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CHAPTER 18

WHAT’S TO LOVE ABOUT TAXES?

Free Riding on Public Goods, Deadweight Loss, and the Lesser of Two Evils

The Stamp Act of 1765 required American colonists to pay taxes to Great Britain for all newspapers, legal documents, commercial contracts, licenses, pamphlets, and playing cards. What rubbed colonists the wrong way was not taxation as such but the fact that they were taxed without having direct representation in the British Parliament. American colonists’ tax dollars were going toward things that they cared little about, such as paying down Britain’s debt after the French and Indian War and supporting British troops who were posted to “protect” the colonies. The Tea Act of 1773 was the last straw, spurring the Boston Tea Party and helping to spark the Revolutionary War. The Tea Act actually reduced taxes and trade barriers for tea imported from the British East India Company, lowering tea prices for colonists. The taxes had been beneficial, however, to colonial tea merchants who sold tea smuggled from Holland. Lower taxes on British tea left little room for competition and gave the East India Company a virtual monopoly on tea sales.

After winning the Revolutionary War, the Americans passed tax legislation as one of the first steps in forming the United States, and taxation is now a favored means of providing public goods throughout the world. We all love to hate taxes, but in our zeal to get the tax man off our backs, we might make missteps if we don’t step back and consider the wisdom as well as the woes of this exercise in pooling money. This chapter examines some of the pros and cons of taxation.

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Chapter 11 introduced the concept of public goods—those goods that anyone can use without paying for them and which rational wealth maximizers would not voluntarily purchase because they can free ride on the purchases of other people. Taxes are the ticket to adequate funding for public goods, such as police, parks, firefighters, national forests, national defense, public transportation, public schools, prisons, courts, environmental protection, and disaster relief. People tend to take public goods for granted, but they form the foundation for civilization as we know it, and taxes are simply the way of paying for them.

Taxes are about cooperation to achieve a greater good. The incentive is for individuals to evade taxes and free ride, but the Internal Revenue Service is in the business of balancing that incentive with the prospects of fines and imprisonment. There are many calls for lower tax rates as a route to fatter wallets without the risk of punishment. The bad news is that tax cuts can necessitate erosion in the provision of public goods, and public goods can be a tremendous bargain. When a neighborhood of 100 homes pools funds for a playground and tennis courts, each family has these services at 1/100th of the cost of building its own playground and courts. When 100 million taxpayers pitch in to pay for the U.S. Centers for Disease Control and Prevention,¹ for a tiny fraction of the cost of a noncooperative approach, the country receives better disease prevention services than individual efforts could provide.

¹ See www.cdc.gov.

Virtually every society on earth has grappled with the concept of taxation and decided it’s a keeper. In ancient times, scribes collected taxes for the Egyptian pharaohs. The ancient Athenians imposed a monthly tax, called a metoikion, on immigrants. Caesar Augustus provided retirement funds for protectors of the Roman Empire by levying an inheritance tax. After Rome fell, the Saxon kings imposed custom duties and property taxes.

As useful as taxes appear to be, voters gobble up promises of lower taxes. The cliché is that, if elected, new politician X will lower taxes without reducing services by cleaning house and eliminating the wasteful inefficiencies of government bureaucracy. Greater frugality is a virtuous goal, but after the election, politician X generally has a much harder time finding and eliminating waste than was suggested in campaign rhetoric. Soon after taking office in 2004, California governor Arnold Schwarzenegger kept his promises to revoke the car tax, freeze state spending, and audit the state budget. Rather than finding enough painless ways to tighten up the budget, the trade-offs necessitated by these measures included cuts in spending for education and transportation, higher tuition fees at state colleges, and $15 billion worth of debt from the sale of bonds. A similar scenario unfolded in Virginia when the 1997 gubernatorial election hinged on promises to revoke a car tax. At the Web site www.virginiaplaces.org/taxes/, the problem is summed up this way: “Cutting government costs without reducing services that are appreciated by the voters is like trying to find the fat marbled through a piece of steak.”

