Benjamin Franklin missed the discussion about taxes as one of the certitudes in life. Tax policy has always been a battleground of ideologies. Now the battle is heating up again especially in recession engulfed western economies. Taxation has become the focus of debt burdened states seeking to placate voters by attempting to arrest rising income and wealth inequality. And if public coffers can be replenished along the way, so much the better.
Taxation has evolved from being a protection payment to ensure that the king's men would not take away one's land, burn one's house and rape one's family. It is now more than a means to fund the sovereign. Tax policy has become a tool for social engineering. Want to promote a certain industry? Provide tax breaks. Want to discourage habits the majority deems inappropriate? Tax them to extinction. So on and so forth. The result is a tax code which runs into hundreds and thousands of pages and provides highly remunerative employment to those with the right law degree. But it utterly fails to achieve its objectives. Regression to a 'simpler' world with taxation being purely a means to fund a small government is not advisable nor is it possible. Instead what is required is removal of counterproductive minutiae and loopholes. These have been put in place by interest groups or by meddling politicians bent on societal over-engineering. What is needed now is a rational and holistic appraisal of tax policy to achieve clearly defined broad societal objectives.
In a modern society, the primary aim of taxation still remains funding the machinery of the state. This means the entire modern welfare state. However, tax policy is independent of the remit of the welfare state. Thus the only difference between a minimal state and a state which provides generous benefits should be the level of taxation not the composition. The secondary aim is fairness which is distinct from equality. It is this aim which leads to controversies and attempts at social engineering. Fairness can be loosely defined as "To each an income according to his ability and from each a tax according to his advantages." What this means is that ability, diligence, creativity and entrepreneurship should not be penalised but alongside this, relative advantages purely due to wealth should be minimised.
The primary aim of funding the state needs to be considered when comparing direct versus indirect taxation. Direct taxes like excise, VAT and customs are easy to levy and collect. The ratio of net tax revenue (tax revenue minus cost of collection) to cost of collection is high. Therefore funding can be substantially achieved with minimal effort. It is here that critics point out the emphasis on indirect taxes runs contrary to the secondary aim of fairness. This is due to the regressive nature of indirect taxes. The argument runs as follows: A 10% VAT on a product costing $10 pushes the sale price to $11. This $1 of tax paid is 1% of income for someone earning $100 but only 0.01% for someone earning $10,000. Thus the poor bear a disproportionate burden relative to their income. The conventional response is to ameliorate the regressive nature by taxing necessities lower than luxuries. However this opens the door for loopholes and creative taxation through multiple tax bands and classifications. For example, food and beverages are a necessity but does that mean Kopi Luwak coffee should be taxed at the lowest rate? As long as indirect taxes are reasonably low there is usually no need to try and over-engineer for fairness. Consumer behaviour and pricing automatically minimise the regressive aspect. Necessities like food and drink are cheap relative to income (in western societies) and there is a limit to an individual’s consumption. So the tax paid as a percentage of income is still very low (1% in the case above). Also reducing the tax is not going to make any appreciable difference to people's incomes. Extending the example above, a reduction in VAT to 5% (which is a 50% tax cut) leads to a difference of only 0.5% of income for the person earning $100. However, it makes a huge difference to the total tax revenue derived by the state. If 60m units were sold every month then a 10% tax nets the state $60m per month. Cutting the tax to 5% cuts the tax revenue by $30m blowing a hole in the government budget while making a negligible impact on disposable incomes. (Tangential comment: This was Gordon Brown’s folly when he cut the VAT rate)
The secondary aim of fairness assumes importance in formulating policy for direct taxation. This is where policy has become mired in controversy and language of class warfare. The latest being the outrage on Republican presidential hopeful Mitt Romney's effective tax rate of 13.9% in 2010.
The first step in formulating policy is to classify factor incomes of rent (land), wages (labour), interest (capital) and profit (enterprise) into those which come about due to labour and those which accrue due to capital. Wages are due to the former while rent and interest due to the latter and profit is a combination of both.
