Tax Burdens-Becker

The burden of taxes to a country depends not only on the fraction of its gross domestic product GDP that are collected as tax revenue –the data shown in Posner's chart- but on many other factors as well. Since my comment is brief I will confine my discussion to the link between tax burdens, the level of government spending, and the structure and incidence of taxes. It is not possible to separate tax burdens from government spending. Obviously, as Posner makes clear, how governments spend their tax revenues makes an enormous difference to the functioning of an economy. In addition, however, the level of government spending also affects the tax burden. If spending exceeds the amount collected in taxes, the excess spending must be financed by an increase in government debt (I ignore inflationary printing of money). Interest payments on the higher government debt have to be financed by higher taxes in the future, so the full tax burden is determined not by tax revenues alone but also by government spending. Senator McCain has justified his initial opposition to the Bush tax cuts by indicating that they were not combined with cuts in government spending -in fact, just the opposite occurred. The tax burden depends in addition on the type of taxes used and their structure. What economists call the "excess burden" is measured by the difference between the cost to those paying taxes and the revenue collected by government. The excess burden is zero for a head tax, which is an equal tax per person, since the amounts paid to governments from such a tax equals the cost to taxpayers. Taxes on income do have an excess burden because they distort taxpayers' decisions toward greater leisure. The higher the marginal tax rate, the greater are these and other distortions induced in labor supply, and hence the greater the excess burden of income taxes. To reduce distortions, broader and flatter taxes are better because then marginal tax rates are lower. Rudy Giuliani has proposed a flat and rather broad income tax with a highest marginal tax rate of only 30 percent to complement the present complicated income tax system. Consumption taxes, such as value added taxes, have lower excess burdens than income taxes. Like an income tax, a general tax on consumption does discourage work in favor of leisure essentially because individuals can avoid both consumption and income taxes by taking additional leisure since leisure is not taxed. However, an income tax has other distortions as well since income is both taxed when received, and also taxed again when the savings out of income produces additional income. Income taxes in effect tax savings twice, while consumption taxes only tax savings once, when they are spent. In order to reduce this double taxation of savings from income taxes, the US and other countries allow families to save in ways that are free of income taxes until the savings are spent, such as through saving with IRAs. There is a natural tendency to assume that the burden of taxes falls on persons or companies that mail the tax checks into the government. To show why this is generally false, consider a 10 percent tax on capital that initially reduces returns on capital from say 8 percent to 7.2 percent. This initial impact is clearly on owners of this capital, who are generally wealthier than the average individual. Over time, however, the capital stock would fall because companies reduce their investments in reaction to the lowering of after-tax returns on investments due to the capital tax. As the capital stock falls, the after-tax return would begin to increase because the productivity of capital is higher when capital is scarcer relative to labor. The capital stock would continue to fall essentially until after-tax returns climb back up to the 8 percent level they were at before the tax on capital was imposed. Since studies confirm that in the long run owners of capital get about the same rate of return that they would have without any taxes on capital, who then pays the capital tax in the long run? The answer is not capital but labor because wages and earnings are lower when workers have less capital to work with. Owners of capital continue to send in the checks to pay a capital tax, but the negative response of investments to a capital tax shifts the burden of a capital tax away from capital to labor. That eventually labor pays a tax on capital even though it is placed on capital explains why economists generally oppose long-term taxes on capital even though in the short run capital taxes have many desirable properties. Investment tax credits, accelerated depreciation, and low taxes on capital gains are some of the ways that the effective long run tax on capital is reduced toward zero.

Comments

[RPFN]

To reduce distortions, broader and flatter taxes are better because then marginal tax rates are lower. Rudy Giuliani has proposed a flat and rather broad income tax with a highest marginal tax rate of only 30 percent to complement the present complicated income tax system.
I don't understand why Giuliani is brought up here. Romney wants to exempt savings for those earning up to $200,000. Huckabee supports a flat consumption tax. And Ron Paul supports no personal tax. Only McCain has a less innovative tax plan than Giuliani.
On a different note, taxing individuals progressively inverse to diminishing marginal utility serves a very important socio-economic purpose. I.e., it's the least costly means of income redistribution. If we didn't have to worry about poverty and income disparity, we would all support a head tax.

[Jack]

RPFN: Hear! Hear! "it's the least costly means of income redistribution. If we didn't have to worry about poverty and income disparity, we would all support a head tax."

............ and what IS the "return to capital" when those of median income and below have virtually no discretionary income?

Also, but for the regressivity of it, were we to redesign a tax system for our era I'd think we'd be wise to put about one third of the tax on non-renewable resources. Had we begun phasing in a BTU or carbon tax back when Pres Carter's efforts to put a tax of one thin dime on gasoline were foiled our mix of gashogging vehicles and inefficient homes would look very different today. Along with being far less dependent on price fixed OPEC oil, my guess is the price gouging would be far less bold than it is today.

[ctw]

"Taxes on income do have an excess burden because they distort taxpayers' decisions toward greater leisure."