Taxes can achieve great things, but that doesn’t mean that all taxes are good, that higher taxes would be better, or that any taxes come without their own troubles. As a student of the economic way of thinking, you know that each particular tax should be evaluated in terms of its costs and benefits, and taxes should be raised or lowered until an additional dollar collected will cause more harm than good. Among many potential pitfalls, taxes can be misused, too high or low, unfair, or inefficient.

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When contemplating new taxes during the Civil War, Senator Garrett Davis pronounced that the guiding principles of taxation should include “the idea that taxes shall be paid according to the abilities of a person to pay.” If it is proper for people who earn more to pay more, how much more should they pay?

A progressive tax obligates people with low incomes to pay smaller proportions of their incomes in taxes than people with high incomes do. For example, the Tax Act of 1862, signed by President Abraham Lincoln to help pay for the Civil War, collected 3 percent of income more than $600 and 5 percent of income more than $10,000.² Like the current U.S. income tax, the 1862 tax collected a relatively large share of large incomes and was, therefore, progressive.

² See www.taxworld.org/History/TaxHistory.htm.

A proportional tax represents the same proportion of every person’s income. At the end of the Civil War the tax laws were changed to require a flat 5 percent of income from all taxpayers. A flat tax is proportional because each person pays the same proportion (in this case 5 percent) of his or her income in taxes. A flat tax can be transformed into a progressive tax by making an initial amount of earnings tax free. The post–Civil War tax code allowed an exemption of up to $1,000 for rent payments or the rental value of one’s home. In the simplified case in which everyone received the full $1,000 exemption, a person earning $5,000 would pay 5 percent of $5,000 − $1,000, or $200, in taxes, and a person earning $10,000 would pay 5 percent of $10,000 − $1,000, or $450, in taxes. Because $200 is 4 percent of $5,000 and $450 is 4.5 percent of $10,000, the tax is progressive.

A regressive tax obligates people with low incomes to pay a larger proportion of their income in taxes than people with high incomes do. For example, in 1643 the British Parliament imposed taxes on essential commodities, such as grain and meat, to pay for the army commanded by Oliver Cromwell. This excise tax was regressive because the poor devote a larger share of their income to essential commodities than the rich do. That is, a person who earns $4,000 per year might spend 75 percent of that income ($3,000) on food, whereas a person who earns $40,000 might spend only 15 percent ($6,000) on food. If there were a 5 percent tax rate on food purchases, the lower-income person would pay $150 of his or her income in taxes, which amounts to 3.75 percent, and the higher-income person would pay $300, or 0.75 percent. The resulting tax burden on the poor led to the Smithfield riots of 1647.

Chapter 9 explained that deadweight loss is loss that, unlike any sort of transfer from one person to another, does not become anyone else’s gain. Taxation is a potential source of deadweight loss. Tax revenues themselves represent transfers from taxpayers to the government. However, when goods and services are taxed, fewer of them are bought and sold, the result being a loss of the net gains that would otherwise be received from units not sold because of the tax. Consider the example of airline tickets. Suppose that, in the absence of taxes, the equilibrium price for a round-trip flight from Reno to Atlanta would be $350. In reality, the tax on this flight is $65. The airlines can’t simply raise the price by $65 and keep filling the same number of flights because fewer people are willing to pay $350 + $65 = $415 for a flight than are willing to pay $350. With any sizable increase in the ticket price, fewer flights will be demanded and the marginal cost of providing flights will fall.³ The airlines will raise the price until an even higher price would deter enough customers to decrease revenues by more than the decrease in costs.

³ The law of diminishing marginal returns implies that marginal cost decreases as quantity decreases.

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Regardless of who actually sends the tax payment to the government, the tax burden is typically shared between customers who pay more than the no-tax price and producers (in this case, airlines) who receive less than the no-tax price. Indeed, the actual airfare for a flight from Reno to Atlanta is $380—$30 more than the supposed no-tax price. After the tax amount of $65 goes to the government, American Airlines receives the remaining $315—$35 less than the no-tax price. The tax revenue is money that would have been part of consumer or producer surplus, but it does not represent a net loss because the government gains what the consumer and producer lose. The deadweight loss results from the decrease in the number of flights. Those flights created consumer and producer surplus—benefits beyond the price for consumers and revenues beyond the cost for airlines—and the surplus from those flights is completely lost.

