What Should We Tax?
We began our examination of government by looking first at proposals to reform the tax system and noting their deficiencies. We then looked at both the purpose and cost of government and noted that government has exceeded its legitimate purposes and hence its reasonable costs. We can now return to the question of tax reform, and determine how this should be done, because at the heart of governmental reform is tax reform. It is evident by now that the “starve the beast” strategy was a failure; under this strange diet, government “bulked-up” rather than “slimming-down.” Only by identifying the proper sources of public revenue, and insisting that government stay within these limits, can we hope to achieve any real reform. So the central question is, “What should we tax?”
There is a bromide about taxes that goes, “If you want less of something, tax it.” Currently, the burden of taxation falls on capital and labor. Now, I can't think of any reason why we would want less less labor or less capital; therefore, the fairest and best tax on labor and capital is a flat-tax of zero percent, with some notable exceptions, discussed below. But if we eliminate taxes on labor and capital, is there anything left? Is there anything in the economic universe that we want less of? I believe there is. In fact there are two things that can be taxed, one with no impact on economic development, and the other with the deliberate goal of limiting adverse impacts. The first thing is economic rent and the second is taxes on externalities.
I repeat here our discussion of economic rent from Chapter X: Economic rent is an amount paid to a factor of production that is more than necessary to keep that factor in production in its current use. It is the very essence of economic inefficiency. For example, the price of steel must be enough to pay for the raw materials in the steel and to compensate the labor and capital that went into making it. If, however, the price rises very much above this amount, then steel claims an economic rent. This rent acts like a tax on all users of the steel, a tax that really doesn't buy anything, but only transfers money from one group (the consumers) to another (the owners). In the case of elastic, reproducible commodities (like steel), this is only a short-term problem, since (in competitive markets) the higher prices attract more labor and capital, the supply is increased, the prices fall, and the economic rent disappears. In the short-term, and for normal commodities, economic rent serves a purpose.
But this does not happen in the case of land; there, the rent is chronic and distorts the returns to both capital and labor. Recall the discussion of the law of ground rents from Chapter IX. Ground rent has the first claim on all incomes, and returns to labor and capital (“the wage line”) can only be paid after ground rent is satisfied. Moreover, this ground rent represents unearned income. Property increases in value because of the growth of population, improvements in technology, or off-site improvements. None of these things are attributable to the land owner; he merely reaps where he did not sow. All ground rent is economic rent. Land costs nothing to keep it in production. Capital and labor are consumed in the process of production and must be replaced; the land endures.
Consider a case where a landowner leases out a piece of property to an entrepreneur to build a factory. The factory lasts, say, thirty years, and at the end of the time it is “used up.” It is torn down and hauled away. But the land remains and is ready for the next use. All this time, the landlord has been receiving an income, and all the while the property has been increasing in value (assuming an increase in population and advances in technology). Yet the landlord did nothing to earn this income; it is strictly a reward for owning the property, not for using it. The income is due to the community, and by rights should go to the community.
Note that we are speaking of taxing only the ground rent; the improvements would not be taxed at all. The improvements to the property represent capital and labor, and their work should not be taxed. Only the ground rent, the portion provided by the community, would be taken, and taken at something close to 100% of its value. This is not a new idea. It was the form of taxation favored by economists from Adam Smith to Milton Friedman. It was most famously popularized by Henry George, a name that is forgotten today, although he was the most well-known and popular of the economists of the late 19th and early 20th centuries. Some measure of his popularity can be gathered from the fact that at his death, 100,000 people filed past his coffin, and thousands of others waited outside and could not get in to pay their last respects. Can you imagine the general public lining up to for the funeral of any other economist?
George's theory is often called a “single-tax” theory, because it reduces all taxes to ground rent alone. However, this is a misnomer, since it should be called a “no-tax” theory. A tax is a cost added to a price or subtracted from an income. A sales tax is added to the price, an income tax deducted from the income. And these taxes tend to get passed along to the final consumer. But the Georgist “tax” simply appropriates the income of the rentier, the person who lives off other people's work. Nor can this “tax” be passed along. Ground rent already tends to absorb all values over the margin of production; the price cannot be increased beyond this.
The major question is whether such taxes are just, whether the major burden of taxation should fall entirely on the rentier. Two points are important here: One is that the value of ground rent is due to the community, not the owner (Chapter IX). It is but justice that the community be funded from its own natural revenues. The second point is that ground rent always represents wealth without work, the primary source of both economic inefficiency and economic injustice. Wherever one person gets wealth without work, another must provide work without wealth. Clearly this is unjust, but it is also inefficient. The maldistribution of incomes affects such technical measures as the velocity of money and the incentives to invest, and thereby destabilizes the economy. But further, it leaves the community without a source of revenue for public purposes; the community therefore has no choice but to go after the returns to labor and capital, which negatively impacts both. Taking the ground rents impacts neither—any further than rent does, anyway. Therefore, we can assert that ground rent is the natural income of a community. Rent derives its power strictly from a legal claim to property; that is to say, it is a creation of government power, a power that recognizes no limits to property. But property, like any other natural thing, has natural limits. And the natural limit to property is that one should profit from its use and not from mere ownership.
