So far in this series, I have spoken at length about the complexities and pitfalls tax policy. In Part 1, I argued that we should first ensure taxes are needed before designing a system. In Part 2, I talked about how the economic system is interconnected and that disruptions are systemic. In Part 3, I cautioned policy makers that tax policy isn’t as easy to target as one might think. Now, in this final part of this series I will discuss some of the pros and cons of different policy options.
Types of Tax
Generally speaking, there are two types of tax: broad-based and targeted. Broad based taxes are typically on either the income or expenditures of the general population. Targeted taxes are levied only on specific goods or actions. Each of these tax categories has many types within them, each has their own strengths and weaknesses, and each impacts the economy in different ways.
Broad Based Taxes
Broad based taxes are generally better at collecting revenues to run a government than any concentrated taxes on specific goods. The thin application across many taxpayers lends itself to lower levels of tax avoidance, but also increases the volume of payments and submissions that the governing agency must review. If a broad-based tax is complicated and requires significant reporting and auditing, the effectiveness of the policy is greatly reduced.
Broad based taxes are often applied on the earnings side of the equation. The most common applications are on business income or personal income.
Business Income Tax
Corporate Income taxes are a popular tax target in many government systems. These taxes are almost always levied on the net profits of a large business. Net profits taxes are generally more complicated to account, but are made effective by the relatively small number of qualifying entities and the generally large amount of profits. Because these taxes tend to allow the recovery of capital and ensure a positive revenue stream before the tax has any impact, these taxes do not tend to be passed on to consumers by nearly the same degree as some other tax types. The danger to the general economy comes in the form of a total loss of the business and its jobs. If the profits potential does not adequately accrue to the business owners, they will seek better returns for their capital in other places. Corporate income taxes are then an effective tax, but policy makers must take care not to lean on this tax to the point it drives business out of the economy.
Taxes on smaller businesses tend to be less effective. While corporate income taxes typically apply only to “C” corporations (in which the business itself is a taxpaying entity), some business taxes are levied on “S” corporations (in which the business partners receive pass-through payments and the corporation does not file its own taxes). Some taxes go down to even smaller business types in which the business owner is a sole proprietor with no employees or perhaps has a hobby that generates occasional sales (these are typically called self-employment rather than small business). Direct taxes on these smaller businesses tend to have a more direct impact on the economy. The tax has a direct impact on the willingness for the individual to conduct such activities and also directly removes money from the economy. Where corporate profits tend to flow to wealthier individuals that may not spend those additional funds in the economy in which they are earned, small business owners almost by definition are living in the economy. Therefore, reductions in their profits has a more direct impact on the economy, much like a personal income tax. Further, major businesses tend to grow out of small businesses and business owners tend to stay close to home. It is typically more effective for the health of the economy over the long run to ensure a fertile soil for entrepreneurship, and then taxing the successful businesses. This is the Silicon Valley approach that has worked very well for California.
Personal Income Tax
Personal income comes from several sources: paychecks, rental property, investments, business ownership, and self-employment come to mind.
A personal income tax typically takes a portion of all income sources, although their may be different tax rules and rates around different types of income. A “payroll tax” is the most basic form of income tax, because the vast majority of people have wages as their only source of income. In the U.S. Federal tax code, people who only have this type of income can file an “EZ” form, dramatically reducing the complications of tax filings. Payroll taxes have a first order effect of reducing the spending power of the general population. However, the market will rebalance to a new equilibrium in which the effective cost of labor will increase, thus cutting into some business profits. As discussed above, self-employment and sole proprietor taxes are similar, except that the business owner will raise their own prices or will seek other opportunities. This type of tax does tend to be one of the easiest and least complex tax types, resulting in little distortion to spending behavior so long as it is a small percentage, broadly applied, and collected incrementally. However, this type of tax is naturally regressive unless designed otherwise.
All other types of income (mostly capital gains and passive income) require much more effort to tax. However, these types of income also tend to be concentrated in the hands of a much smaller portion of the population with much higher propensity to save rather than spend. From the perspective of a regional economy rather than a global one, it is also the case that these types of income are less likely to circulate in the regional economic system and so have smaller effects on the regional economy. Therefore, taxing these income types are generally worth the effort from a pure cost effectiveness approach, but must be implemented with tremendous care and should be divorced from payroll taxes for the purposes of tax filings. These types of taxes are naturally progressive, as those paying these taxes tend to be of higher income.
The other approach to broad-based taxation is to implement it on expenditures rather than income. The most common form of this type of tax is the “sales tax.” The sales tax is generally a percentage of a purchase, added to the cost of a purchase. The seller of a taxable good or service typically collects the tax and pays it to the government. In this way, the cost of all goods in the market place are increased by the amount of the tax, shifting the cost curve up and reducing the number of goods sold. Eventually, the market will adjust to this new price level as though it were inflation, adjusting wages up as well. In both ways, some of the tax burden is shifted to the business, although it is levied on the buyer. In any event, the tax tends to have a dampening effect on the economy as a whole, especially if the tax can be avoided by purchases from outside the taxing authority. It is also creates more market distortion than a lump sum tax, but can lead to minimal behavioral changes if the tax is small enough to be considered a nuisance and not a burden. This type of tax tends to be regressive in nature as lower-income individuals tend to spend more of their income, thus paying a larger share of their income in tax. Efforts to reduce the regressive nature by exempting basic necessities is partially effective.
