Chapter XII: Taxes and Tax Reform

This is the twelfth chapter in Equity and Equilibrium: The Political Economy of Distributism. The draft of each chapter is posted as it is written, in order to get some help form my readers about what works and what doesn't. All comments and critiques are welcome.

The Fourth Factor

Thus far, we have been speaking of economics in terms of three factors of production, land, labor, and capital. This way of speaking has a long tradition in economics, but in fact there is a fourth factor: government. Production takes place within a framework of laws, institutions, and improvements such as roads, schools, airports, coinage, national defense, courts, etc. There are those who claim that these things can be provided apart from government. That may indeed be true, and for some things it must be true. However, since it has never happened, in all of human history, that all of these things were supplied apart from the government, we have no such systems to examine, and hence we can safely leave that argument to the higher realms of economic speculation, and concentrate on what actually occurs in the real world.

Are Taxes Theft?

Unfortunately, all of these things have a cost and need to be paid for. Typically, they are funded through taxation. “All taxes are theft” proclaim certain libertarians. Perhaps. But the claims would have more force if libertarians would refuse to call the police when their homes have been robbed, or the fire department when they are burning. One could say that this holds the libertarian to too high a standard, since we must all live in the world as it is and obey its rules. But since we do live in the world, we must pay for the services we consume; this is not theft, it is simply being an adult.

Nevertheless, even if we cannot agree that all taxes are theft, we might agree that most taxes are, or at least are ill-considered, poorly administered, unfairly allocate the burdens of government, negatively impact production, are expensive to administer, intrusive into the private life of citizens, and a host of other complaints as well, all of which are valid objections. From both the right and the left, we have a near-unanimous consensus that something is wrong. Unfortunately, they cannot agree on just what is wrong. Reform proposals abound, but none have sufficient political support to gain any traction. The major disputes concern two issues: the progressive nature of taxes (whether those who make more should pay a proportionally higher rate) and the whether income from capital ought to be privileged over income from labor, or even whether such income should be taxed at all. On the left, the principles of progressive taxation and the taxing of capital are generally agreed upon, and reform is simply a matter of adjusting the existing code to realize these principles more perfectly. But on the right, there are at least two proposals which eliminate or seriously compromise the progressive nature of income taxes and reduce or eliminate taxes on capital income. These proposals are called the flat tax and the fair tax. Examining these proposals will give us some insight into the nature of income taxes.

The Flat Tax

The flat tax replaces the current graduated tax rates with a single tax rate applied to all incomes. The rate is designed to be “revenue neutral,” that is, to raise the same amount of money for the government that the current income tax does. And if that were all it was, the debate would be confined to the question of whether taxes ought to be “progressive,” that is, whether those with a higher income ought to pay a greater share of that income. However, most flat tax proposals go far beyond this to radically redefine the very notions of income and cost accounting.

The flat tax would have a single rate, usually about 17% in most proposals, and also eliminate all deductions, except a standard deduction, usually about $12,000 for each adult and $6,000 for each child. Proponents of this plan say that all the complex tax forms can be reduced to two postcards, one for individual payers and another for businesses. The individual postcard would simply have a line for “income,” a line for the standard deduction and another for the 17% tax rate. The business postcard would have a line for revenues, another for cost of goods sold, and any positive difference between the two would be taxed at 17%. The business taxes would exclude income from interest, dividends, rents, and capital gains. Proponents believe that they can get the nine-million word tax code down to a few pages. It should be pointed out that the “postcard” form for individuals already exists, the 1040EZ, which although it is not printed on a postcard, could be and still remain legible.

The first problem with the flat tax is that it only replaces current income taxes, not the Social Security and Medicare taxes. These taxes come to 15.3% when the employer's contribution is considered. Therefore, the average worker will have all of his income taxed at 15.3%, and any amount over the standard deduction taxed at a total of 32.3%. This is close to the 35% currently paid by those with the highest incomes on the last portion of their income. Further, since the wealthy earn a higher proportion of their income from interest, dividends, rents, and capital gains, a large portion would not be taxed at all. The result would be a massive shifting of the tax burden from the rich to the middle class; people at the bottom would continue to pay the FICA taxes, as today, the people in the middle would have their total tax increased to 32.3%, and the rich would see their taxes substantially lowered or eliminated entirely. To put it another way, the rich will pay approximately what the middle class now pays, while the “middle class” (defined as anybody making more than the poverty level) will pay a marginal rate equal to what the rich now pay. And those among the rich whose income is completely from capital (dividends and interest) will see their taxes abolished entirely; they will be “taxed” as if they were desperately poor, at a 0% marginal rate.

Indeed, any “revenue neutral” scheme can only shift taxes, not lower them, by definition. If everybody pays the same rate, and if that rate raises the same revenue as the current system, then some must be paying more and other less. Proponents of the flat tax counter that fairness demands equality under the law, while opponents argue that fairness demands a higher rate from greater incomes. But whatever the outcome of the moral argument, the economic argument is dubious. The poor and middle class would lose precisely what the rich will gain. The resulting reduction in the take-home pay of the average worker must have a negative impact on aggregate demand. The rich simply cannot spend or invest their increased incomes fast enough to make up for the losses in wages. This is a phenomenon known as the velocity of money. Money simply moves faster (is more efficient) at the lower end of the income scale. For example, if you give a dollar to a poor man, he immediately takes it to lunch, or spends it to fulfill some other pressing need. But if you give the same dollar to Bill Gates, he doesn't know what to do with it. It fills no immediate need and takes a long vacation before it does any work. During that vacation, it represents purchasing power lost to the economy.