Although I understand the qualitative argument behind this assertion and in the past have made such trade-offs (driven much more by laziness than marginal tax rates), I wonder how significant the effect is. In some specific situations, it seems like the effect would be roughly nil. Eg, demand for output from people in highly competitive positions isn't necessarily all that elastic (eg, would an untenured prof not write a book because of marginal tax rates on the profits?), salaried employees have limited opportunity to expand income, etc.

Is there quantitative evidence showing that the assertion is correct and that the effect is significant? ("Yes" or "no" is sufficient; I'll take the answer on faith.)

Thanks.

- Charles

[Diversity]

The least bad real taxes are always different from, and worse than, ideal theoretical taxes. As an extreme example, the British tried a "head tax" in the 1980s. It moved rapidly towards a position in which the only people who were going to pay it were those with high costs if they dropped off the tax register. This distortion proved politically intolerable before it did much economic damage. A less extreme example is that value added taxes always seem to have exemptions and categories of goods and services at lower rates, thus increasing the economic " excess burden"

"Excess burden" is a term to use with great caution in real life because it begs the question of excess over what. That said, it is possible that some real "green" revenue raising may offer negative excess burden when all costs and benefits are taken into account; and it is highly probable that a good deal of green taxation has a lower excess burden than income tax or corporate taxes. Green revenue really does look like the way all Treasuries ought to be moving.

[Jack]

Ian of Ann Arbor: Geez I thought Forbe's Flat Tax was dead after he failed to sell it with nearly 100 million of his inherited wealth, and wonder why you and Huckabee are bothering to shill for it today?

And given the mess in housing; he wants to install and even greater amount of market distorting subsidy for building out-sized energy hogging homes?

IF the thing has more progressivity than the current system, NOW would be the time for Huckabee to reveal it to the voters before the Feb 5th "super Tuesday" that could decide things for his party.

[Jack]

Charles: I'm always a bit suspicious of this one too. Typically it seems to be trotted out in regard to getting guys to work overtime and it they opt for leisure time that's just fine with me.

As for small businessmen it seems as though one either gets something rolling or they don't, and once good income comes in that would put the owner up in the higher tax brackets, it would seem a good incentive to higher more lower paid people and delegate more tasks to them; again just as it should be.

And, at the upper levels, say film stars, athletes and upper management, I doubt they stay home much due to the effects of progressive taxation; if they do or retire early, great! it gives someone else a chance, after all today's "globalism" has created just about an infinite source of labor.

"Taxes on income do have an excess burden because they distort taxpayers' decisions toward greater leisure."

[Pablo Escobar]

Dr Becker,

I was wondering if you have analysed presidential candidate Ron Paul's economic platform anywhere? If not, will you do a blog post on this topic in the future?

I'm particularly interested in a historical perspective on eliminating the income tax, which is one of Paul's proposals. America lived for a good many years (till 1913) without an income tax. Without the income tax, the federal government would be about the size it was during the Clinton administration. What other sources of revenue are available for the federal government?

In addition, he has a Friedmanite view on the importance of the money supply in controlling inflation, although he is also similar to Austrian economists like Hayek and Mises with his talk of the gold standard and allowing competing private currencies.

[RPFN]

Jack, a carbon tax would not necessarily be regressive. It would hit people with Hummers and large homes hardest. Any residual regressivity can be offset by a more progressive income/consumption tax.

Escobar, I am a Ron Paul supporter but the Congressman has been very elusive with details on how to raise money after he abolishes the income tax and replaces it with nothing. Tariffs would be the obvious answer but he's against those too. I'm sure he's against any corporate tax. The federal government can't tax property.

[Jack]

RPFN, I suppose the regressivity of a carbon tax might be offset by income tax policy but with so many falling below the level of having any tax liability we'd end up with more "earned income credits" that are politically upsetting to many. I guess in one sense, I'm one as other taxpayers are subsidizing extremely low wages which of course is a distortion that creates inefficiencies too. Consider how many dress shops we might have if the taxpayer is paying most of the low salary while the owner or chain gets the profit from the dress.

I've been watching to see what the effect of the recent doubling of fuel costs are to those around me and note it's but a small annoyance and only occasional subject of conversation for those of good earning power, even less so if they can deduct most of the cost in their business and of course nearly crippling to those on low incomes and older folks of fixed low incomes.

I'm close to the new home biz and find that still, as in the recent past, FEW of America's "adult children" show much interest in Energystar Rated designation and considering the energy situation, Energystar is sort of the "FHA minimum" in terms of what is wise.

Worse, most do not occupy their homes for over 6 years and when they do look at expense/benefit, if it's not a two year payback they won't pay for it....... thus a home with at least a 50 year lifespan is created; like CEO's with a one year horizon! Thus far it doesn't appear that appraisers or "the market" is willing to pay for energy efficiency beyond that of single pane aluminum windows and some insulation.

I end up thinking that despite my wishes to the contrary that the grown-ups will have to impose the standards that are wise for future and survival of the group, much as we have had to do with auto safety equipment and minimum building standards.

Ha! With Bush arguably having been put over the top by cutting income taxes regardless of ability to pay the bills it would seem that running on no tax would be a big hit, but perhaps the "lower taxes creates higher revenues" theory has its limit of belief?

