In support of progressive taxation

After todays attack on effective “left-wing” politics of blanket transfers and the idea that we need government to save the day, I thought I should come out with a post in favour of other general government action.  So lets looks at progressive taxes.

It is common for economists to attack progressive taxation as it can be seen as:

  1. Unfair, given that some people who work have to get income have to pay a greater proportion of there income to the state (even more than a greater amount!)
  2. Unfair, because we may believe that most of the spending benefits people on lower incomes,
  3. Inefficient, given that we are taxing our “most productive” citizens at a higher marginal rate, reducing their labour supply.
  4. Or inefficient, because if the tax is passed on to the business, we are taxing highly skilled industries more than unskilled industries, which is a distortion.

However, there are reasons why society may want a progressive tax system, and when it would dominate other tax systems:

  1. Society may believe that it is fair for those who are “endowed with luck” to pay a greater amount of tax – even proportionally so (often diminishing marginal utility is used for this – but that is a “cardinal” sin (ignore my economics pun)),
  2. People on high incomes may benefit disproportionately from government spending – who benefits more from investment in a road, those on high incomes (which are partially a function of domestic infrastructure) or those on low incomes
  3. Ramsey pricing:  Demand for skilled labour may be more price “inelastic” – implying that, for a target level of government spending, we can minimise “dead-weight loss” from the taxes that raise revenue by placing more of them on skilled labour.
  4. People value the idea that poor people are being helped out, however any individual income they provide may not help people very much.  Furthermore, if we are in a situation where everyone else is giving income to the poor, this person does not need to and so won’t – as a result there is a prisoner’s dilemma.  People want society (including them) to provide for the poor, but have an incentive to pike out themselves, leading to a worse outcome for everyone.  In this case a progressive tax can help to circumvent the prisoners dilemma.

As a result, if you hear anyone say that the argument for a flat tax system is obvious,and progressive taxes are a historical mistake – ignore them 😛

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  • goonix

    I prefer regressive taxation personally. Added incentive for people to work harder and earn more.

  • I would argue against any income tax at all. It punishes people for working hard. I know many people are against it, but a progressive sales tax would be much better, imo. First, people would have much more to actually spend (because they would not be taxed on their wages). Basic necessities like groceries would be tax-free, but the more discretionary the item, the higher the tax would be. maybe 10% for clothes, 20% for cars, 30% for boats, etc… reason being if you have the money to spend on a luxury item, then you have the money for the luxury tax. It also would recoup much of the gray and black market where no one is currently taxed. And it is completely discretionary. If the consumer wants to avoid the tax he can avoid the purchase.

  • Steve

    rather than a tax on income, what about a tax on spending only? after all, savings are simply future spending, therefore all income would eventually be taxed the same as today, but only at the point of consumption, rather than earnings.

    Make it a constant rate say 10%, on everything, including labour. we might end up with a similar outcome to a flat tax system.

    Thinking about it like this, perhaps income tax , is really not a tax on labour (or other earnings etc) but a tax on future consumption. Therefore there are losses to all markets, not just the labour market etc.

  • The idea of a progressive sales tax is interesting, a couple of problems jump out to me

    (1) It would be VERY subjective
    (2) related to (1) it would likely distort relative prices and thus be inefficient

  • goonix

    I think you could have necessities tax-free and ‘other’ items taxed, but I think getting into defining luxury goods/etc would be far too complicated (determining necessities would be bad enough).

  • Adam, NZ used to have what you suggested. They were known as luxury taxes and were messy as hell.

    However, what about a progressive sales tax, not based on good or services, but on price thereof? eg. Goods or services over $100,000 attract an extra 2 percent GST. Luxury cars, real estate and other large purchases would be caught, leaving the cheaper lower consumption bracket. It might be cleaner than introducing a Capital Gains Tax, but is this still opening another universe of loopholes?

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  • I think any system like that would be subject to gaming, big ticket items would be broken down into less costly components that you can buy.

  • Andrew W

    I’d prefer a flat rate tax on tradable assets, with the assets owner determining the assets value and IRD having the power to buy it at that valuation.
    – It’s simple, very low compliance costs.
    – effectively it’s progressive, as wealthier people tend to own more assets
    – It discourages excessive investment in luxury goods.
    – It encourages efficient use of goods.
    – It’s not totally unfamiliar, as the local government rating system is an assets tax on property.
    – Most people could work it in with their insurance.
    – It’s a visible tax, I hate the way governments have quietly increased revenue by using “hidden taxes”.

  • Wouldn’t that then distort people away from buying tradeable assets?

