In part 1, I spoke about why taxes are necessary in an economy. In part 2, I discussed how an economy functions and how taxation impacts an economy in general terms. Now, in part 3, I will discuss a little more deeply how to measure a successful tax policy. In part 4, I will compare a few options for taxation.

Measures of Success

When evaluating a governmental policy, the two considerations of highest importance can be distilled down to its effectiveness and its equity. Each of these measures is full of political landmines, so I will attempt to focus purely on the quantitative aspects from an economics perspective.

I should probably tell you right up front that if you are searching for an optimal taxing strategy, you won’t find it. That is a much bigger question that requires extensive analysis of the specific economic and political conditions in any region. Chances are that the computationally optimal solution would not be politically tractable, and would almost certainly be required to come in the form of several tax policies which combine into something that can work. However, each individual policy will have its own flaws when viewed in isolation.

Effectiveness

To determine if a tax is effective, we must look in two places. First, the direct effects of the tax, then the follow-on effects.

The first order effects of the policy can be demonstrated graphically and calculated mathematically. To do so, we measure something called the “deadweight loss” to the economy. Many introductory economics courses end the discussion here, and therefore many policy makers don’t pursue the issue any further. But as I said many times over the last couple weeks, the system is complex and dynamic.

To get a true feel for the net effects of a policy, we must look at how all markets respond to the direct change. Those responses are behavioral, changing your spending habits due to changes in relative pricing or finding ways to avoid the tax with clever accounting.

Deadweight Loss

I passively introduced the idea of a deadweight loss in part 2, when I gave the example of a simple one-good economy that saw a price change. Raising the price from $10 to $11 decreased the economic activity by one unit of consumption. That lost unit of production and consumption implies that fewer resources are being employed and less benefit is received by the consumer. Those losses of profit, labor, and consumer benefit combine into what we call a deadweight loss or DWL.

Generally speaking, the size of a DWL is a function of the size of the market undergoing the change and the price sensitivity of the market. This price sensitivity (sometimes called “elasticity”) will always complicate the discussion of tax effectiveness. Taxing things that people can’t live without tends to have lower first order effects and it will be much easier to predict tax revenue from them. Taxing luxury goods will tend to discourage the purchase of those goods, leading to larger economic loss in those markets and less than expected tax revenues. This is counter to the intuitive tax targets. This doesn’t mean we should tax bread rather than boats, but it does mean that the behavioral responses are likely to be more meaningful than first assumed.

DWL is important to consider, but remember, this is only the “cost” side of the cost/benefit analysis of taxation. Although important, you should not be satisfied with this lopsided analysis of economic implications of tax. We already concluded that the benefits to society from employing these revenues must outweigh the costs of assessing them. If that is not true, we should not impose such a tax. Therefore, the DWL consideration itself is an incomplete analysis.

Tax Avoidance

It is always a challenge when designing a policy to ensure that it will create the outcome desired by its drafters. In the case of tax policy, the goal is typically to raise a desired amount of revenue. As discussed above, that can be difficult as the policy tends to create changes in behavior, which are often hard to predict.  The tax policy may also encourage those being taxed to find ways to minimize their tax burden. And the heavier the burden, the more the incentive to find ways around it.

This reality puts us in an “arms race” type situation. If the government levies a heavy tax, those being taxed will have a financial incentive to employ tax professionals, accountants, and lawyers to find ways to minimize that burden. The government then must hire its own army of accountants, auditors, and lawyers to enforce the tax policy. That in turn feeds back on the industry increasing their litigation capacity and lobbying efforts. This is the same situation that arises out of a tax structure that is too complex. The more room for interpretation that is left open, the more people will try to interpret it in their favor.

In other cases, the tax may push the consumer away from the taxed goods in favor of those same goods elsewhere. In the modern era, this typically means online shopping. In some cases, it means the creation of a “black market” which doesn’t collect or pay the taxes, or “under-the-table” labor arrangements that go unreported.

The point here isn’t that people or industries are malicious or sinister in their dealings. Rather, the point is that government must balance its sovereign right to tax against the implications those taxes may have. If they lean too hard on taxation, it sometimes pushes people and businesses into situations that are not intended by the policy. There are limits to tax policy, and those limits are reached far before 100% of the taxable gains are captured.

Secondary Effects

Much attention is paid to the direct effects of any injection or leakage from an economic system. However, the indirect and induced reactions to the change are often more important. These secondary effects are the ripples in the pond that flow out from the initial shock.

For example, if you impose a tax on pizza, we would expect the pizza shops to lose business as they increase their price to cover the tax. That results in lost profits to the business owner, and less hours for her employees. But there are other impacts that can be traced back to the tax as well. For example, the cheese manufacturer will now receive a smaller order, impacting his business and employees as well. And the employees with smaller paychecks will have to adjust as well. They may have to stop going to the movies for example. This pushes down on the movie theater profits and labor needs as well.