The second step is distinguishing how income accrues to labour and capital. Income earned from labour is intrinsic to the labourer. The ability to work is not transferable. Also the labourer has to work to earn thus placing a physical and mental limit to the amount of productive work which can be done. In contrast, income from capital is extrinsic to the owner of capital and without limit. Capital is transferable across generations and people. It is true that effort is expended in managing capital, i.e. investments, but effort only increases linearly for an exponential increase in capital managed. Moreover, capital has a force multiplier effect. The owner of capital can hire an owner of labour and thereby expand the limit of effort which can be expended. This ensures that the theoretical limit to effort in managing capital is never realised as capital tends to infinity before the limit is reached.
This difference between an intrinsic, limited income from labour and an extrinsic, unlimited income from capital is critical. However, this by itself does not imply that income from capital should be taxed higher than income from labour. In a modern capitalist society where creation and accumulation of capital is a proxy for growth, a punitive tax on income from capital is undesirable. Society broadly agrees that entrepreneurs should be encouraged and rewarded for their success. This means allowing owners of capital to keep most of their return from investing in risky ventures.
The third and final step is to consider "fairness" and distinguish between income arising from the diligence of the taxpayer versus that which comes about irrespective of his diligence. Wages and profit are in the former category whereas rent and interest are in the latter. Whether wage or profit itself is fair given the perceived ability and diligence of the factor earning it is irrelevant from the point of view of devising tax policy. Also owners of capital will claim that their rent and interest income is derived from investment ability and hence should have similar tax treatment. This is a specious argument. True, investment ability does determine the magnitude of the income but this ignores the force multiplier effect of capital. The owner of capital can hire the ability while corralling most of the income.
Keeping in mind the points above, a basic framework for direct taxation can be constructed. Wages and profits should be taxed lower as they are intrinsic and limited and in the case of profit desirable from a societal point of view. Rent and interest should be taxed higher as they are extrinsic, unlimited and are due to an effort to preserve capital rather than create it. The reader may make two main criticisms at this stage, first, profit is clearly not limited and second, are not creditors also necessary for enterprise?
The rejoinder to the first is that profit is limited insofar as entrepreneurship is limited. It is intrinsic to the entrepreneur whose creative effort has a limit. But then what about an owner of capital who invests in established enterprises through the secondary (stock) market? He displays no more creativity and effort than a rentier? This is a valid point which has to be taken care of through progressive tax rates. As for the second point, creditors are indeed necessary for enterprise but growth itself is more dependent on ability, creativity and diligence of the entrepreneur. And debt is already structured to be a safer investment than equity. Therefore the interest the creditor receives is a fair return for financing enterprise at minimal risk and effort.
Fairness again has to be the guide in approaching the contentious issue of whether tax should be charged at a flat rate or a graduated, i.e. progressive rate. It must be reiterated that fairness does not imply equality. A doctor with several years of training is entitled to earn multiples of a high-school dropout. But to maintain a welfare state which ensures a certain minimum standard of living for all its citizens, the burden has to fall more on those with higher incomes. This is not an excuse for a rapacious tax regime with tax rates approaching 50% or higher. What is required is a reasonable top level of tax, say not more than 35% or so. Alongside there should be a universal application of progressive tax rates across all incomes (wages, profit, rent, interest). The latter is not only justified but necessary based on the nature of income accruing to labour and capital.
Putting it all together a broadly defined tax policy can be exposited.
- Indirect taxes should account for a majority of state funding requirements.
- Direct taxes should be levied on all factor incomes and at a progressive rate.
- Wages and profits should have the same progressive tax rates with the highest tax rate at a sufficiently high level so that very few, if any, wage earners and only a small proportion of profit earners pay the top rate.
- Rent and interest tax rates should be at a slightly higher level.
- Any social engineering projects which the political leaders of the day wish to take up should be separate from the tax policy.
The advantages of such a tax system are that it is simple to understand, promotes broadly agreed societal objectives, minimises distortion of incentives and is reasonably fair. Moreover, by separating social engineering projects, it allows a more objective evaluation of the project aiding democratic verdict on government policies.