But that is not the only problem with this scheme. The two real problems are, one, the flat tax radically changes our notions of financial accounting, and; two, it conflates “exemptions” with “loopholes.” To take the latter problem first, an “exemption” is some provision in the tax code that allows a person or firm to deduct some specific expense, such as charitable contributions or mortgage interest, from their income. There are thousands of these exemptions in the tax code, most of which benefit some preferred business group. But while an exemption is something specifically addressed in the tax code, a loophole is just the opposite: it deals with situations that are not addressed in the code, but which arise in real business situations and about which the taxpayer is allowed to make his own ruling, a ruling he usually makes in his own favor. There are excellent arguments for eliminating all or most of the exemptions; there are no good arguments for multiplying loopholes. Exemptions are eliminated by repealing portions of the tax code, but loopholes are eliminated by adding to it. The fair tax proponents want to “slim down” the 60,000 page tax code to a few pages. But while this will eliminate all the exemptions, it will multiply the loopholes exponentially.

Why? This brings us to the first issue, the treatment of revenue, expenses, and income as simple and uncomplicated notions. But this is not so. If you ask an accountant how to compute a firm's expenses or income, and they will point you to the Financial Accounting Standards Board's rulings, which run several volumes, and which are always growing as new situations arise. No tax code that deals with income can be any shorter than the Generally Accepted Accounting standards, and in fact must be some multiple of them, since the accounting standards allow wide latitude in the choice of methods, a latitude that would simply allow businesses to choose their reported income, which would, in effect, abolish any tax on business. Income taxes can only work to the extent that they are intrusive and complex, and any attempt to “simplify” them turns the tax code into a series of loopholes that benefit mostly the rich and shift the entire burden of taxation onto labor.

The fair tax plan also makes some other rather odd changes to financial accounting. All capital expenses would be 100% deductible in the year they were made, rather than amortized over the life of the capital goods purchased. This, in effect, converts financial accounting from an accrual basis to a cash basis. In fact, the flat tax as it applies to business is really a cash-flow tax rather than an income tax. A business would pay no taxes on its investment income, but interest expense would not be deductible, which sounds bizarre. Equally bizarre is the provision that payments for “fringe” benefits, including the employer-paid social security tax and health insurance, would not be deductible. This would force these payments to be made as “wages” and therefore taxable to the employee at the 32.3% rate. It is hard to interpret this provision as anything but a direct and gratuitous attack on labor.

The “Fair” Tax

If incomes cannot be taxed without an intrusive and complex code, what about consumption? This is the idea behind the so-called “fair” tax, which is actually a National Sales tax of 30%. Unlike the flat tax, this tax would replace all income, social security, and medicare taxes, and would be levied on purchases of new goods and services by all consumers and governments. Business purchases would be exempt. “All” purchases here means just that: cars, homes, medical services, drugs, food, insurance policies, etc.

Since a 30% tax would cripple the poor, a monthly “prebate” would be given to all citizens, equal to a “consumption allowance” calculated to be near the poverty line. For example, a single person would have a consumption allowance of $10,400/year, and 23% of that amount would be “prebated” to him on a monthly basis at a rate of $199/month. A family of four would get a prebate of $567/month. This amount would go to all citizens, whether they were poor or not; everyone would be on the welfare system.

Fair tax proponents believe that the entire Internal Revenue Service and its army of agents could be eliminated because the current state sales tax agencies would collect the tax. They argue that the accounting expenses of the tax code would be eliminated, prices would go down because there are no tax expenses on production, that there would be no deductions on paychecks so that workers would keep all that the earn. Further, the proponents claim that there would be no room for fraud. All of these claims can be easily shown to be false or even fraudulent.

The first problem is that fraud would be rampant, and the new system creates many opportunities for fraud. The first opportunity is that all business purchases are exempt. But since the elimination of the income tax means that businesses no longer report their incomes to the government, everybody will want to declare themselves a “business” and exempt all of their purchases. Without auditing their books, it will be impossible to know whether or not they really are a business or just a tax dodge. In order to prevent such fraud, you would have to have a reporting system similar to the one that is already in place. The second opportunity for fraud comes from legitimate businesses converting all of the living expenses of their owners or employees into business expenses, thereby making them exempt from the tax. Without auditing their books, it will be impossible to say if the expense actually is a business or a personal expense. The third source of fraud comes in the exemption for “used” goods. The plan does not define a “new” and “used” good, nor the method to distinguish between the two. The simplest way would be to define a “used” good as something upon which the tax had previously been paid. But this would require an enormous record-keeping system, and the system would be easy to avoid. For example, suppose a builder had a new home valued at $300,000, upon which a tax of $90,000 would have to be paid, for a total price of $390,000. Instead, he “sells” it to a confederate for $100,000 plus the tax, now $30,000. Now he has a “used” home, and can sell it for what he likes with no tax He sells it for $360,00, pays his confederate a commission, and undersells his competition by $30,000. But the biggest source of fraud would be in false identification papers. Since every citizen is entitled to a prebate, the traffic in manufactured id's will be tremendous. No self-respecting crook would be without at least ten social security cards, and the prebate that goes with them. Short of the establishment of a police state, it would be impossible to monitor all citizens closely enough to see if they were real persons or imaginary ones.

