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The Politics of Taxation

The government must obtain resources in some way if it is to carry on its activities. The way it obtains resources from the private sector will affect economic efficiency and the distribution of income, though government may not always consider these effects. If government raises funds by taxation, the price one party in a transaction sees can diverge from the price the other party sees, which can either lead to economic inefficiency or correct a case of market failure. The ability of taxes (and subsidies, which are negative taxes) to change the way people act is the key to their ability to affect economic efficiency.

The normative biases of the majority of economists can be seen in the terminology they use to discuss the effects of taxes on the distribution of income. A tax is a progressive tax if its rate increases as the level of income increases, it is a regressive tax if its rate decreases as the level of income increases, and it is a proportional tax if its rate remains constant as income changes. A key word in each definition is "rate." Suppose that people earning $10,000 pay an average of $100 in a tax, and that people earning $30,000 pay an average of $200 in this tax. This tax is regressive in this range of income because the tax rate falls from 1% to .67% as income goes from $10,000 to $30,000.

The unintended consequences affecting both economic efficiency and distribution of income that occur as a government raises funds have long interested economists and have been a major topic of a subfield of economics called public finance. However, the private interest view of government suggests that the issues that fascinate economists may not play an important role in the considerations of elected politicians who write the laws.

Taxes are unpopular with the electorate but are necessary to pay for government programs that are popular with the electorate. A successful politician will be one who seems to give the benefits of programs and not the burdens of the taxes (or one who seems to lift the burdens of taxes without substantially cutting the benefits of programs).

Taxes that are hidden from the electorate should be very attractive to the completely self-interested politician, as should taxes that seem to raise large amounts of money while affecting very few. Taxes can be at least partially hidden when they are shifted, which means that the incidence of the tax is not borne by the person who visibly pays the government.

A major example of shifting involves the corporate income tax. The employee of the corporation who writes the check to the government does not feel the burden of the tax because he pays with corporate funds. Neither does the corporation because the corporation is merely a contractual relationship, and as such it cannot see, think, use resources, or feel pleasure or pain. When government takes resources from the private sector, it must reduce the resources available for real flesh-and-blood people to use. It is not clear, despite much effort that economists have spent on the problem, which flesh-and-blood people have resources diverted away from them by the corporate income tax. It might be the legal owners, the holders of common stock. It may be the employees--both blue-collar and white-collar--and others who supply resources to the corporation. It may be those who buy from the corporation. It may be all owners of capital because if the corporate income tax reduces the return investors can get from investing in corporations, they will reduce investments there--driving up the return--and increase them in the noncorporate sector--driving down returns. In the complex and interdependent system of a market economy, a change in one place can have effects in other places that at first glance seem totally unrelated.

The value added tax (or VAT) is very popular in Europe, but is not used in the United States. It is a sales tax based on the value added at each stage of production. Value added is computed as final sales minus the cost of raw materials and unfinished goods. The tax in Europe also allows the deduction of expenditures on capital goods (machinery, tools, etc.). In its effects, the VAT is similar to a retail sales tax, only the tax is collected at each level of production instead of being collected at the retail level. The advantage of the VAT from the viewpoint of the self-interested politician is that the tax is hidden in the final sales price of the product. A reason that this tax has not been adopted in the United States is that the state governments make heavy use of sales taxes to raise revenue, and they fear that the federal government may eventually seriously undermine the abilities of the state governments to raise revenue if it adopts the VAT. They prefer that the federal government stay away from sales taxes and leave sales taxes to the states. As a result, state governors and legislators have strongly lobbied against all proposals for any sort of federal sales tax.

Another tax that is partially hidden is the tax for Social Security. The amount of the tax that is shown on the worker's pay stub is only one-half of what his employer has paid to the government in his behalf. The other one-half is not reported to the employee, but in the eyes of the employer is just as much a cost of employing a person as are wages that the employee does see. A reason that the employee's pay stub shows any of the tax is that the Social Security program has always been promoted as a pension fund, and the amounts paid in as "contributions" rather than taxes. If a majority of people considered them as taxes rather than as contributions, there might be more opposition to this tax because it is clearly regressive.

The whole Social Security program raises interesting problems of incidence, because not only may the tax be shifted, but so may benefits. The granting of money to retired persons lessens the need for children to support their parents in their old age. Instead of John and Jane directly giving money to their parents, the Social Security system takes the money from John and Jane and gives it to their parents. The large transfer of money from young to old that the Social Security system seems to entail may be largely offset by reductions in other payments that would take place in the absence of the system.

We next continue on to a question that has long been central in public finance, the question of how taxes affect economic efficiency.

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Copyright Robert Schenk