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.
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.
Deadweight Loss
Raising the price of a good decreases the consumption of it. That lost 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.
Taxing things that people can’t live without tends to have less of these effects. Taxing luxury goods tends to have more. 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.
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 her 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 too.
The complexity of an economic system stems from these connections.
Tax Avoidance
And then there is another problem. Will the tax even generate the revenue it is designed to capture?
The tax policy may 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 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. This typically means online shopping these days.
In some cases, it means the creation of a “black market” which doesn’t collect or pay the taxes. Or, “under-the-table” arrangements that go unreported.
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.
Equitable Taxation
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.
Distributional Effects
The way we tend to measure these distributional effect of taxes is by measuring its “regressive” or “progressive” nature.
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.
Trickle Down Impacts
From a macroeconomics perspective, the impacts of any tax will eventually impact most people in the economy, regardless of where it is initially directed.
A property tax raises rent. A tax on oil increases the price of gas at the pump. Corporate income taxes raise the costs of the products they sell. Personal income taxes reduce the amount of money people spend at stores. It’s all connected.
In general, 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.
Fairness
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 debate gets overheated fairly quickly, with accusations ranging from “evil corporate villains” all the way to a dehumanizing of the impoverished. I once heard the poor compared 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.
The effectiveness of a tax is a function of how easy it is to cheat, the administrative burden it creates, and the weight of the tax 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.