Nor would this proposal eliminate the IRS. On the contrary, it would vastly expand its powers. It is true that most states have a mechanism for collecting sales taxes, but they all operate under different rules. And no state has a sales tax that intrudes into the doctor's office, home sales, insurance payments, and every other possible purchase. All 50 state departments will have to be put under the direct supervision of the IRS. Further, and a vast welfare apparatus will have to be created to pay the prebate, a welfare department that will cover every citizen, whether real or fraudulent. This would constitute the largest expansion of government intrusion into the life of its citizens since the establishment of the income tax itself.

The proponents of the fair tax claim that pre-tax prices would go down by an amount equal to the tax itself, since businesses would no longer be paying any taxes. But it is not at all clear that this would happen. Certainly, some prices would go down, for items made in this country by firms in highly competitive markets. But this is hardly true of all products, or even most of them. For example, it will have no effect on the price of oil; the Arabs will not give us a break because we have an unreasonable sales tax. Indeed, it will have no effect on imports in general, and they are, alas, a large part of our consumption. In truth, nobody can know what the effects of such a tax would be, because it constitutes the biggest government intervention into free-market pricing ever contemplated since the Russian Revolution; we simply have no experience to guide us in assessing the effects of such a massive intervention.

One cost that would go up under the fair is the cost of state and local government. This is because government purchases are taxed under this plan. And these governments, unlike everybody else, are not likely to engage in tax dodges. Now, at the federal level, this makes little difference; the government both pays and collects the tax; there will merely be some additional bookkeeping costs. But state and local governments will have to raise property and other taxes to pay for the 30% increase in the cost of their purchases.

Finally, for people who must consume all or most of what they make, a sales tax is the equivalent of an income tax; all of their income must be converted to purchases. Every dollar earned beyond the poverty rate will be taxed at 30%, a rate near what the rich pay on their last dollar earned.

Is Reform Possible?

I could offer further critiques of both of these tax plans, but the more interesting question is why two such obviously flawed—indeed, harebrained—tax schemes could generate such support and loyalty. Part of the reason is ideological. People raised on standard economic theory tend to believe that it is wrong to tax capital in any way; they have been taught that capital is the driver of growth, and taxes on capital limit growth more than any other tax. Hence labor, and labor alone, must bear all the burden of taxation. Whatever the differences in these plans, this is the one point upon which they agree. Now, it is certainly true that a tax on anything limits that thing. Hence, a tax on capital limits capital formation (to what degree, however, is debatable). However, a tax on labor limits labor, and labor, not capital, is the true source of all economic values. To limit labor is, therefore, to eventually limit capital formation; the two have the same source.

The second reason is that people are genuinely disgusted with the intrusive nature of the income tax and the government bloat that seems to accompany it. All of our financial dealings must be reported to officers of the state, which is sure to make us all uncomfortable, even when we acknowledge the necessity of paying taxes.

The third reason is that people see the tax code as nothing but a network of loopholes, a veritable tunnel system that allows the rich and well-connected to get around any meaningful taxation, and they believe that these systems will somehow change that. Of course, the “reforms” will just make this worse, but it is the perception rather than the reality that counts in politics.

If the flat and fair taxes are not a practical basis for tax reform, are we limited to fiddling with the various rules and rates that make up the current codes? We have seen this kind of “reform” for the last 30 years and especially in the last eight. The results have not been encouraging. Even in the so-called “recovery,” growth rates were sluggish and seemed to be driven not by any real growth, but by a mere credit bubble in housing, a bubble that is now collapsing with disastrous consequences. Indeed, during this time, the median wage actually fell. And above it all, the debt of the United States is expanding at a dangerous rate, a debt that whose interest now comes to $429 Billion per year and rising.

If the Republican plan has been a disaster, will a “reform” in the other direction work? Obviously, it will work as well (or as poorly) as it worked in the past. These reforms generally have the effect of broadening the tax base to include more capital income, and redistributing that income. This has the effect of giving a slight preference to labor, or would if all the odd exemptions are eliminated.

All of these debates center around the question of whether capital or labor should get preferential treatment. But is this really a rational question? On the one hand, it seems bizarre to tax the labor of a man who digs ditches for a living, while exempting the “labor” of another who only clips coupons. On the other hand, if the bonds that the coupon-clipper clips represent savings from his past labor, his prior-period ditch-digging, why should he be penalized in any way? So the real question is, “Should labor and capital be taxed at all, or, if they are, should the be the primary source of government revenue?”

From our current perspective, this question is astounding. Income taxes are the mainstay of the federal budget, most state budgets, and even many city budgets. Could these taxes be abolished or significantly reduced without wrecking all public finances? What could possibly replace them? However, income taxes are not a constant in human history, nor even in American history. The founders recognized the possibility of an income tax and and prohibited them in the constitution. It was not until the 16^th Amendment was passed in 1913 that the tax had a legal basis. The tax was originally 7% of incomes over $500,000, an enormous sum in those days that would likely have affected a few hundred persons at most. Therefore, the income tax was really on tax on concentrated wealth. But under the pressure of war, debt, and depressions, the rates went up and the minimum income level went down, so that it quickly became a labor tax.

Historically, such taxes have always been regarded as suspicious, or even a sign of oppression. In 1381, for example, when Richard II imposed a poll tax (essentially, a labor tax), the result was Wat Tyler's rebellion, which gathered widespread support across England and quickly captured London and the King. Tyler nearly succeeded in establishing a republican form of government in England centuries before it actually happened, and would have done so, had not Richard reneged on the promises he was forced to sign and had Tyler killed after his army disbanded. Would that we were as conscious of our rights as were the medieval peasants.

