Efficiency, equity, and tax
From Kiwiblog we hear the following statements from Bill English:
Low-income earners would have to be compensated if GST was increased as a result of the current tax review, Finance Minister Bill English says. …
“We don’t want to go down the route of raising taxes,” he said. “The Government has a strong preference not to increase taxes to close the deficit. We prefer more efficient taxes over higher taxes.”
Cool. The government believes that it is fair to charge those on low incomes proportionally less (equity) and it would like the tax system to be efficient. The only issue here is that there is a trade-off between these two elements of the tax system. People can approach Tax Shark: tax preparation services in Roseville to help them.
In terms of proportionality we can think of GST like a flat income tax – in both cases an individual will pay the same proportion of their lifetime income in tax eventually. Offering rebates to people on low incomes is then the same in either case – it implies that people on a lower income pay proportionally less of their income.
How does this impact on efficiency? Well, to raise the income to pay rebates the government has to increase tax rates on people with higher incomes, providing a disincentive to work. Furthermore, there will be some range of income over which the rebate will be abated. Depending on how the tax system is designed this implies that there will be very high “effective marginal tax rates” for some groups. We see this with Working for Families where some households would get taxed at over 90% on any additional income they earn – providing a strong disincentive for these people to work additional hours, or do anything to earn additional income. Finally, higher and more progressive tax rates give people with the ability to try and avoid tax the incentive to – another factor that hurts the efficiency of the tax system.
As a result, I agree with what the finance minister said, we need to look at efficiency and equity when making decisions. It will be interesting to see exactly what trade-off the government, and society as a whole, is willing to agree upon.
“… to raise the income to pay rebates the government has to increase tax rates on people with higher incomes, providing a disincentive to work. Furthermore, there will be some range of income over which the rebate will be abated. …” What an excellent idea to implement!
I doubt whether it would ever be approved by the Government officials since most of the decision making officials belong to the higher income group and they may not like this to happen!
“In terms of proportionality we can think of GST like a flat income tax – in both cases an individual will pay the same proportion of their lifetime income in tax eventually.”
I know that this line is often used to explain why the GST is supposedly not regressive (in response to the ‘prima facie’ case that because in any given year low income individuals consume a higher proportion of their income, GST IS regressive), but I’m not convinced.
Is there any evidence to show that this actually holds? And for which types of people this is necessarily true?
Before I’m accused of being a jackass, let me clarify. I’m aware that, logically, if all individuals eventually consume all the income they ever earn, and if consumption tax rates are constant over their lifetimes, then all individuals pay the same proportion of their lifetime income in tax.
But the two assumptions required here: ‘consuming all lifetime income’, and ‘constant rate of consumption tax’ seem quite dodgy to me.
Firstly, if people bequest their leftover wealth to their inheritants, then they are clearly not consuming all their lifetime income. This is true even if the inheritance they received themselves happened to be equal to that which they bequeath to their children; after all, the inheritance they received was a form of income. From my understanding of intergenerational mobility (correct me if I’m wrong), wealth tends to ‘breed’ wealth, so rather than a received inheritance being spent in the recipient’s lifetime, it is rather more likely that the recipient will then in turn pass on an even larger bequest. An individual in this situation would therefore pay a smaller proportion of their lifetime income in tax than an equally long-lived individual who neither received nor passed on an inheritance; the latter individual has a pretty good claim that such a tax is regressive.
Another small ‘regressive’ aspect of consumption taxes is that the wealthy are more likely to spend a larger proportion of their income overseas where it is not subject to tax collection (at least by the NZ government).
The second assumption, that we are in a ‘steady state’ world of GST where the rate has been unchanged since before today’s generation were born and will remain unchanged until their deaths, also seems to point to unfairness of a transitional kind, at any time the GST is raised.
