One thing I have noticed of late is that many people want to talk about tax cuts in terms of “who gets what”. We see someone with an income of $XXX and say they will get $Y a week from the tax cut. I find this perplexing as I have never seen tax this way.
The reason why I find this way of looking at tax changes strange is that it ignores how prices change in response to the structure of the tax system. I fear that, to many people, this seems like a benign (possibly even esoteric) issue – when actually it is one of the most essential issues to keep in mind when thinking about the design of a tax system.
The first step required to analyse this is our good friend the “economic scissors” – or supply and demand. The introduction of a tax creates a “wedge” between our supply and demand curves, which in turn implies that the quantity produced in the industry is lower, and the prices faced by the supplier and the purchaser are different.
Now in the case of the labour market, the purchaser is a firm and the suppliers are workers. Only by looking at how responsive supply and demand are to changes in the “price” (wages) can we infer what will happen when we change the tax rate – both to the welfare of the individuals in the market and the output produced in the market.
Update: Eric Crampton discusses experimental evidence that shows where people struggle with this concept.
However, our scissors only take us so far. The labour market is not independent of other markets out in society. A higher tax in the labour market implies that input costs are higher in the goods market – a factor that influences prices and output. Furthermore, lower production in the labour market implies just that – lower production/output.
Given the general nature of a tax on all labour income, and given the fact that labour is an input, it is not really clear exactly how a tax on one group will impact on everyone is society. It is possible to say that, although a tax on the wealthy which redistributes will make the poor relatively better off – it may also make them worse off in an absolute sense [note, this is not inconsistent with the second welfare theorem as a labour tax has a supply side impact that a “redistribution of endowments” does not]. Now I don’t believe that we are near a stage where this is the case – but it does illustrate that the idea of redistribution is inherently fraught with complications.
Furthermore, the welfare costs of the transition between different tax systems are inherently difficult to understand. Saying that so-and-so gets a $Y a week tax cut may be true in that very moment of time – but within a year the path of prices in the goods market, the negotiation of wages in the labour market, and the path of government spending will all have likely changed relative to their pre-tax cut level.
As a result, how this transition functions has costs and benefits in of itself – which is also an important issue to understand.
As we have described above, the issue of “redistribution” through “labour tax” is unclear. This is one of the primary reasons why economists like the idea of a “flat tax” – since the redistributive impact of progressive taxation in itself is unclear.
If we combine a flat tax system with a targeted benefit system (which is based on both extensive research and an exploration of societies preference for redistribution) we have a clear and transparent equity-efficiency trade-off. This seems like an appropriate way of forming, and then fulfilling, our social contract.
However, the same people complaining about the $Y a week so-and-so gets would criticise such a shift to a flat tax system on the same grounds. Hopefully, by pointing out that such a static view of tax changes doesn’t make sense we can help put the desires for a more transparent tax system in context.