But if we exclude or severely limit these taxes, what is left? An age that requires battleships for defense and freeways for transportation might be somewhat more expensive to run than 14^th century England. How will we finance such things? That question can only be answered if we first answer some questions about the scale and scope of government, and the government's role in producing the wealth and prosperity that we all share, or wish to share. These questions are the subject of the next chapter.

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Taxes: What Should they Buy?

Fourth in a four-part series on taxes.

“Taxes are theft!” judges one reader of this humble blog, and more than a few libertarians would agree with him. As near as I can tell, this judgment is based on a view of man as a completely autonomous individual, dependent on no one but himself, answerable to no one, and subject to compulsion by no one. Under this view, to the degree that taxes are compelled they cannot be just.

My problem with this view is that it does not describe any man or woman I have actually met. Every person of my acquaintance emerges not from autonomy, but from dependence. We are all called into being by the ready-made community of the family. Most of what we are comes not by an individual “consumer” choice but by gift. Along with the gift of family, there are the gifts of language, nationality, religion, community, city, state, and nation. Our values are socially formed by these gifts of social context and only after that formation do we find ourselves in a position to accept or reject these received values. What “freedom” we have consists mostly in decisions about how to use the gifts we are given; how to re-arrange them and pass them on. Our very being itself turns out to be already a “being-in-community” which mirrors in some fashion that ultimate community of persons that is at the root of all being, namely the Trinity. At their most basic level, humans are social beings, already formed by institutions “outside” themselves.

And since man is a social being he has social obligations; the gift demands a return if it is to survive to the next generation. Hence, each man has obligations which may, in certain circumstances, be compelled of him. Individual goods are themselves the product of social goods and are dependent upon such social goods; if there is a break-down in the social goods, no individual goods will survive. We are all dependent upon each other; the common good precedes any individual good. A philosophy of pure individualism contradicts the social nature of man. Clearly, there are common goods which no individual (or very few) could provide by themselves. The obvious example is the common defense, but there are others, and they are normally supported by taxation.

But if this rule of the common good gives us the ground for legitimate taxation, it also gives us the ground for judging when taxes are illegitimate. For if the legitimate purpose of taxes are to pay for those things necessary for the common good, then taxes are illegitimate when they purchase not the common good, but individual and particular goods. That is, when good money is taken from all to provide goodies for a few, goodies not connected with the common good, then they are illegitimate.

When we examine the actual expenditures of the modern state, we have ample grounds for questioning whether all of this money, or even most of it, goes to the common good, or are just private goods paid for by the commons. And while we should never (in my opinion) proclaim that “All taxes are theft!” we have more than ample grounds for shouting, “Most taxes are theft!” The one-word difference is crucial.

Of course, there can be different judgments on what constitutes the common good. But there can be no doubt that the system of special bills for special friends (“earmarks”) which burden every budget bill are nothing but theft. And even things that fall in the common good can be used in such a way that much of the money goes for other purposes. For example, we certainly do need an army for defense, but does our defense really require troops stationed in more than 130 countries? Certainly there are private contractors on whom the military is dependent, but do we really need the army of parasites and mercenaries provided by Halliburton and Blackwater? I tend to doubt it.

To take another random example, we can note farm subsidies. Now, a secure food supply is in the common good. As someone who likes to eat three or more times a day, I want to see secure and prosperous farmers, as my own security depends on them. Further, I have no objection (and much praise) for a fund which insures the farmer against the vicissitudes of the weather and the market, since the farmer himself cannot control these things. This fund ought to be largely supported and controlled by the farmers themselves, and it is not unjust if this fund receives a contribution from the general taxes, or at least, from those tax-payers who actually eat. But the current system is not an insurance program at all, but a subsidy, and one not so much to the “farmer” as to the giant “agri-businesses” such as Archer-Daniels-Midland and the like.

Further, we can note that not every common good needs to be paid for by general taxes. Take transportation, for example. Certainly it is a common good, and a prosperous people need a good transportation system. However, it turns out that most expenditures for particular forms of transportation constitute a subsidy for private persons. We build highways, but the only ones who can use them are those who can afford the high capital costs and operating expenses of an automobile. And when we invest so much public money in highways, we privilege one group of users over another, and force people to buy a car whether or not they want to, or whether or not it makes economic sense for them to do so. Now, its not that I think the government should get out of the transportation business; there are good arguments for public roads, since every particular route would have to be a monopoly anyway; you could not efficiently have two competing roads operating on the same route. However, these roads should be paid for by user fees (tolls) and not by general taxation. Indeed, subsidizing the roadways turns out to be both contradictory and self-defeating (see Free Markets, Free-ways, and Falling Bridges.)

We can also note areas where the free market has proven itself incompetent. Modern medicine is one of these areas. Indeed, so long as we are talking about a market that is so dependent on licenses and patents, there cannot be, even in principle, a free market at all (see Sicko-phancy!) We did have a free market in medicine, in the 19^th and early 20^th centuries, and it was a disaster. Hence, there is ample justification for a public system of health care. The specific taxes applied to this can certainly be debated. I will not here enter into that debate, but I will merely note that such a system ought to be supported by taxes dedicated to that purpose, such that if the costs rise, the public will have instant feedback via an increase in those specific taxes.

Our other big problem is retirement funds. Now, in days gone by, there were two sources of social security: have a lot of money or have a lot of children. We have made the latter unfashionable and the former damned near impossible (median wages haven't risen in 30 years). As a practical matter, we cannot do away with the system in any near term without causing social chaos (besides, the old folks vote.) Nevertheless, the system itself is not sustainable and in reality constitutes a surtax on labor incomes that is now used to support the general fund. In other words, it is just an additional income tax on one class of workers but not on others (see Social Insecurity.)