The last form of broad-based taxation is to implement a tax on the individual rather than their economic contributions. This ensures that all members of the society receiving government services are contributing to those services. By definition, this is a regressive tax as the fixed dollar amount in taxation is a larger share of a lower-income individual that a higher income one. Some taxing authorities are currently experimenting with a “negative head tax,” in which the citizens are refunded tax payments at a fixed dollar per person amount, in order to encourage increase economic activity, replace other redistributive programs, and to offset other regressive taxes.
In addition to broad-based taxes, some taxing authorities levy special taxes only on specific products, behaviors, or activities. As a general rule, these types of taxes tend to discourage the activity being taxed. Although, the degree that the discouragement is effective depends on the price sensitivity (“elasticity”) to the object of the tax. These targeted taxes can be levied for the purpose of discouraging activity, or can be effective revenue generation levers when the object is “inelastic.”
An excise tax is one that targets a specific good or service. By aiming the tax at the individual good, it raises the relative price of that good in the marketplace, discouraging its purchase. That is why “sin” taxes on things like tobacco and alcohol tend to be viewed as “good” governance, discouraging these “bad” activities by nudging the individual away from them rather than banning them directly. The addictive nature of these goods tends to resulting in less behavioral changes than its supporters would like, but has proven effective at some level. That high inelasticity tends to be more effective in raising revenue than discouraging consumption, which is typically reinvested in educational efforts to further move the consumers away from the destructive behavior. These taxes tend to be regressive in nature, as there is a strong inverse correlation between income and use. However, these taxes should not be viewed as revenue generation tools, but rather as efforts to reduce healthcare costs.
Occasionally, these types of excise taxes are attempted as revenue generation tools by targeted high income purchases. It turns out that this is usually an ineffective strategy. Luxury goods tend to be more price sensitive than other goods. Therefore, the increase in cost tends to result in a lower volume of purchases, decreasing the effectiveness of the tax as purchasers simply go elsewhere.
Economic Rent Taxes
Some economic regions have the benefit of natural resource development to generate a source of employment and a commodity for export. Typically, those extracting the resource do not operate solely within the economy in question. This results in a considerable amount of the value creation leaving the region. In these cases, a government may attempt to redirect some of that value back into the economy through taxation, thus reducing the burden of government on the citizens. This type of tax is largely effective in many regions around the world, so long as the tax does not exceed the amount of value necessary to retain the development. In general, a government cannot tax more the amount of “economic rent” that is generated, that is the value that exceeds all costs resulting in sufficient profits to justify capital investment. The term “economic rent” is best defined by Adam Smith as “to reap what he did not sow.” In other words, the value that was created by nature rather than by man. For example, the value of lumber is a combination of man’s effort to chop and transform a tree and nature’s efforts to grow it. Any value in excess of those efforts is ascribed to the sun and soil, which we call “economic rent.”
An effective tax would capture all of the economic rents, allowing the resource developer just enough value to continue investing. However, this would require a stable tax system throughout the life of the investment, which is seldom achievable without a contract. Therefore, no owner governments tend to fall back on a simpler tax system that approximates the same net effect. It is important to draw the distinction between economic rents and business profits. A government in a capitalist region does not typically seek to capture all business profits in excess of a minimum capital return. It is the ownership aspect of the resources that encourages this different treatment.
A resource extraction tax is generally the most effective and most equitable tax possible for a regional economy. It has a positive effect on the economy by shifting the tax burden off of the citizens, pulling new money into the economy that would have otherwise flowed out. However, the government must be careful not to lean so hard on this golden goose as to kill it.
Ad Valorem Tax
One last tax type is one that assesses a tax as a percentage of asset value, typically in the form of real property. A “property tax” is probably the earliest form of taxation, although it was originally assessed as a portion of the crops grown from the land rather than a portion of the market value of the land itself. Today, property taxes are common among regional economies, but are rarely assessed at the higher forms of government. This is mostly due to the difficulties associated with assessing the value upon which to tax. Property taxes themselves have very little first order effects. Because of the finite amount of land, it is difficult to demonstrate a willingness to abandon land rather than pay the tax on a large-scale. This results in almost no direct economic effects from volume change due to price sensitivity (what I called “dead weight loss” in a previous post), which makes this a very effective tax from a general economic perspective. However, there are second order effects. The increased tax will tend to decrease property value and will crowd out other purchases. The tax is not truly progressive (only applying to property owners who tend to have higher incomes) because the tax increase is passed on to lower-income individuals through increases in rent. The net effect of the property tax is a broad economic reduction (just like all broad-based taxes), although it falls first of the property owner with little first order impacts.
This post introduces some basic tax types and describes their economic impact from a high level. As you can see, there is no perfect tax and there is no free lunch. All taxation will have a dampening effect on the economy, which must be offset by the economic gains from the government spending it permits. While there is no perfect tax, there are tax systems that perform in a more effective and equitable way. That system will be unique in each region, but will almost always consist of a combination of many small taxes rather than attempting to lean on any one tax type. A diversified tax system of simple tax types will create stability in government revenues and will minimize the need for continual changes to the tax code. Complex systems will tend to be less effective and too heavy a tax on any single group will tend to promote tax avoidance.
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 a 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.