    Also what do you mean by excessive investment in luxury goods? Is there some sort of negative externality from having a nice car? I guess I get kind of pissed off when I see people driving a porsche SUV (don’t care if they drive normal porsche) 🙂

    Ulitmiately, pretty much any tax is distortionary in some way. if only we could have have lump sum taxes…..they are non distortionary but almost as much of distant dream as perfect competition 🙂

  • Andrew W

    “Wouldn’t that then distort people away from buying tradeable assets?”

    What would they buy instead?

    “Also what do you mean by excessive investment in luxury goods?”

    I’m thinking of million dollar beach houses that remain empty 10 months of the year that are bought in the knowledge that a tax free profit is likely to be made from future capital gains. I doubt someone looking at a porsche would be too worried about an assets tax when compared to the cost of depreciation on such a vehicle. With an assets tax I’m aiming for a practical and as all embracing tax as possible, rather than a complex combination of progressive income tax + capital gains + GST.

    Such a tax at a rate of about 2-4% should do it.
    I’d also like to see it applied to government departments to encourage more efficient use of resources.

  • I see that there has been a few idea here – I’ll jump in and add my 2c 😉

    “I prefer regressive taxation personally. Added incentive for people to work harder and earn more.”

    If labour supply becomes more elastic for higher income earners this also has other possible efficiency benefits. However you have to say that there are fairness issues.

    Think of it this way – if someone is effectively endowed with a higher paying job then they can earn more for no additional effect than someone with a lower endowment. Given that society values a closer relationship between effort and return a movement to a regressive tax is a movement in the wrong direction.

    Now there is both an endowment and effort impact from taxes – the right tax system will balance these factors.

    “I would argue against any income tax at all. It punishes people for working hard. I know many people are against it, but a progressive sales tax would be much better, imo.”

    A sales tax also punishes people for working hard – as it increases the cost of consumption, which is the ultimate purpose of income in the first place.

    ….

    More to come

  • “I’d prefer a flat rate tax on tradable assets, with the assets owner determining the assets value and IRD having the power to buy it at that valuation.”

    Assets are effectively savings – so you want to tax just savings?

    “What would they buy instead?”

    Consumption – they would spend more on consumption now.

  • Andrew W

    “Assets are effectively savings – so you want to tax just savings?”

    I’d be looking to avoid taxing shares, as the tax would apply to the assets that the shares represented, I’d also be excluding bank balances, both in credit and debt, so literal savings (if that’s an OK term) wouldn’t be included.

    People might spend more on consumption – but any goods consumed needed to first be produced, the assets used for production would be taxed.

    I see this as similar to residential tennants who don’t directly pay rates, but in practical terms do, it’s included in their rent payments.

    The basis for the whole idea is to have as all inclusive a general tax as possible but with minimal compliance costs, both to the state and the taxpayer.

    The way I see it is that to increase productivity in NZ we need to maximise the manpower we have in producing desired goods and services and minimise that which we have in producing goods and services that don’t create wealth, but actually consumer wealth providing “services” that people, given the option, wouldn’t buy.

  • Hi Andrew,

    So is the tax only on income producing assets? If this is the case then it creates a wedge between two inputs – capital and labour. Firms will “over-use” labour relative to capital in order to avoid the tax leading to relatively inefficient production. Currently we have a tax on all income, which shares the burden between inputs types.

    I’m not sure that I believe it is an improvement – and the required regulation (pricing the assets, setting up IRD as a asset buying body) would increase compliance costs wouldn’t it?

  • Andrew W

    I was thinking all assets that have a monetary value (which is what makes them “tradable”), I’d include intangable assets eg. the Goodwill component of businesses, copyrights, Tm’s.

    I recognise that the over-use of labour to avoid taxation on capital is factor but given all the other costs of employing capital I don’t see it as having a major impact on decisions on employing capital.

    Another point is that it would be an incentive for people to maximise the efficient use of the assets they employ, eg. there are a lot of farmers surviving on farms that could be doing 20% or even 50% more production than they do now (I know this, I’m a farmer).

    Another point is how much income in terms of capital gains escapes the tax man now? This applies to all property types, leading to them being way over valued in terms of their economic productivity.

    How much does the administration of the present tax system cost the country? For large organisations it might not be too much of a problem, but for small business compliance costs are significant.
    Pricing assets would be done by the assets owner, we do this already for insurance for most assets. Under what I propose IRD should actually make a profit buying under-valued assets and on-selling them.

  • “I recognise that the over-use of labour to avoid taxation on capital is factor but given all the other costs of employing capital I don’t see it as having a major impact on decisions on employing capital”

    I’m not sure – if we want to rise enough tax revenue to fund government spending something will have to give. In the long-run I would expect a sharp decline in capital accumulation surely.

    “Another point is that it would be an incentive for people to maximise the efficient use of the assets they employ”

    I’m not sure about this – people already have to incentive to use their assets, taxing them reduces the benefit associated with putting more effort into getting your asset running.