The Joint Economic Committee of the U.S. Congress reports that each additional dollar of income taxes collected creates a deadweight loss of 25 cents.⁴ The deadweight loss created by a tax is often unavoidable, but policymakers decide that the loss is outweighed by the benefit of the tax. There are also ways to craft tax plans that minimize or eliminate deadweight loss. When consumers will purchase the same quantity of a good at any price, as might be expected for a lifesaving medication that has no substitutes, the demand is described as perfectly inelastic and the demand curve is vertical. If a $10 tax on heart medicine did not change the quantity purchased because of inelastic demand, no deadweight loss would result because there is no reduction in consumption and, therefore, no loss of surplus. The manufacturer would not need to absorb any of the tax burden because the consumers would pay any price for the product, and the $10 tax revenue would come entirely from patients and would exactly offset the lost consumer surplus. A tax on heart medicine may be unpopular, but the same logic applies to taxes on, say, cigarettes, whose addictive qualities create demand that is inelastic, though not perfectly inelastic.

⁴ See www.house.gov/jec/tax/taxrates/taxrates.pdf.

A lump-sum tax is a predetermined amount that is collected from firms or individuals regardless of their behavior. Lump-sum taxes create no deadweight loss because they do not distort incentives to produce or consume. Firms produce until the marginal revenue no longer exceeds the marginal cost. If each airline paid a $200,000 lump-sum tax, the marginal revenue or the marginal cost of flights would not be affected, so the behavior of the airlines would not change unless the tax put them out of business. A sizable lump-sum tax on consumers might induce them to purchase fewer goods as a result of the decrease in their disposable (after-tax) income, but there would be no distortion in the incentives to buy some goods rather than others, as is created by taxes on particular goods, and lump-sum taxes are the most efficient way to collect a given amount of tax revenue.

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Fans of efficiency praise lump-sum taxes for keeping deadweight loss at bay; fans of equity dislike them because they are regressive. Choosing among the equity of proportional taxes, the arguable fairness of progressive taxes, and the efficiency of lump-sum taxes is a tough call. Jean Baptiste Colbert (1619–1683), French economist and minister of finance under King Louis XIV, summed up his view of the dilemma this way: “The art of taxation consists of so plucking the goose as to get the most feathers with the least hissing.” Given the morals, politics, and emotions involved, there is no easy answer, and the next section explains that in practice we see a mixed bag of taxes.

Income taxes, collected as a percentage of earnings, generate more than $1 trillion in annual revenue for the U. S. government. For single taxpayers, the Internal Revenue Service collects 10 percent of the first $6,000 of taxable income, 15 percent of the next $20,500, 25 percent of the next $37,250, 28 percent of the next $70,000, 33 percent of the next $156,000, and 35 percent of all additional income (these dollar values are approximate). The rising marginal tax rates make this tax progressive. In practice, the progressivity of the tax depends not only on the tax rates but also on the abilities of taxpayers at various income levels to shelter their earnings from taxation by taking advantage of legal exemptions and deductions. Billionaire Leona Helmsley is infamous for saying, “Only the little people pay taxes.” But then, Helmsley went to prison for tax evasion, so the little people got the last laugh.

A sales tax is collected as a percentage of payments for purchases. The United States currently has no national sales tax; state sales tax rates range from 7.25 percent in California to 0 in Alaska, Delaware, Montana, New Hampshire, and Oregon. Sales taxes are regressive because relatively rich people devote more of their wealth to saving and investment and spend a smaller share of their income. Most states exempt food from sales taxes, a policy that reduces the regressivity of the tax. A fixed sales-tax credit to low-income families based on the number of residents in a household is used in Canada, and has been considered in the United States,⁵ to mitigate the regressivity of sales taxes.