Looking over the budget as a whole, it is my unscientific judgment that at least one-third to one-half of the expenditures are for things that are mere subsidies, or that could be moved from the general taxes to special funds and user-fees. Hence taxes could be cut, conservatively speaking, by one-third to one-half, and could be done without harming, and indeed improving, things that really contribute to the common good. However, cutting taxes depends entirely on cutting expenditures. Candidates don't like to talk about cutting expenditures because each cut cuts into a constituency, either one that contributes a lot money or a lot of votes. We are left with vague promises of cutting “waste, fraud, and abuse” only to see all three increase. Or we get nonsense like Huckabee's “revenue neutral” plan, which on inspection turns out to be “all taxes on the rich are theft; everybody else pays 30%.” And all will end up continuing the program of borrowing to pay for “tax cuts” while spending like drunken sailors. Such “cuts” are not cuts at all, since borrowing is not tax-cutting but tax-shifting; taxes are shifted from the current generation to the next one. We are, quite literally, spending our children's money.

It is unfortunate that Ron Paul, the only actual Republican in the race, has taken the “all taxes are theft line.” It is not merely that it prevents him from getting elected (since most sensible people don't believe that), but more importantly it prevents him from speaking about the more important issue, namely, insisting one fiscal discipline. Spending only as much as you take in, and spending it only for the common good. That platform might actually win, if backed with sufficient funds for a credible campaign. But win or lose, it would certainly be a great moment of political education.

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Taxes: Advice from Adam Smith

Third in a four-part series

When considering any subject relevant to government and economics, I always like to consult Adam Smith. Now, there are many who would disagree with this. Smith gets attacked from both the right and the left, usually for all the wrong reasons. Worse, he gets “defended” for all the wrong reasons; his “supporters” often attribute to him opinions he never held and against which he used his strongest arguments. For example, Smith was not a mindless supporter of “big business,” but in fact fulminated against it. For more on this theme, see my The Forgotten Agrarian: On Rereading Adam Smith. It may be Smith's fate to be among the most often quoted but least actually read of the modern philosophers.

It is not that I consider Smith infallible, but I usually find him sensible, and even when he is wrong or incomplete, he usually highlights the correct issues. In Book V of the Wealth of Nations, Smith has an extensive discussion of taxation, one that still serves us well today. Smith begins his discussion by laying out four maxims by which any particular tax can be judged.

The Four Maxims

• Taxation should be proportional to income. Smith seems to mean this in a negative sense, namely that taxes should not be regressive, because he praises taxes that fall disproportionately on the rich.

• A tax ought to be certain and not arbitrary. That is, “The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor and to every other person.”

• A tax ought to be levied at the time and manner in which it is most convenient for the contributor to pay it. For example, a tax on rents ought to be paid when the rent is paid and not before.

• The cost of collection should be as low as possible. Under this heading, Smith includes four points:

1. The tax should require as few “officers” as possible to collect it.

2. It should as low an impact on industry as is possible.

3. It should create as few temptations to evasion as is possible. Where temptations to cheat are high, the law should be lenient.

4. A tax should not be such as to subject the people to “odious investigation” of their affairs.

Using these four maxims, Smith examines a wide variety of taxes. We shall confine the discussion to those taxes most relevant to our situation, income, sales, and land taxes. One note about Smith's methodology: he discusses issues based not only on theoretical considerations alone, but examines, in great detail, actual examples of taxes as they function both in England and other countries. His method, therefore, is a combination of theory and practice, which saves it from the dry abstractions of the Austrians as well as the pointless empiricism of Chicago School Friedmanites.

Taxes on Labor and Incomes

Taxes on lower wage workers can only have the effect of raising wages sufficiently to accommodate the tax. This is because a worker needs a certain amount to live, and will not work for less than that. Hence, a tax on low-wage labor is, in effect, an increase in the cost of production and is passed on to the consumer.

When a tax is levied on profits fall, for Smith, into two parts, a tax on interest and a tax on the labor of the entrepreneur. The entrepreneur must earn enough above the interest to make his living, or he will simply cease operations. Thus a tax on his profit about interest is equivalent to a tax on labor. A tax on interest payments, however, cannot have any effect on the rate of interest, since that will be set by the market. However, a tax on interest has two problems: one, the amount is difficult to ascertain (this was before the extensive reporting requirements of the modern era), and; two, capital is mobile, and high taxes will cause it to seek other climes.

In all cases, a tax on incomes must involve a severe inquisition into the circumstances of private persons. We all understand what that means. For myself, I do not object so much to the paying of the tax (which Smith regards as the duty of a citizen and the badge of a free man), but to the “severe inquisition” of the tax filings.

Consumption (Sales) Taxes

Smith divides consumption taxes into two parts: that on necessities and that on luxuries. By necessities, he does not mean “the poverty line” or what is merely necessary to sustain a man in subsistence, but that which is necessary for him to participate in a meaningful society. Smith uses the example of shoes. In some societies, it is perfectly acceptable to go barefoot, but not in England. A man who goes barefoot to a job interview in England (or America) is not likely to get the job, is not likely to be counted as a full participant in his society. Therefore, necessities for Smith means a lot more than subsistence.

A tax on necessities works in exactly the same way as a tax on labor. By raising the cost of necessities, one must necessarily raise the cost of labor by the same amount, with the difference passed on to the consumer. The consumer therefore gets a double whammy: an increase in the price via the taxes and an increase in the cost by the necessary rise in wages.