    “Another point is how much income in terms of capital gains escapes the tax man now? This applies to all property types, leading to them being way over valued in terms of their economic productivity.”

    I agree with this in part. Ultimately though, as long as the income from the asset and the income from selling the asset are taxed surely incentives are fine. The only problem comes about when we tax different assets at different rates.

    “Pricing assets would be done by the assets owner, we do this already for insurance for most assets. Under what I propose IRD should actually make a profit buying under-valued assets and on-selling them.”

    Good point, that does deal with the administration costs.

    I just don’t understand where the revenue comes from though – and if we do raise sufficient revenue it appears that we will make capital sufficiently less desirable.

  • Andrew W

    We agree that the lower the tax rate is with this system, the less significant it would be in distorting the price of labour vs the price of capital, that’s obvious.

    One thing I would like to see is (dreams are free) a reversal in the decades old trend of an ever increasing government tax take.
    As this would be a highly visable tax I hope that voters would be less accepting of it being imposed at higher rates.

    Government revenue and expenditure half of what we have now sounds about right to me. Could that be financed with just a ~2% assets tax?
    It would be interesting to see the result of such a tax were appied to all government owned assets as well.

    While I’m on the increasing size of government how does this theory sound to you:
    The reason governments in the West have grown as a percentage of GDP as they have over the last century is because voters have been happy to see this happen. Voters have been happy to see this happen only because increasing wealth has made it affordable for them, so if we were all suddenly as poor as we were 100 years ago for society to support government, government would need to be far smaller.
    I know that government is a producer of services, we do get something for our tax money, but a lot of money is spent by government redistributing rather than creating wealth.

    As a tax on assets it would have little impact on the poorest people, and doing away with income tax means every job would be a “cash job”, making legal short term casual work practical again. I actually like the idea that people who wish to live simple unskilled itinerant lives should be able to do so, the income tax system (and admittidly other legislation) have made this lifestyle all but impossible in the modern world, so instead these people who, because of their nature don’t fit rigid working rules, live on benefits.

    Matt, I appreciate you taking the time to discuss these ideas,
    regards.

  • “Voters have been happy to see this happen only because increasing wealth has made it affordable for them, so if we were all suddenly as poor as we were 100 years ago for society to support government, government would need to be far smaller”

    Agreed.

    “As a tax on assets it would have little impact on the poorest people, and doing away with income tax means every job would be a “cash job”, making legal short term casual work practical again”

    I’m not sure if this is how it will function overall. Taking income making assets only will reduce the value of these assets and so reduce investment. If we reduce investment then the product of labour will be lower and so the amount people get paid will also fall as a result of the tax – ultimately all forms of tax fall on income (well fundamentally consumption) in some way, the only way to reduce the tax burden would be to actually reduce the amount of tax we raise.

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  • Andrew W

    “people already have to incentive to use their assets, taxing them reduces the benefit associated with putting more effort into getting your asset running.”

    I don’t follow, if I have a capital asset that yields a 5% return if poorly run and a 10% return if well run, and the asset is taxed at 2%, poorly run gives a net return of 3%, well run a net return of 8% (in reality not quite this big a difference in return as the well run asset will be worth more – but that just means the owners equity is greater)

    “the only way to reduce the tax burden would be to actually reduce the amount of tax we raise.”

    Yeah, I made the point earlier that as a “visible” tax it would be harder for politicians to get increased tax rates passed the voters (though admittedly this seems to be no obsticle to local government in their eternal efforts to increase rates).

    I suspect an assets tax would reduce investment in assets by about as much as income tax reduces employment and GST reduces spending.

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  • “I don’t follow, if I have a capital asset that yields a 5% return if poorly run and a 10% return if well run, and the asset is taxed at 2%, poorly run gives a net return of 3%, well run a net return of 8%”

    I thought that the asset tax we were discussing was on the value of the asset – not on the rate of return. The value of the asset will be determined by the rate of return that people think they can make from it – as a result if using the asset is costly won’t people put less effort into using it well (and pushing up the value of the asset which is based on the rate of return) if the value is taxed?

    “I suspect an assets tax would reduce investment in assets by about as much as income tax reduces employment and GST reduces spending.”

    This is a little bit “partial equilibrium”. It will increase the relative price of capital – so that firms will use more capital and less labour. But it will also have an “income effect” whereby people will produce less and make less of both.

    Ultimately I am not saying that the tax is definitely wrong – just that it is not clear whether this is a more efficient tax than an income tax or a tax on goods.

    Still, thanks for raising the idea – I will see if I can give it some more thought and maybe do a post. Then we can discuss it in there 🙂