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.
Earnings Taxes
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 a business and its jobs. If the profit potential does not adequately accrue to the business owners, they will seek better returns for their capital in other places.
Corporate income taxes are 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. Or prevents them from making the initial investment.
Small Business Taxes
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 economic system.
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 have 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, capital gains, and self-employment come to mind.
A personal income tax can take a portion of all income sources; or, may apply 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. Because less money in the bank means less shopping, the tax ends up cutting into business profits as well.
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.
Taxing these income types are generally worth the effort from a pure cost effectiveness approach, but must be implemented with tremendous care.
Consumption Taxes
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.
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. And, those exemptions tend to create market distortions.
But, generally speaking, a sales tax can lead to minimal behavioral changes if it is evenly applied and is small enough to be considered a nuisance rather than a burden.
Head Tax
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 increased economic activity, replace other redistributive programs, and to offset other regressive taxes.
Targeted 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. But, they also tend to generate significant revenues.
Excise Taxes
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 result in less behavioral changes than its supporters would like, but has proven effective at some level. Revenue from these taxes is often reinvested in educational efforts to further move the consumers away from the destructive behavior.
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 than the amount of “economic rent” (total value minus total costs) that is generated.
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, owner governments tend to fall back on a simpler tax system that approximates the same net effect.
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.
Summary
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 would likely utilize many tax types in small doses.
After assuring that all government expenses are worth their cost, consideration of taxes are appropriate. If additional taxes are needed after appropriate levels of business, excise, extraction, and property taxes are levied, a broad-base tax should be considered.
At a state level, the holy grail of broad-based taxation would one that it as small and far reaching as possible. It would have no exemptions, no credits, no deductions, no exclusions, no brackets, and no alternative treatment for different people. It would take the same percentage of income from all participants and would be as easy as possible to report and verify.