As for a tax on luxuries, Smith has little objection. It will discourage useless consumption by the poor and derive revenue from the rich. But all such taxes are difficult to enforce and the higher they are, they more they encourage what we would call “black markets”. Sales taxes, when they are high, often lead to lower revenues for the government, since the cost of collection is high and the inducement to fraud even higher. Smith's intuitive division of sales taxes into necessities and luxuries is recognized by most taxing authorities, which exclude things like food, housing, medicine, etc. And the taxes are kept relatively low so that the cost of avoiding them will not exceed the cost of paying them.

Taxes on Land

Smith distinguishes between agricultural land and land used for buildings or houses. I will not here take up his discussion of agricultural land. As for developed land, Smith divides the rent into two portions: ground rent and rent paid for the improvements. Any amounts above what gives a reasonable profit on the improvements goes to ground rent.

Ground rent is likely a new concept to many people, but it was of extreme importance in the economic debates of the 19^th and early 20^th centuries. Smith, Ricardo, Mill, Marx, Marshall, Walras, Clark, Senior, Henry George, and many other luminaries debated the issue at great length. Unfortunately (from the standpoint of a complete economic theory) the subject died after J. B. Clark subsumed land into the general “capital fund” theory. Ground rent is the price or rent of land that underlies any improvement on it. It rises with the population of the surrounding area. That is, a parcel of ground in a densely populated city will cost more than than an equally good parcel in a smaller city, which will cost more than a similar parcel in the country. In other words, it is not anything the landlord adds to the land, but what others add to it that raises the ground rent. Peace, prosperity, and population increase raises the price of land without the landlord actually having to do anything. Such increases in the rent or price of land are unearned increments, involving no effort whatsoever on the part of the owner.

For this reason, Smith found that ground rent was the most appropriate subject of taxation.

Ground-rents...are altogether owing to the good government of the sovereign....Nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly, or should contribute something more than the greater part of other funds, towards the support of that government.

Taxes on house rents, Smith held, would fall most heavily on the rich, but he held that to be an advantage. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.

To sum up, we can arrange Smith's taxes in order from most appropriate to the least in this way: taxes on ground rent, house rent, luxuries, incomes, and necessities.

From Smith's principles we can evaluate the tax proposals before us. Of course, the present system of reliance on income taxes violates most of Smith's principles. However, the most touted alternatives are generally worse. The Flat-tax involves all the inconveniences of the current system, plus makes the system highly regressive. This is because it maintains, on top of the flat tax, the FICA taxes, which will give most people a much higher marginal rate than they currently have. However, FICA stops at about $90,000, which means the marginal rate for the highest incomes will be cut in half. The middle class will pay the marginal rates of the rich, while the rich will pay the marginal rates now paid by the middle class. It is hard to think of a tax plan more poorly planned or more unfair.

Unless it is the “Fair” tax. For the majority of people, who must convert all or most of their incomes to consumption, it will function as an income tax with high marginal rates. For the rich, who convert less of their income to consumption, it will be a tax reduction, while for the very rich it will come near to tax elimination. In addition, it will require massive collection and enforcement bureaucracies and encourage cheating on a massive scale. Of all the proposals, it violates just about every one of Smith's maxims.

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Taxes: Fair or Foul?

The second in a series on the principles of taxation.

Somewhere in the Analects of Confucius, the Master says that the first step in solving a problem is to call things by their right name. When things are mislabeled, it is very difficult to think about them correctly. On the other hand, if you do not wish people to think correctly about an issue, the first step is to mislabel things. If you deliberately wish to confuse people, you can start in no better place than to give things the wrong name. A name describes what a thing is, and if you wish to conceal from people what that thing is, then call it something it is not.

However, mislabeling things does give a clue to the fact that someone is trying to mislead you. If someone is afraid to call something by its right name, then they are afraid that people will find that thing fearful. Which brings us to the 30% National Sales Tax. I use this name because it describes what the thing is. But if you have not heard of it before, it is because the supporters of this idea do not call it by this name. They are afraid that any name which accurately describes it would certainly cause people to fear it. And I am afraid that they are right. The name they have chosen is one that gives an opinion about the tax, rather than describe what it is. One is certainly entitled to one's opinions; one is not entitled (this side of Karl Rove and George Bush) to misuse the language. And the opinion they have rendered on their own plan, the mislabel they have chosen for it, is the “Fair” Tax. I am not concerned, for the moment, with whether this opinion, rendered as a “name,” is accurate. My concern for the present moment is why they chose this particular bit of propaganda for their moniker.

The reason is simple: they have perceived, quite correctly, that fairness is a basic principle of a just tax system. Now, I do not know what standards the backers of this tax use to render the judgment of fairness on their plan. I have searched their web site (www.FairTax.org) in vain for a definition of “fairness.” So I will have to supply my own. And I believe that we can define fairness as justice.

But what is justice? Obviously, there are many different notions of what constitutes justice, but I believe that they all have one thing in common, namely the idea that what one gets should be proportional to what one gives, that one's rewards should be commensurate with one's contributions. There is not much dispute, I believe, about this principle. However, the devil is in the details. No one will quarrel with the proposition that if you spend a dollar, you should get a dollar's worth of goods; if you pay for a pound of ground beef, you should get a pound, and it wouldn't be just if the butcher had his thumb on the scales. This is justice in exchange, or what Aristotle called commutative or corrective justice. This kind of justice deals with exchanges between individuals or between firms acting like individuals.

