What’s Wrong with Taxes?

January 27, 2010

The desirability of any given product is the result of the mix of attributes imbedded in the product. For example, the demand for a Southwest Airlines plane ticket is a function of the mix of attributes that the airline ticket provides, such as the timing and location of the flight, leg room, meals on board, on-time performance, etc.

When a rational consumer thinks about a product in this way (demand for the attributes of the flight as opposed to the flight itself), it provides a framework for the consumer to evaluate his/her demand for other modes of transportation besides the SWA flight, such as an AA flight or a train ticket or maybe driving.

This same principle can be applied to taxes. Just like a rational consumer asks himself, “Why is this SWA flight good or bad?”, any policy scholar should ask the question, “Why is a given tax policy good or bad?”

If you answer this question about every tax policy, the collection of answers should establish a consistent framework for evaluating tax policies. Of course, you could be intellectually lazy and just say, “All taxes are bad just because they’re called ‘taxes,'” but there’s no framework there and that’s mostly just semantics.

So for example, if Pres. Obama proposed to double personal income tax rates, why would this be bad? There are multiple answers to this question. First, you can argue that it would have adverse supply-side economic effects and thereby increase the efficiency costs of taxation (i.e. deadweight loss) and possibly have adverse short-term effects (like higher unemployment). Second, you can argue that the revenue portion of the tax increase is stealing from the American public (or some components of the American public) because what the revenue will be used for is not worth as much to those Americans as the taxes that were taken away, and it’s thereby an infringement on their liberty, which should have some intrinsic value placed on it in policy evaluation. Or you could have a simple framework that government should not levy taxes at all (and thereby not exist).

Now suppose Obama proposed a new nonrefundable tax credit (maximum of $500) for purchases of snow shovels. Would this be good tax policy? Well, legally, it would be classified as a tax cut so the simpletons with no framework for evaluating tax policy would say yes. But there is no such thing as a free lunch. From a supply-side framework, there is the benefit of the zero marginal rate zone, but then there is the question of how this tax credit is financed. If it’s financed by higher taxes in the future, then all you have is a tax shift from a relatively inefficient tax cut to a tax hike that likely increases the excess burden more than the credit decreases the excess burden. If the tax credit is financed by reduced spending, then your answer all depends on the expected value of the government spending that has been foregone. If you believe the value of that marginal government spending is always zero, that’s extreme, but it’s at least a framework.

Finally, suppose Obama proposed a tax on carbon emissions to internalize the negative externality of greenhouse gas emissions. Again, a simpleton will say that’s a tax, it raises revenue, and is thereby bad. But there’s no framework there. What if instead a regulation was proposed that imposed command-and-control policies on industries using carbon. This would be much less efficient than a carbon tax under a traditional economic welfare framework, but if the word “tax” is all anybody cares about just because of semantics, then society ends up with a worse policy. If the carbon tax is bad for whatever reason, then the command-and-control policies are likely bad for the same reason. Just because one is called a tax and the other isn’t called a tax isn’t a legitimate framework at all for judging policies.

In summary, taxes are an input into producing both good and bad for society, and should be evaluated by comparing the good to the bad.



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