Taking ground rent would have profound macroeconomic consequences. For one thing, land speculation would be unprofitable. The only way to make money off of land would be to use it, to employ it in providing a useful good or service to one's neighbors. The whole problem with the speculative rent line and the resulting land bubbles and subsequent contractions would disappear. The economy would be far more stable. For another thing, wages and investment would get their full return; both are now burdened by both rents and taxes. Without taxes on either, the work and investment climate would be very much improved.
But is it Enough?
Although many economists generally concede the superiority of ground rents, they also doubt that it is adequate, especially when the total government expenditures come to $5 trillion. In this critique, they are absolutely correct. It is unlikely that ground rents could support a government establishment that takes one-third of GDP, an amount that is growing, especially during this current crisis. But that is not so much a critique of the land tax as one of its greatest advantages. Under a land tax, the public revenues would be fixed and known. Government at all levels would be confined within the limits of their funding. But how much would that funding be, and is it adequate to a reasonable level of government?
Empirical studies are hard to come by, since local taxing authorities are not overly concerned with separating the price of the land from the price of the improvements. The best studies suggest that ground rent revenue would come to about 20% of GDP, or about 60% of funding at all levels of government.1 This would certainly leave a big hole in the current level of government, but this might not be as big a problem as it appears at first glance. It would force government to consider what should be funded from general revenues, and what should come from user fees. We have already discussed how the highway system is the obvious example of an expense that can be moved from general revenues to tolls. But there are many items in the budget that are in fact services to particular clientèles. For example, the Food and Drug Administration is a service to the pharmaceutical firms, among others, and its entire budget should come from user fees. By cutting the bloated defense budget, going to debt-free money, eliminating useless departments such as education, charging public works to the properties that benefit from them, and such like measures, the federal budget could easily be cut by 40% without compromising any current services.
I suspect that the same rules would apply to state and local governments. The lion's share of these budgets are consumed by an ever-more-expensive education system. However, while it is certainly a duty of government to ensure that every child has the same opportunities to get an education, there is no reason for the state to actually run any schools, a task which they do not do well. A system of vouchers to parents would likely bring both great diversity and great economies to the educational system, while allowing the public to recoup their investment by selling the schools and putting the land back on the land-tax rolls. Support for education should also include some modest support for home-schooling.
Political power tends to flow to the greatest funding source. When the Federal Government gained the power to tax incomes, power naturally flowed upward, so that today senators and presidents routinely handle matters that are best left to the town council or the statehouse. A land tax, however, is most efficiently collected at the local level. The apparatus for doing so is already in place, since localities collect property taxes, though under widely varying rules and rates. The rules and methods would have to be standardized across the nation. But a land tax would entirely change the nature of government in the United States. With taxes collected at the local level, and divided in a fixed proportion among local, state, and federal authorities, we can expect that power will begin to flow back to the states and cities. And with a fixed budget, it will be easier to confine the federal government within its constitutional limits.
I suspect that the two great debates in a land-tax system will be how to split the revenues and which programs should be funded or subsidized from general revenues and which should be funded by user fees. As matters currently stand, states and cities have an incentive to “kick problems upstairs” to the federal government, where the money is. Relying on the federal budget allows local entities to claim a bigger share of the income taxes their citizens pay, and to isolate the local tax base from these responsibilities. But a land tax reverses these incentives; since the tax base is the same for all levels of government, only the division of the revenues is at issue. Local entities therefore have an incentive to accept greater responsibility and hence claim a greater share of the revenue.
Further, they have an iron-clad argument when dealing with the federal government; they merely need to ask about any particular program, “Where in the Constitution is this authorized?” Of course, they have that argument today, but they are not inclined to use it because the funding argument will always trump the Constitutional one. Under a land tax, both arguments will work in favor of the local entities. The land tax will therefore advance the distribution of power which is an essential part of distributism. It will also encourage leaders at all levels of government to offload as many programs as possible from general revenues to fee-based services.
The Land Tax and Distributism
In advocating the land tax, I am not advocating something without historical precedent or current practice. In fact, the majority of tax systems before the modern age were based on land. The English feudal system was essentially a land-tax system. And in the modern world, highly successful states like Singapore, British Hong Kong, and Taiwan are “Georgist” land-tax states. However, these states also indicate the problem with the land tax. In theory, the value of land should be easy for the authorities to calculate, since there is always an active market in land. And this is true, so long as there are no tax implications in separating the price of land and the value of the improvements. Two problems arise: One is that since improvements are not taxed, there is an incentive to attribute as much value as possible to the improvements and as little as possible to the land. The second is that when land ownership or control is concentrated, the landowners exercise considerable influence in setting the rules. Thus, a “pure” land-tax system has been difficult to establish or maintain over time. It tends to degenerate into a mere property tax which is insufficient to fund the state and becomes supplemented by income and other taxes (although usually at a much lower rate than in non-Georgist states). Large landowners like to see other taxes, because these are easier to avoid or to pass on to the final consumer.