Personally I'm ready to revisit some tariffs both in terms of dealing with the "Chinas" who are fiddling with their exchange rates and, at least, in terms of work rules. I've never bought the idea that "relative advantage" meant competing with countries that have legions of workers that can be forced into sweat shop conditions. We still are the premiere consuming nation and should have considerable say in regard to the terms of "trading" with us.

In this election year I'm reflecting on "the dream" that might be that of leading the world by example and these days I don't think we're setting much of an example.

[Kurt]

I think one thing that is missing from this piece is a connection between taxes on capital and a reduction in capital stock. For if I get the same returns regardless of taxes, why would I reduce capital expenditures when the taxes on it go up?

"Since studies confirm that in the long run owners of capital get about the same rate of return that they would have without any taxes on capital, who then pays the capital tax in the long run? The answer is not capital but labor because wages and earnings are lower when workers have less capital to work with."

[truedough]

Charles:

Regarding your request for evidence that taxes on income may distort taxpayers' decisions toward greater leisure, an interesting case can be found in Europe beginning in the 70s.

Edward Prescott wrote on this in 2005 in the WSJ.

Prescott:
"Why did the European labor supply decrease by a third from the early 1970s to the mid-1990s? Because the marginal effective tax rate was increased to 60% from 40%. People chose to work less than before. Consequently, tax revenues fell."

http://www.minneapolisfed.org/research/prescott/wsj/WSJ_8-2-05_Even_Europeans_Will_Respond_to_Incentives.pdf

[Jack]

Truedough: Interesting, if true, but what did they live on? Did they just up and quit? Or??? were there lots of Euros doing a LOT of overtime? Or? with Euros low fertility rate did a lot of "labor" just age out of the workforce?

[truedough]

Jack:

First, actually measuring "leisure" is difficult. Sometimes if workers feel that the conditions in the labour force and in the economy in general are "right" they'll delay getting a job to hold out for a better one. Maybe they'll decide to retire early. Maybe they'll decide that it's really not necessary that all of the adults in the household work full time. Maybe urban sprawl causes workers a longer commute to work. Any of these adjustments in work time can fall into the category of what some economists call "increased leisure."

Second, was it the tax increases that caused the increase in "leisure?" As you imply, a so-called increase in leisure could have actually been, say, a wave of retirements unrelated to taxes. I don't know.

With so many things going on in an economy at once, it's difficult to swallow that there was such a defined and linear relationship between income taxes and leisure. I've yet to read a non-libertarian paper on the subject though, so I wouldn't know. Anyone?

[Jack]

Truedough........... true!

First, actually measuring "leisure" is difficult.

........ probably true........ though economists have numbers on hours worked per week etc...... but it's likely they don't know whether the guy is snoozing in his hammock, or fixing his car or working til the wee hours to "flip" his house to make the ends meet or add some savings.

Sometimes if workers feel that the conditions in the labour force and in the economy in general are "right" they'll delay getting a job to hold out for a better one.

....... I'll admit to something of a subjective bias here. Though most econ books begin with "what's to be produced, for whom....... et al" and most state Constituions mention "developing resources for the benefit of its citizens" and I DON'T think it the ideal goal for human beings to work 50 long weeks per year......... it seems we've lost sight of even a balanced life and that if a family has two adults and a teenager they should all have their shoulders to the wheel. Well, SOMEone has to pay for military excess I suppose.

Maybe they'll decide to retire early.

............. If so and we believe all of our myths the early retirees have produced what was expected of them........ otherwise not enough "GDP" on which to retire.

Maybe they'll decide that it's really not necessary that all of the adults in the household work full time.

........... Indeed! And what are some of the major "industries" that weren't large at all in the 50's? Tourism, recreational vehicles, gourmet restaurants, vineyards etc. Not to worry...... capitalism keeps on creating "needs" or wants. Consider if we only consumed the basics of food, simple pre-70's housing, and mfg goods they could all be supplied by half or less of our workforce. So........ to the Euro stats "out of the labor force" is not out of the economy.

Maybe urban sprawl causes workers a longer commute to work.

............FIW today's commute is the longest in history and has eaten up ALL of the fuel savings of CAFE stds and tech improvements in the last couple decades. Well, the echo boomer kids are launched and it's time to return to the cities where we can walk to cafes, parks et al and not waste so much time and fuel getting to our little patch of fenced yard? Buy yourself a downtown apt to regentrify and flip?

Any of these adjustments in work time can fall into the category of what some economists call "increased leisure."

.......... Well, for most the commute comes out of the worker's hide, on the other hand a recent estimate indicated office workers were spending an hour and half a day surfing the net on company time. About 20 years ago all the talk was about a "four day work week" and today the French take off far more time than we do (per hour French productivity matches that of the US) soooooo......... perhaps it's time to revive that idea! Do 32 good efficient hours, skip the overhead and fuel costs of commuting one day and decide whether you want to fool around on the net 8 hours a week or go to the beach or enjoy that big barn you worked so hard to secure?

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