Counting the costs of higher taxes

Raising the income tax rate can disproportionately burden young people and low-income earners. www.seniorliving.org

Oliver Wendell Holmes, jnr famously said that he liked paying income tax: it was the price of civilisation. Sure, he bought his civilisation at about seven cents in the dollar, but the general point remains true today. Absent anarchy, there will always be government and always taxation.

So let’s explore that price idea a bit more. If tax rates are prices, then we quickly encounter some challenges. When I go shopping, I look at prices and compare them to my subjective value. If prices are too high, I don’t but the product and, if everyone thinks prices are too high, the shopkeeper earns less money than he expected.

Keeping things simple, the government faces much the same problem. If tax rates are too high, it doesn’t raise as much money as expected. The UK Coalition government has just realised that, and cut the 50p tax rate for high-income earners.

The 50p rate was introduced by the Brown government in 2010. The increased tax rate was expected to raise two to three billion pounds but failed to reach those expectations. In fact, the UK-based Institute for Fiscal Studies told the UK Daily Telegraph that the 50p tax rate might reduce revenue to Treasury. This would be due to both tax avoidance and tax evasion.

At first glance, many people find this sort of argument unconvincing. After all, there is a huge difference between buying regular goods and services and buying civilisation via the tax system. The former is voluntary, while the latter is coercive. Now, I’m not going to make the simplistic argument that anyone who can afford an accountant pays no tax. But let me say this: there are limits to coercion.

High tax rates have behavioural consequences. People stop working. Early retirement is a form of tax avoidance that the government can’t do much about. As James Buchanan – the 1986 economics Laureate – argued in the late 1960s, entrepreneurs who choose to sit at home due to high tax rates are not creating better goods and services, or providing employment opportunities. By providing incentives for people to retire young, the tax imposes costs on everyone.

Early retirement is only one form of tax avoidance. Long holidays is another. It turns out that Americans work more than Europeans. Of course, we could always argue that Americans are simply workaholics, while the Europeans have learned to enjoy the finer things in live. There must be some truth in that, yet the tax system plays its part too.

Edward C Prescott – the 2004 economics Laureate – argues that “virtually all the differences between US labour supply and those of Germany and France are due to differences in tax systems”. Alberto Alesina and Francesco Giavazzi also point to labour market rigidities as an explanation.

Over time, European economic growth has become sluggish. Alesina and Giavazzi ask the question: “What will become of Europeans who choose to work less and less, to retire early, to eschew work, thereby raising taxes that pay for an expensive welfare state, and opt for policies that discourage innovation and impede productivity?” Well, over time, they’ll get poorer.

As Adam Smith said, there is a lot of ruin in a nation. Yet we are witness to events in Europe, where government has simply run out of money to prop up inefficient welfare states.

So far, I’ve just spoken about early retirement and long holidays. But then there are location choices. High-income earners start moving away from high-tax countries. Social activist Bono – lead singer of Irish rock group U2 – understands the principle. In response to changes in Irish tax law, the band moved their business to Holland and a lower tax regime.

The bottom line is that there are no free lunches – even in tax policy. There are costs associated with raising tax revenue and taxpayer dollars are expensive. That means they should be used wisely.

It might seem that high tax rates are a win-win proposition. Politicians get to implement populist policy, but they don’t actually raise much revenue so the very rich aren’t paying too much. But it is the side effects that cause all the damage. A tax that doesn’t raise much revenue is distorting economic activity away from productive value-add towards unproductive activity. I’ve just talked about increased demand for leisure and location choice, but other forms of avoidance (and evasion) can have much higher costs.

These costs are disproportionately borne by those individuals who are sensitive to economic conditions: the poor and the young. By choosing high taxes, society chooses that some people (the rich) will work less through early retirement while others work less through unemployment.

In short, we shouldn’t be looking to the tax system to do anything more than raise revenue. Other social or political objectives should be dealt with - if at all - through different government programs and tools.

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