The land tax works best where ownership is well divided and property not concentrated into large estates or tracts; in other words, in a distributist state. With land well distributed, political power is also well distributed, and the incentives to “off-load” the taxes from land to labor are decreased. On the other hand, a distributist state needs the land tax to prevent property from re-aggregating; without a land tax, the distributist state tends to degenerate into a capitalist state, and no one is better off. Therefore, a Georgist polity needs distributism for its implementation; distributism needs Georgism to maintain itself.
Other Forms of Economic Rent
Land rent is not the only form of economic rent, even if it is the most obvious and important one. Other rents arise from monopoly or oligopoly control of economic resources, from patents, from control of scarce commodities, and from occupying positions of power with large institutions, mainly the corporation. This rent manifests itself in various ways, but the most obvious way is suspiciously high returns to capital. To deal with these other forms of rent, I suggest that the corporate income tax be maintained, but only assessed when the return to capital gets to be outsized. I suggest that we adopt some figure as a “normal” return to capital, say 8%, and start a modest tax when double that return is reached (16%), a high tax when it is tripled (24%), and a punitive tax when it is quadrupled (32%).
This would not impact the willingness to invest. While in general high returns attract investment, such returns, like every other economic quantity, have a “marginal utility.” That is, at some point, higher returns do not attract additional capital, and at a higher rate, the returns actually act as a perverse incentive to discourage further investment. This is especially true in monopolies or oligopolies. When returns are so high, why invest to increase the supply and thereby lower the returns?
In the same vein, high-level executives often collect an economic rent in the form of perversely high salaries and bonuses. These salaries seem to be paid whether or not the enterprise is successful, and indeed some of the highest bonuses are paid for failure, such as when a CEO with a “golden parachute” is fired. These bonuses come out of the rewards that rightfully belong to the workers or the investors. One or two generations ago, a CEO would typically make 20 to 40 times what the line worker made; now CEO salaries run 300 to 500 times that of the line worker. The simplest solution is to require corporations to pay a tax penalty for such salaries. When a salary reaches some multiple of the line worker's salary, say 40 times, the company would pay at least a modest tax, a tax that at some point, say 200 times the average, becomes punitive, in the 75-90% range. Note that this tax would be on the company, not the executive. It would entirely change the nature of the negotiation with that executive, would be certain, and would be easier to collect.
Aside from wealth without work (economic rent), the other great economic evil is forcing some portion of the costs of a transaction on some third persons who are not a party to the transaction. Firms, and especially large corporations, do their best to externalize as many of their costs as possible. The obvious example of an externality is pollution, by which a company will treat the common air, streams, and ground as a free sewer. This sewer will have no cost to the company, but surrounding communities will pay the cost in declining health, increased medical expenses, and shortened lifespans.
Externalities take many forms. One common form is subsidized infrastructures. The “free” transportation systems, for example, are actually subsidies to businesses that depend on wide distribution and supply networks. These subsidies work to the disadvantage of local businesses and suppliers, because they unfairly lower the transportation costs of national and international competitors. “Big-box” stores like Wal-Mart could likely not survive if their transportation costs were not subsidized. This is especially true since the greatest amount of damage to roadbeds is done by large trucks. If there were weight-based tolls for using the roads, it is likely that the Wal-Mart model would simply be uncompetitive with local and regional producers and retailers.
Externalities distort the price system and give companies that can externalize their costs a competitive advantage over those who cannot. As it works out in the real world, it is large, international companies that can more easily take advantage of externalized costs, leaving small and local competitors at a disadvantage.
Aside from going to fee-based services, like tolls, government should use its taxing power to force companies to internalize all of their costs. The current “big idea” for controlling pollution is “cap-and-trade” systems. But such systems convert pollution into a property right, and then give the right to the wrong people, to the polluters rather than those harmed by the pollution. Clearly, if you want more of a thing, turn it into a “right,” especially a marketable right. You may take it for granted that the producers can produce more forms of pollution, and therefore more property rights, faster than you can print the new deeds. The best method is a scale of taxes on pollution that increase over time so as to “encourage” a firm to internalize all of its costs.
In general, government should be vigilant to detect and eliminate externalities. No price system can function properly if firms are freely allowed to externalize their costs either to government budgets or to the public “commons.”
But Should We Cut the Budget?
We have assumed throughout this discussion that cutting government expenditures and eliminating economic rent and externalities are good things. The reality, however, is a bit more complex. The current industrial system actually depends on large government expenditures, economic rent, and the ability to externalize costs. So while cutting the budget in the abstract would be a good thing, in reality it would destroy the current system of industrial production and global trade.
So before we take our scalpel in hand to perform surgery on the budget, we need to understand what we are doing and where we are going. We need to couple fiscal reform with a reform of the industrial system itself. Otherwise, our surgery may be successful but the patient will die. What a new industrial system could look like, one not dependent on government largesse, is the subject of the next chapter.
1Fred Foldvary, “Intellectual Tyranny of the Status Quo,” http://www.econjournalwatch.org/pdf/FoldvaryIntellectualTyrannyApril2005.pdf.