. Unskilled labour is easier to replace then skilled labour. As a result, firms’ will pay unskilled workers a wage closer to their “reservation” wage in net terms, while skilled labour has the ability to gain more of a surplus. When a tax cut is given to the poor, the firm will (over time) cut their gross wage back towards their reservation level.
As a result, tax cuts to the poor will probably have a greater impact on firm costs then they will on achieving the equity goal of giving the poor a wage that more closely matches the effort they put in.
Ultimately – I think that the tax incidence argument, in conjunction with the transparency argument, is sufficient to illustrate why our equity goals should be achieved through direct government spending instead of fiddling with the revenue generating device that is taxes.