But there is another kind of justice called distributive justice, which deals which how collective entities (a family, a company, or a state) distribute their corporate products to the individuals that make up that collective entity and contribute to it. And it is a fairly well established principle that rewards from the corporate entity (the state, in this case) should be distributed in proportion to the contributions each individual makes. Now, there are many different kinds of contributions to the common good (which is, or should be, the “product” of the state). There are soldiers to protect us, nurses and doctors to heal us, mothers to give us life and serve as our first teacher, entrepreneurs to create new wealth, and so forth. It is difficult to judge the relative merits of each of these contributions, but we know that life would be more precarious, or even impossible, without the contribution of each of these people. Hence we know that it is in our best interests to see that each person is properly rewarded for their contribution to our comfort and well-being.

There is another kind of contribution to the common good that we all make, one way or the other, and that is the contribution of money to pay for the whole thing. This brings us (at last) to the question of taxes. Who should pay, and how much? I think the answers are: “Everyone,” and “In proportion to the benefits they receive.” Now, we don't have to worry too much about the first point, since many taxes will be passed on, one way or another, in the prices we pay for things. Hence, everyone will pay, even if taxes are not directly collected from everyone. It is the second point that is the interesting one, since we receive different levels of rewards from society and from government. For example, the police are there to protect us in our persons and our property. Now, we all have the same “property” in ourselves and receive the same benefit (in theory) from police protection. But we have differing amounts of property in “things.” Some have very little, but others have a great pile of things, and derive greater benefit from the protection of those things. Clearly, they receive a greater benefit and should pay a larger proportion of the costs of police protection.

Now, even with a flat-tax, the rich will pay a greater amount, but should they also pay a greater proportion of their income? This brings us to the great debate about taxes: Should they be regressive (the poor pay a larger proportion of their incomes), flat (everybody pays the same percentage), or progressive (the rich pay a larger proportion of their income)? Each of these answers embodies a different ideal of justice. Here we cannot reduce things to a rule (as we could in the case of simplicity) but must make a judgment about what constitutes justice.

A regressive tax embodies the ideal of the ruling class as the leaders of society who should receive the bulk of the rewards. At its most extreme, regressive taxes express the ideals of a slave society, since you can regard the slave as someone who is taxed at a 100% rate, minus some “prebate” equal to the level of subsistence the that the master is willing to give to the slave. One would think that regressive taxes are excluded from a democratic society, but in fact many of our tax structures are regressive. Sales taxes are one example. Another is the differential rates of taxation for income from capital and labor. Labor is taxed at a higher rate than capital gains, which is regressive because the rich tend to make a higher percentage of their income from their capital rather than their labor.

A flat tax embodies abstract ideals of economic and political equality; each person is deemed to be rewarded by the economic system in a manner proportional to his or her efforts. As such, the flat-tax has some appeal from the standpoint of the ideals of equality. However, the evidence that people are rewarded in exact proportion to their contributions and productivity is weak at best, and flat contradicted at worst. Look at the following chart (click on the chart to get a clearer view).

What it shows us is that median wages (adjusted for inflation) have been flat since 1973. Yet in that same time-frame, productivity for all classes of workers has increased dramatically. What has happened is that one relatively small group has appropriated to itself all the gains arising from increased productivity; the connection between contributions and rewards has been broken. Now, while there may be good arguments for a flat tax in the case of taxes on wealth (land taxes, for example), these arguments are weak when applied to incomes, at least in the concrete situation in which we find our society. This is not only a violation of basic justice, but has deleterious practical consequences as well (see The Investor's Dilemma and The Investor's Dilemma II).

This would seem to leave progressive as the only system that would meet the standards of fairness and justice, at least, in our current situation. Those who receive a disproportionate share of the rewards should contribute a disproportionate share to the upkeep of the commonweal.

Both the 30% National Sales Tax and the Flat-Tax proposals make a nod in the direction of progressive taxation, the former by establishing a universal welfare program that prebates the sales taxes up to the poverty level, and the latter by a standard deduction equal to the poverty level. In the case of the Flat tax, the degree of progression is trivial. Further, since the tax only replaces the income tax and leaves the FICA taxes in place, it ends up being regressive. A worker will pay the 17% flat tax, plus the 7.65% payroll taxes. A self-employed person (like myself) will get a flat tax of 32.65%, which is close to the marginal rate for the richest Americans, and I am by no means rich. Further, since the FICA taxes stop at about $90,000, the resulting structure is regressive.

In the case of the National Sales Tax, "progression" is an outright lie. The “progression” comes only if you assume that the rich convert all of their income to consumption, which is patently untrue. At the extreme, a man like Warren Buffet has difficulty converting even 1% of his income into consumption; therefore his tax rate will equal 23% of 1%, or 0.0023% of his income. This is a rate more compatible with a class-based or even a slave society than with a democratic nation.

Obviously, there can be different judgments about justice; it is not something that can be calculated, but must resolve itself back to some basic, but “unprovable” notions about the kind of society we want. But I do believe that any discussion will have to take into account the factors that I have mentioned here, namely the proportion between the benefits one receives and the contributions one makes.

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Taxes: The Simple Life?

This is the first of a four-part series on the principles of taxation. In the next year, the public will be besieged by various claims about taxes. These claims cannot be evaluated without enunciating principles that apply to all taxes of any type. Without foundational principles, we can get no further than ideology and propaganda, and shrillness rather than reason must dominate the discussion. This first post deals with the question of Simplicity in taxation. Reader comments are welcome.

