What is a Tax?

September 29, 2009

Is a financial cost imposed by government for not having health insurance a tax?

From an economists’ perspective, I always answer the question that it doesn’t really matter and that it’s all semantics. That’s because whether you call it a tax, a fine, or call it a pillow, it has the exact same economic outcome.

But that’s not the issue here. The question being debated is indeed on the semantics. (While it’s not really the case here, sometimes the “semantics” actually matters legally given that states have constitutional rules in place relating to changes in tax policy.)

So is it a tax?

Everytime the government collects $1 in revenue, it isn’t a tax. If I buy some Astronaut Ice Cream at the Smithsosian Gift Shop down the street from our office, is that a tax? Of course not. That’s because it is essentially a market transaction with government acting as the seller.

To the extent that the Smithsosian has a legal monopoly over the product and enforces that monopoly, that would be an implicit tax, according to any economist. But no serious tax scholar would agree that the full revenue amount collected by the Smithsosian from my astronaut ice cream purchase is a tax.

So we have this exception for policies that collect revenue when a product is provided in return, conditional on payment. And most tax scholars would agree with this.

But what about the fines versus taxes distinction? Here I think it gets a little murky, and this is where the “penalty” for lack of health insurance would fall.

If I get caught speeding through a federal park, I must pay the federal government a penalty for that action. The federal government collects revenue, but is it a fine or a tax? Most would say it’s a fine. But what if the fine is in excess of its optimal amount and being used as a way to raise revenue as opposed to merely serve as a deterrent for speeding (and to compensate society for their costs)?

The same would apply to regulations imposed on companies for polluting. Suppose government makes it illegal to pollute beyond a certain amount and imposes a penalty for a company doing so. Most would probably call that a fine. This fine’s purpose would be the same as the optimal fine above for speeding: make those people pay for their costs imposed on society and to reduce the amount of pollution (in economic jargon “internalize the externality”).

But now suppose the government imposed a cap-and-trade system that had essentially the same “price” for polluting? Would you now call it a tax? The economic outcome is the same and the purpose is the same. If the tax is beyond the negative externality amount and merely used to raise revenue, then it’s clearly a tax. But what about the portion of a cap-and-trade tax that is designed to make polluters pay for the damage they are doing (and act as a deterrent to it), similar to the “fine” that we charge speeders for the damage they are doing to others (and act as a deterrent to it)?

On this question, I’m glad I’m an economist who can say “it doesn’t really matter,” and not have to face this question on a daily basis like my colleague Joseph Henchmann…and not just in cases like this where it’s mostly an issue for political talking point purposes, but actually in cases where it legally matters.

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