Public Finance: The Economics of Taxation
(Part B)
by
Charles Lamson
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Tax Equity
One of the criteria for evaluating the economy that we defined earlier in this analysis was fairness, or equity. Everyone agrees that tax burdens should be distributed fairly, that all of us should pay our "fair share" of taxes, but there is endless debate about what constitutes a fair tax system. One theory of fairness is called the benefits–received principle. Dating back to the eighteenth-century economist Adam Smith and earlier writers, the benefits-received principle holds that taxpayers should contribute to government according to the benefits they derive from public expenditures. This principle ties the tax side of the fiscal equation to the expenditure side. For example, the owners and users of cars pay gasoline and automotive excise taxes, which are paid into the Federal Highway Trust Fund to build and maintain the federal highway system. The beneficiaries of public highways are thus taxed in rough proportion to their use of those highways. The difficulty with applying the benefits principle is that the bulk of public expenditures are for public goods---national defense, for example. The benefits of public goods fall collectively on all members of society, and there is no way to determine what value individual taxpayers receive from them. A different principle, and one that has dominated the formulation of tax policy in the United States for decades, is the ability-to-pay principle. This principle holds that taxpayers should bear tax burdens in line with their ability to pay. Here the tax side of the fiscal equation is viewed separately from the expenditure side. Under this system, the problem of attributing the benefits of public expenditures to specific taxpayers or group of taxpayers is avoided. Horizontal and Vertical Equity If we accept the idea that ability to pay should be the basis for the distribution of tax burdens, two principles follow. First, the principle of horizontal equity holds that those with equal ability to pay should bear equal tax burdens. Second, the principle of vertical equity holds that those with greater ability to pay should pay more.  Although these notions seem appealing, we must have answers to two independent questions before they can be meaningful. First, how is ability to pay measured? What is the "best" tax base? Second, if A has greater ability to pay than B, how much more should A contribute? What Is the "Best" Tax Base? The three leading candidates for best tax base are income, consumption, and wealth. Before we consider each as a basis for taxation, let us see what they mean. Income---to be precise, economic income---is anything that enhances your ability to command resources. The technical definition of economic income is the value of what you consume plus any change in the value of what you own: Economic Income = Consumption + Change in Net Worth This broad definition is essentially consumption + saving but it includes many items not counted by the Internal Revenue Service and some items the Census Bureau does not include in its definition of "money income." Economic income includes all money receipts, whether from employment, interest on savings, dividends, profits, or transfers from the government. It also includes the value of benefits not received in money form, such as medical benefits, employer retirement contributions, paid country club memberships, and so forth. Increases or decreases in the value of stocks or bonds, whether or not they are "realized" (Realized income includes income that you've already earned and received. Wages and salary income that you earn is included in realized income, as are interest and dividend payments from your investment portfolio.) through sale, are part of economic income. For income tax purposes, capital gains count as income only when they are realized, but for purposes of defining economic income, all increases and asset sales count, whether they are realized or not. A few other items that we do not usually think of as income are included in a comprehensive definition of income. If I own my house outright and live in it rent free, income flows from my house just as interest flows from a bond or profit from a share of stock. By owning the house, I enjoy valuable housing benefits that I would otherwise have to pay rent for. I am my own landlord and I am, in essence, earning my own rent. Other components of economic income include any gifts and bequests received and food grown at home.  In economic terms, income is income, regardless of source and use. Consumption is the total value of things that a household consumes in a given period. Wealth or net worth, is the value of all things you own after your liabilities are subtracted. If you were to sell off today everything of value you own---stocks, bonds, houses, cars, and so forth---at their current market prices and pay off all your debts---loans, mortgages, and so forth---you would end up with your net worth. Net worth = Assets - Liabilities Remember, income and consumption are flow measures [A flow variable is measured over an interval of time. Therefore, a flow would be measured per unit of time (say a year)], we speak of income per month or per year. Wealth and net worth are stock measures at a point in time [A stock is measured at one specific time, and represents a quantity existing at that point in time (say December 31, 2004)]. For years, conventional wisdom among economists held that income was the best measure of ability to pay taxes. Many who feel that consumption is a better measure have recently challenged that assumption. The following arguments are not just arguments about fairness and ability to pay; they are also arguments about the best base for taxation. Remember as you proceed that the issue is which base is the best base, not which tax is the best tax or whether taxes ought to be progressive or regressive. While sales taxes are regressive [See last post. (A regressive tax is one where the average tax burden decreases with income.)], it is possible to have a personal consumption tax that is progressive (A progressive tax is one where the average tax burden increases with income). Under such a system, individuals would report their income as they do now, but all documented saving would be deductible. The difference between income and saving is a measure of personal consumption that could be taxed with progressive rates.  