The complexity of an economic system stems from these connections. Just like an ecosystem, no changes really fall only where the stone lands.

Distributional Impacts

When debating tax policy, the most vocal opponents will come from the “unfair” burden the tax places on one group of people or another. One group will argue that saddling business owners with taxes will drive them out of business, thus destroying the jobs that they create. Another group will argue that burdening the working people to support people who do not work is morally appalling. Another will decry the rich getting richer as we steal bread from the mouths of the poor. There is no shortage of rhetoric in politics. If only we could tax that.

The way we tend to measure these distributional effects is by measuring its “regressive” or “progressive” nature. We tend only to measure the first order effects on this spectrum, and only on the relative weight of the tax on individual incomes. So, it’s not a great measure of distributional effects, but it isn’t a terrible one.

A tax is said to be “regressive” if the burden is heavier for lower-income families than on higher income families, as a percentage of their income. For example, a “head tax” in which everyone pays the same dollar amount in taxes would be regressive as it represents a larger share of a lower-income person’s total income. On the other hand, a “progressive” tax is one that falls heavier on higher earners. The federal income tax is a good example of this, the tax brackets impose higher taxes as you make more money. In political debates, regressive taxes tend to be called amoral and progressive taxes tend to be called unfair.

A “flat tax” is one with a constant percentage across all income levels. That type of tax is typically considered neutral, from a pure mathematical accounting, but is often considered regressive from what economists call a “utility” perspective. That is simply to say that not all dollars are the same. The benefits that a person get from moving from $0 to $10,000 of income are food and shelter, whereas the going from $100,000 to $110,000 of income may not have nearly the same improvement in their quality of life. In this situation, it may be more painful to take $500 from the lower-income individual than $5,500 from the higher one, even though the percentages are the same. Unfortunately, designing a tax that levels utility is an impossible task as it cannot be measured.

From a macroeconomics perspective, the impacts of a tax will eventually impact most people in the economy, regardless of where it is initially directed. These first order effects are important, but not the whole story. A good microsimulation model, with enough agents to capture the full diversity of the population, will demonstrate this fact. In general, the economy as a whole reacts more positively to progressive taxes than regressive ones. This is a simple outcome of the MPS I spoke of last week. Taxing money that is more likely to be leaving the economy (through importation, travel, out-of-state earnings/profits, or savings) will tend to have less detrimental effects on the economic system.

Equitable Taxation

Some policy makers and members of the public will bring “fairness” to the debate. This topic is often couched much like a Robin Hood story from the left and as extortion from the right. The soundbites range from “taking from those that are in dire need” to “taking from those that earn to support those that don’t.” The debate gets overheated fairly quickly, with accusations of “evil corporate villains” all the way to a dehumanizing of the impoverished, comparing them to domesticated animals, becoming dependent on assistance to the point they forget how to “survive in the wild.”

None of these talking points are helpful and as economists we try to stay away from such discussions. The equity, or fairness, of a tax is a natural outcome of good tax design geared at improving or protecting the general economic health of the region. While our models often point in the direction of one type of tax or another, good economists try to stay away from normative assertions in their analysis. There are certainly some that fit the data to their political beliefs. I encourage you to avoid those people when seeking policy advice.

 

Summary

When the decision that taxation is necessary has been made, we should seek out a suite of tax policies that minimize the negative impacts to our economy. We should also acknowledge that the individuals being taxed will respond to the changes we create. We must therefore consider the effectiveness of the policy in raising the desired revenues, giving full consideration to the market distortions caused by relative price changes and the incentives to cheat created by the burden of the tax.

The effectiveness of a tax is therefore a function of how easy it is to cheat, the administrative burden it creates, and the weight of the tax is on those directly impacted. It would stand to reason that the best policy will tend to be easy to administer and audit, and be spread thinly across a broad range of tax targets. For the reasons stated above, it generally makes sense to target taxes to those that are less impactful to the current economic system, leaning in the direction of a slightly progressive tax system. I will speak about some forms of tax a little more next week.

 

Disclaimer:

The Governor of Alaska recently announced that he would be calling a special session to work on “revenues.”  As I currently advise the Commissioner of Natural Resources on several issues, I want to make it clear that I do not advise the Commissioner of Revenue or the Governor on tax policy or revenue issues. This series of posts are not intended to provide any policy guidance. Anything perceived to be an opinion or policy recommendation is mine alone and should not be construed as a reflection of the administration’s position. I intend for these posts to be purely objective and educational. Please do not project any of my words onto anyone other than myself.

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