Suppose that I had paid income taxes my entire lifetime in the absence of a GST, and just as I turn 65 and retire the income tax system is replaced with a consumption tax (in a revenue-neutral change). Because I consume but do not earn income after 65, the new system is not equivalent to a flat income tax for me: under a flat income tax I would pay no tax at all, but under the newly introduced GST I pay tax on all my consumption. It’s the same in effect as a retrospective tax on my previously earned income.
The same principle would hold to a lesser extent for smaller changes in GST settings. I don’t know if this necessarily makes a tax system change in favour of greater GST regressive, but it certainly makes the claim that we all pay an equal proportion of our lifetime income in GST (and hence it is like a flat income tax) false. And it points to significant unfairness in its introduction which would need to be allowed for with compensation.
However the first point – about the wealthy saving more of their income and therefore paying proportionately less tax – is the one that worries me the most. The often cited defense of “if the wealthy don’t spend it, their children will” also seems wrong to me; their children will probably pass it on, with interest, to their children. How many generations worth of regressivity will occur before that inherited income eventually gets spent?
Finally, what is the great attraction of consumption taxes?? It’s not at all clear to me. As we agree, it’s equivalent to a flat income tax with a deduction for savings. To make a switch to a flat income tax distributionally-neutral, rebates have to be financed from other taxation, probably providing disincentive effects, as you pointed out. I just can’t see where the gains are to be made. If the government can design a revenue-neutral and distributionally-neutral package which nonetheless reduces labour supply and investment distortions, then I’ll be impressed, but I think it’s impossible. Particularly since I’m skeptical that high marginal tax rates have much distortionary impact on the labour supply of the rich (although I’m happy to be convinced otherwise if anyone can provide empirical evidence).
Talk of the efficiency benefits of greater consumption taxation smells to me like a smokescreen designed to hide either reductions in the tax take or redistribution towards the wealthy, in which case the real issues we ought to be debating are about the size of government and about inequality.
Apologies for the long post. Any thoughts?
Same what Tim said.
My old man sold GST on the condition that there had to be a quid pro quo for the low incomes. Dad used to sharpen his arguments on us! So believe me when I agree that flat taxes are regressive 🙂
But it ain’t no thing. The benefits of a flat tax stem from the long term certainty it provides, not a sudden bump in tax revenues. It’s not an adrenaline shot to the Treasury, nor is it meant to be. The cost to cover the bottom rungs is pretty much a short term pain which time heals.
Unfortunately, a large chunk of damage was done to the goodwill of the poor by the Mother of All Budgets, which was brought about by the BNZ debacle. The blanket given to them to insulate them from GST was ripped away and never replaced, which sparked a decade of Jim Anderton’s Alliance/Progs voters.
So I can understand why Bill English is treading warily here.
The existence of bequests means that lifetime income is not all consumed. There is evidence that high-income people bequeath more to charity than low-income people, avoiding GST on the bequest (see the second section of http://philanthropy.com/free/articles/v21/i07/07000601.htm).
Your argument for the non-regressivity of GST, therefore, is not convincing.
Hi all, thanks for the comments,
One thing I would point out is that, eventually, all lifetime income gets taxed in either the GST or income tax case. This makes the tax flat by definition – even though the relative welfare consequences of the taxes (due to timing and the such) will differ heavily.
Note, I did not say that a person pays the same tax over their lifetime – as doing this would ignore the purpose of bequests. A person gives a bequest either because it is delayed saving that they left behind (due to uncertainty about their lifetime) or because they are giving it to someone. Both of these reasons for bequests still end up with income that is going to be consumed (because the ex-ante decision of the person is still based on a motive for inter-temporal consumption) – and so the proportionality holds.
Now, in welfare terms the argument is MILLIONS of times more complicated. But the purpose of the post was to look at one of the trade-offs associated with the tax system – and to say that this trade-off needs to be faced. Saying that we want to maintain the current level of equity but greatly increase efficiency sounds a bit too much like free lunch talk.
@fibby
Hi Fibby,
If the charity was domestic this wouldn’t matter – as the consumption goods purchased by people who receive the charity are taxed at the GST rate.