Consumption as the Best Tax Base The view favoring consumption as the best tax base dates back to at least the seventeenth-century English philosopher Thomas Hobbes, who argued that people pay taxes in accordance with "what they actually take out of the common pot, not what they leave in." The standard of living, the argument goes, depends not on income but on how much income is spent. If we want to distribute well being, therefore, the tax base should be consumption, because consumption is the best measure of well-being. A second argument with a distinguished history dates back to work done by Irving Fisher in the early part of the last century. Fisher and many others have argued that a tax on income discourages saving by taxing savings twice. A story told originally by Fisher illustrates this theory nicely. Suppose Alex builds a house for Frank. In exchange Frank pays Alex $10,000 and gives him an orchard containing 100 apple trees. Alex spends the $10,000 today, but he saves the orchard, and presumably he will consume or sell the fruit it bears every year in the future. At year's end the state levies a 10 percent tax on Alex's total income, which includes the $10,000 and the orchard. First, the government takes 10 percent of the $10,000, which is 10 percent all of Alex's consumption. Second, it takes 10 percent of the orchard---10 trees---which is 10 percent of Alex's saving. If this is all the government did, there would be no double taxation of saving. If, however, the income tax is also levied in the following year, Alex will be taxed on the income generated by the 90 trees that he still owns. If the income tax is levied in the year after that, Alex will again be taxed on the income generated by his orchard, and so on. The income tax is thus taxing Alex's saving more than once. To tax the orchard fairly the system should take 10 percent of the trees or 10 percent of the fruit going forward . . . but not both! To avoid the double taxation of saving, either the original saving of 100 trees should not be taxed or the income generated from the after-tax number of trees (90) should not be taxed. The same logic can be applied to cash saving. Suppose the income tax rate is 25 percent and you earn $20,000. Out of the $20,000 you consume $16,000 and saving $4,000. At the end of the year, you owe the government 25 percent of your total income, or $5,000. You can think of this as a tax of 25 percent on consumption ($4,000) and 25 percent on savings ($1,000). Why, then, do you we say that the income tax is a double tax on saving? To see why you have to think about the $4,000 that is saved. If you save $4,000, you will no doubt put it to some use. Saving possibilities include putting it in an interest-bearing account or buying a bond with it. If you do either, you will earn interest that you can consume in future years. In fact, when we save and earn interest we are spreading some of our present earnings over future years of consumption. Just as the orchard yields future fruit, the bond yields future interest, which is considered income in the year it is earned and is taxed as such. The only way you can earn that future interest income is if you leave your money tied up in the bond or the account. You can consume the $4,000 today or you can have the future flow of interest; you can't have both. Yet both are taxed!  It is also inefficient. As you will see later, a tax that distorts economic choices creates excess burdens. By double taxing saving, an income tax distorts the choice between consumption and saving, which is really the choice between present consumption and future consumption. Double taxing also tends to reduce the saving rate and the rate of investment and ultimately the rate of economic growth. Income as the Best Tax Base Your ability to pay is your ability to command resources, and many argue that your income is the best measure of your capacity to command resources today. According to proponents of income as a tax base, you should be taxed not on what you actually draw out of the common pot, but rather on the basis of your ability to draw from that pot. In other words, your decision to save or consume is no different from your decision to buy apples, to go out for dinner, or to give money to your mother. It is your income that enables you to do all these things, and it is income that should be taxed, regardless of its sources and regardless of how you use it. Saving is just another use of income. If income is the best measure of ability to pay, the double taxation argument doesn't hold water. An income tax taxes savings twice only if consumption is the measure used to gauge a person's ability to pay. It does not do so if income is the measure used. Acquisition of the orchard enhances your ability to pay today; a bountiful crop of fruit enhances your ability to pay when it is produced. Interest income is no different from any other form of income; it enhances your ability to pay. Taxing both is thus fair. Wealth as the Best Tax Base Still others argue that the real power to command resources comes not from any single-use income but from accumulated wealth. Aggregate net worth in the United States is many times larger than aggregate income. If two people have identical annual incomes of $10,000, but one also has an accumulated net worth of $1 million, is it reasonable to argue that these two people have the same ability to pay, or that they should pay equal taxes? Most people would answer no. Those who favor income taxation, however, argue that net wealth comes from after-tax income that has been saved. An income tax taxes consumption and saving correctly, they say. To subsequently take part of what has been saved would be an unfair second hit---real double taxation.  No Simple Answer Before the 1970's, most tax economist's favored a comprehensive income base. Today, many economists favor a comprehensive personal consumption tax. Part of the reason for the increasing popularity of consumption taxes is a growing concern with the low savings rate in the United States. Since 1978 there has been concern with productivity growth, and many point to the inadequacy of saving as the culprit. As we saw in earlier posts, household saving provides resources for firms to invest in capital that raises the productivity of labor. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 356-360* end |
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