In spring a young man's fancy may turn to thoughts of love, but in winter they turn to darker thoughts indeed, and none darker than the thought of filling out his income-tax returns. That season is hard upon us, and the joy of the Christmas is inevitably followed by the gloom of the tax season, as Santa Claus is replaced in our imaginations by Uncle Sam. The former giveth, the latter taketh away. And while one is awash in receipts and W-2s and 1099s and forms of every sort, it is natural to cry out, Why can't we have a simpler tax code? And even more damaging to our perception of the tax system is the knowledge that the tax-code is laden with “gifts” for special-interest groups large and powerful enough to purchase a legislator or two; the corporations expect a return on the 100's of millions they pour into politics, and special tax treatment is part of that return. So along with a desire for a simpler tax comes a cry for a fairer tax.

Such a cri de coeur creates a demand for schemes which are “simpler” and “fairer.” And with such a great demand, there comes any number of plans from both reformers and charlatans alike willing to supply the demand. And, of course, it gets harder and harder to tell the reformers from the charlatans. Indeed, there may not be much of a difference between them on this issue; every attempt to simplify the tax code has made it more complex; every attempt to make it fairer has made it more unfair.

To be sure, the tax-code is laden with bounties for special interest groups which could easily be removed and so greatly improve the tax code. But even removing these would not greatly simplify the code. The plain fact is that the complexity of any tax code arises from the complexity of the thing being taxed; no code can be simpler than the thing to which it applies. And in the case of an income tax, the tax code cannot be simpler than the concept of income. In truth, there is no single or simple definition of the concept of income either in economics or in accounting. Or rather, there are any number of contending definitions, each of which has some validity in a given situation or for a given purpose. In the accounting trade, the rules for defining income (or profit) are given by the Generally Accepted Accounting Procedures (GAAP) which is governed by the Financial Accounting Standards Board (FASB). The GAAP manuals currently run to five volumes. Thus, no tax-code that deals with income can be shorter than these five volumes.

But in reality, the code must be very much longer than the five volumes of GAAP. Why? Because GAAP allows a wide variety of methods for calculating income since it covers, in theory, every possible situation. Using GAAP, a business firm could simply select its level of income by combining the most advantageous methods. This is not really a problem when it comes to most uses of financial statements. For each type of business, the users expect a certain type of accounting, and a business that violates these expectations will likely be punished by investors, bankers, and financial analysts. But the opposite is the case with the tax code; selecting the method that most understates income will result in rewards for the firm and an intrinsic unfairness in the tax-code. Therefore the simplest possible code will not only be as long as GAAP, but must be some multiple of the five volumes, since it must state the allowable accounting methods in each situation. We can know state an absolute principle for any income tax-code: An income tax-code cannot be, even in theory, any shorter than the Generally Accepted Accounting Principles that define income and must be, in fact, some multiple of these procedures.

We can apply this principle to a specific “tax simplification” proposal, the Flat Tax. Former congressman Dick Armey has proposed this tax with a simplified business tax return that fits on a post-card. Basically, there is one line to state the firm's “income,” another to state its cost of goods sold, which is then subtracted from the income, and a 17% tax rate is then applied. That's it. Pretty simple, no? Well, no, it is very complex. Each of the lines, “income” and “cost of goods sold,” would have to be backed up by forms which are in fact every bit as complex (if not identical to) the current forms. For example, when is “income” recognized? At the time the order is booked? At the time delivery is made? At the moment payment is received? At each stage of completion for works-in-progress? For different kinds of businesses, each one of these methods has a certain validity and is used in different situations but not in others.

The complexities that apply to “cost of goods sold” are even greater. Should inventories be charged when they are purchased or when they are consumed? Should capital equipment be charged off in the first year or over the life of the asset? These, and literally thousands of other issues are covered in the GAAP manuals and must be specified in the law and detailed on the tax return. Armey may be able to summarize the forms on half a page, but the supporting forms would be just as lengthy as they are today. They cannot, even in principle, be any shorter.

At this point, the alert reader might interject, “yes, that might be true for business taxes, but certainly personal taxes can be just as short as Dick Armey says: state your income from the W-2, apply the flat rate, and that's that!” The problem with this is that the amount on the W-2 is already the result of complex calculations covering several volumes of the tax-code. Certain amounts one does not actually receive (like the FICA tax) are counted as income, while certain amounts one does receive (like health benefits) are not counted. The return that Dick Armey is proposing already exists; it is the 1040EZ. This form is “simple” only because the complex accounting has already been done by somebody else and because all other possible deductions are denied in advance. The flat tax “simplifies” only a few pages of the tax code: those pages which deal with the varying rates of taxation. Of the thousands of pages, it addresses only a few; everything else would have to remain in place.

This brings us to our second principle of taxation: Whatever the government taxes, it must also measure, regulate, and control. If the government taxes income, it must be able to define, measure, track, and audit income. There must be a bureaucracy and a both a legislative and judicial process to accomplish this task. If it taxes consumption, it must be able to define consumption, and track every transaction that fits that definition. The oft-advanced claims of “reducing bureaucracy” ring hollow because the bureaucracy must be co-extensive with the thing taxed. One can “abolish” an income-tax bureaucracy like the IRS only by replacing it with a bureaucracy as large and complex as the thing you choose to tax; if that thing is simpler, the bureaucracy can be simpler; if it is more complex, the bureaucracy will be more complex. There is simply no way around this principle. By selecting the thing taxed, one must, at the same moment, select the size and scope of government. A simpler government can be obtained only by taxing something simpler.

Next Post: Fairness.

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