⁵ See www.willamette.edu/centers/publicpolicy/projects/oregonsfuture/PDFvol2no3/2_3mcbri.pdf.

An excise tax differs from a sales tax in that it is imposed on particular goods and services. Excise taxes are usually unit taxes, meaning that a certain amount is collected per unit, but they can also be ad valorem taxes, meaning that the tax is a percentage of the sales price. The state excise taxes on cigarettes (ranging from 5 cents to $2.46 per pack) and liquor (ranging from $1.50 to $12.80 per gallon)⁶ are unit taxes. These taxes are sometimes called “sin taxes” because they are usually imposed on goods that some consider immoral or unhealthy. The reasons behind these taxes may also have to do with the desire to minimize the hissing to which Colbert referred: It’s harder for the “goose” to complain about taxes on products that can be deadly, and the relatively inelastic demands for addictive substances result in a smaller consumer response to the taxes. Sin taxes are often regressive because relatively poor people spend a larger proportion of their incomes (not to be confused with spending more in absolute terms) on consumer goods, including cigarettes and alcohol. Conversely, some excise taxes are applied to the indulgences of the rich, such as yachts and large homes, and these “luxury taxes” are clearly progressive.

⁶ See http://www.taxadmin.org/fta/rate/liquor.html.

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Value-added taxes (VAT), known as goods and services taxes in Australia and Canada, are imposed at every step along the path to market. Producers of raw materials, manufacturers, wholesalers, and retailers pay the tax on the difference between what they paid for their input and what they received for their output. On selling sugar to Cadbury, Inc., a sugar beet farmer in England is charged a VAT of 17.5 percent of the price she receives for her product. When Cadbury sells its chocolate to a wholesaler, the company pays 17.5 percent of the difference between what it paid for its ingredients and what it received for its chocolate. The wholesaler then pays the VAT on the difference between what it paid Cadbury and what it received from the retail store, and the retail store pays the tax on its markup.

A poll tax is a type of lump-sum tax that requires a specific payment from each adult. Poll taxes are regressive because they require the same payment from each individual regardless of income. A poll tax of a half-shekel (about 31 cents) per adult is mentioned in the Bible (Exodus 30:12–16), and poll taxes were common in the United States until the early twentieth century. In 1964, the 24th Amendment to the U.S. Constitution disallowed poll taxes as prerequisites for voting in federal elections, and in 1966 the U.S. Supreme Court extended that prohibition to all elections. The political demise of British prime minister Margaret Thatcher is widely attributed to her unpopular attempt to impose a poll tax in England in 1990.

A property tax is levied on some measure of the value of property, such as a home, an automobile, land, or an inheritance. For simplicity, the value of homes has previously been measured according to the number of windows, and, as one would expect, people responded by bricking up windows in old homes and installing fewer windows in new ones. Property taxes are generally progressive because people with high incomes are more likely than lower-income people to own homes, cars, and land.

A capital gains tax is levied on profits from the sale of an asset, such as a home or shares of a stock. Capital gains on assets held for less than a year (for example, that Coca-Cola stock you bought yesterday and sold today) are taxed at the same rate as ordinary income. Capital gains on assets held for more than a year are taxed at a lower rate, which depends on your income and the length of time that you held the asset. Because capital gains go disproportionately to wealthy investors, the favorable treatment of income from capital gains makes the tax code less progressive.

Participation in the popular sport of tax bashing is good fun, but when it comes time to fine-tune tax policies, it is important to understand both sides of the tax dilemma. As a solution to the inadequate provision of public goods because of free riding, taxes can be the lesser of two evils. When people complain that the roads are full of potholes, that the public schools should have more resources, that the police should stop more crimes, and that more should be done to fight disease, they’re calling for benefits that more tax dollars could provide. Taxes are like medicine: It’s terrible to have the wrong medicine and bad to have too much, but you’ll be glad tomorrow if you take the right dose today. The provision of public goods is central to our quality of life; the challenge for policymakers is to develop a tax system that does as little as possible to distort the incentives to produce and consume and that reflects a proper balance between equity and efficiency.