The issue only exists then if the charity is sent overseas – and it can be solved by taxing charity money heading overseas. Now, if we don’t do that we have to ask – why are we not taxing this charity money? Do we want government (and as a result society) to implicitly donate this charity money overseas (which is what we are doing).
It doesn’t defeat the proportionality argument at all – it merely illustrates something that would be taxed by a proportional system, but isn’t due to the way the government has designed it.
The consumption goods purchased by people who receive the charity are taxed, yes. But the tax is not paid by the person who made the bequest, so that tax can’t be counted against that person’s income. As a result, the bequest allows them to avoid paying as much GST (proportional to their income) as a person who does not leave such a bequest.
@fibby
The value of giving charity to someone is the set of real consumption goods that can be purchased with the goods. So the tax is effectively being paid by the person giving charity.
Huh? No it’s not, it’s being paid by the users of the charity. If I give $50 to a homeless guy who then goes and buys food or whatever, he pays the GST on that purchase. Not me. This is pretty unambiguous.
@fibby
It doesn’t matter who is paying the tax along a supply chain, what matters is the incidence of the tax.
So, a person gives to charity to provide a set of real consumption goods for someone – they are giving because they put a value on this other person gaining this consumption. If they pay income tax on that income first then they have a lower nominal income level than in the case of a GST rate. But, in the case of a GST rate the nominal price level is higher than in the case with a nominal income tax.
The motive behind a bequest to charity – my original example – may be very different from the motive behind a donation made during life. I did blur this distinction with my point about the homeless guy, so sorry about that.
Before we get too far from the point, Matt, please would you define precisely what you mean by “progressive tax” and “regressive tax”?
@fibby
“Before we get too far from the point, Matt, please would you define precisely what you mean by “progressive tax” and “regressive tax”?”
I take the definition that a flat tax is a tax where the same proportion of lifetime income is paid in tax irrespective of the income level (also note that this does not have to be over the persons lifetime – as long as the accrued income is taxed eventually).
This in no way implies that the welfare consequences of different flat taxes are the same – not at all. For example replacing some flat income tax with a GST rate would disproportionately hurt people who are credit constrained. However, the definition is both common when discussing tax policy and objective, as it is solely a technical definition.
My aim was to illustrate that the movement from a flat GST rate to a GST rate with rebates involves the same type of trade-offs as the movement from a flat income tax to a (technically) progressive income tax.
Thanks for that. That does clarify, and yes, by this definition you seem to have achieved your stated aim.
Your definition deviates from the definition which I believe is traditional for discussing matters of inequality. I don’t currently have access to a source for this belief, so I leave it aside for now.
Instead, let’s consider the implications of your given definition for donations made to a nonproductive charity (one which operates on donations alone). If the incidence of GST is measured against the original income stream generating the consumption (rather than against the income stream of the individual doing the consuming), we have the following implications:
1. The incidence of GST on nonproductive charities is zero.
2. In the case where a business donates some of its profits to a nonproductive charity, some GST is incident on the capital of that business, rather than any labour income stream.
Do you agree? Do you see any paradox in either of these?
@fibby
“Your definition deviates from the definition which I believe is traditional for discussing matters of inequality”
I would not disagree with that as:
1) The change in timing does have income effects,
2) The change in timing has (additional) welfare effects.
However, as I stated my aim wasn’t to discuss inequality – but to use typical definitions of the tax system to illustrate the equity-efficiency trade-off between any “flat” and “progressive” version of a given tax rate.
“Instead, let’s consider the implications of your given definition for donations made to a nonproductive charity”
The non-productive charity is merely a part of the chain between income and consumption. Where the burden of the tax falls depends on the incidence of the tax – not where the tax falls.
So, if a charity gives out all the funds it receives then it does not matter whether the tax is on the consumption of those that receive the donation or on the income of those giving the donation – the real transfer will be the same. That is the only point I’ve attempted to make.