The Pakistani Spectator

In the current American elections, John McCain’s last-gasp attempt at gaining the support of a majority of American voters revolves around trying to make voters believe that Barrack Obama is a Socialist, deep down, because Obama wants to raise taxes for the richest Americans. (Obama’s tax rate on the richest taxpayers would still be lower than it was under tax-cutting president Ronald Reagan, though!) I’d like to look at the whole range of arguments regarding what sort of tax system, if any, is fair and just. I’ll begin with some arguments I’ve read and heard for a wide range of positions, then move on to some arguments of my own (Note, please, that these first listed points are other people’s arguments, not my own!): 

• “All taxation is evil.” Unless there is unanimous agreement on taxation (which is obviously impossible), any form of taxation is simply a government-supported and government-enforced armed theft sponsored by the majority (assuming a democratic government behind the tax laws) robbing the minority who do not agree to the taxation. This is the basic position of the very small Libertarian Party in the US, which argues for the very smallest government consistent with protection of individual liberties.
• “Some government spending is necessary, but the cost of that spending should be paid for equally by all, so a fixed amount should be charged to every taxpayer.” I heard this idea from a super-conservative teenage friend when I was growing up. It is the ultimate “flat tax” that I’ve actually never heard advocated by even very conservative adults, because of the awkward fact that if you actually enforced it, a large fraction of the US population would be left with too little income after taxes to avoid starvation, assuming that America continued paying interest on our debts, and at the very least kept paying for the large military that conservatives assume we will always need, and assuming we ever hoped to balance the federal budget, or at least prevent a runaway debt that would ultimately destroy the economy. Assuming that the federal budget stayed anywhere near its current size, such an ultimate flat tax would also mean that the richest taxpayers would pay vastly less than they do, now, and most of the rest of us would pay much more than we do now, so this would obviously be a very hard idea to sell in a democracy, where the majority must generally agree with major changes to the law, else they will vote out the party that made those changes.
• “Some government spending is necessary, but the cost of that spending should be paid equally by all through an equal percentage of everyone’s income.” Even here, there is that awkward business of taking money from some people who are already desperately poor, so even those favoring a “flat” percentage tax would generally exempt some first block of income, something like the income of the poorest fifth of the population or so. As a result, even the flat tax isn’t really flat, but starts at zero-percent of income and approaches the flat percentage as the exempt portion becomes an ever-smaller fraction of a very large income.
• “Considerable government spending is necessary, and the least-painful way to fund it is to tax a significantly larger fraction of the incomes of the rich than of the poor.” Income tax systems taxing a higher percentage of higher incomes than of lower incomes are called “progressive.” Since much government spending on the surface benefits the poor at least as much as it benefits the rich, this seemingly has the effect of “spreading the wealth,” at least somewhat. For the rich, this tends not to seem such a good idea, although it may be appealing to the poor. In most countries, most wealth is held by just the richest 20% or so of the population, so if voters simply voted in their personal best interests, it might seem that such “spreading of the wealth” would consistently win the day in democratic governments, and might even be carried to an extreme, with very high tax rates on the richest 20% or so. Indeed, it is true that almost every government (do any readers know of even a single exception?) with an income tax does use a progressive system with higher tax rates on higher incomes. (Note, however, that in the US, and likely in many other countries, I expect, there are also more special laws giving ways for the rich to avoid taxes, so in practice, many of the rich actually pay a lower fraction of their income in taxes than most middle-class taxpayers, even while the taxes rates are theoretically moderately higher for the rich!) Most democratic countries do not take such spreading of the wealth to an extreme, however, in spite of how this might seem in the best interests of most voters. Therefore, although taxes are generally progressive, even the wealthiest are generally allowed to keep a substantial fraction of their incomes (well over half, in the case of the US). Why is that? I see several reasons, some better reasons than others:
  • Even though the wealthy don’t have a majority of the votes, they do have most of the economic power, so their control of the media and of politicians (through campaign contributions, media influence, and outright corruption) greatly outweighs their number of votes, even in the most democratic countries.
  • At least in America, a surprising number of the less-wealthy assume (usually unrealistically) that they have a high probability of becoming wealthy, someday, and they like the idea that they will not have to share too much of their wealth when that happens.
  • Many of the less-wealthy recognize that the incentives to earn more are a very useful driver for efficient economic development under capitalism, so if “spreading of the wealth” was practiced too vigorously, investment would be discouraged, and the economy as a whole would suffer, and would develop much more slowly, with the result that there would be far less wealth, overall, to spread around, and the less-wealthy would actually be worse off! (Of course, there is plenty of room to argue about how much taxation is possible before taxation starts to really slow economic development, but clearly at some point too much taxation of the rich would badly harm the economy as a whole.)
  • Many of the less-wealthy recognize that it is simply unfair to take too much from people who have honestly earned great wealth through very hard work and very intelligent choices and investments that created wealth that would not have existed without that hard work and good choices. (Of course, not everyone with great wealth earned it (many were just lucky, and some were dishonest!), but surely some did!) As the Libertarians point out, for the poorer majority to take wealth from the richer minority, simply because they hold most of the votes, without any just reason, would amount to nothing more than legalized theft.

To consider what sort of taxation is fair and just, I think it is important to distinguish between three sorts of wealth:

1. Wealth that a person owns. For most really wealthy people, most of this wealth is investment wealth: stocks, bonds, property that is owned not for personal use, but to make more money. A few people have great wealth, but actually live, day-to-day, like people in the middle class, with at most modest homes and cars, simple food, and no servants.
2. Income. This is wealth that the government is likely to count when calculating annual income tax; how much money was a person paid, for example for salary or dividends from investment, and how much profit did a person make from selling some investment for more than its original price. Note that a very wealthy person might have a very modest income, perhaps even a negative income, if the wealth is investment wealth. An investor might sell stock that has gone down in value, for a negative income, while holding stock that has greatly increased in value, with no impact on income since that stock was not yet sold. Most persons who become very rich without inheriting their money get rich by simply holding some excellent investment or investments, silently building far more wealth (in the form of investment wealth) than you would calculate if you simply added up their incomes over their lifetime.
3. Consumed wealth. This includes a sort of “virtual rent” (the annual value, whether or not that person owns the land) on the quality and quantity of land a person requires to maintain his or her lifestyle, not only the land he or she lives on, but also the land to grow his or her food, and to provide the goods he or she uses. It includes the long-term cost of land destroyed by harm to the environment, and the cost of non-renewable resources (like oil) consumed, and it includes the value (in quantity and quality, again) of the labor to maintain that person’s lifestyle. (I would advocate that harm to the environment, for example for the burning of fossil fuels that contribute to global warming, should be taxed directly, for example by a carbon tax on fuels, rather than through any sort of income tax, and the revenue from this tax should be used to repair the environmental harm or somehow to compensate the victims of unrepaired harm (victims who tend to be poor, and often are outside of the country). New taxes are hard to sell, but this tax might be sold by also lowering income-tax rates in every tax bracket so that the average taxpayer in each income range came out even. Of course, some people, people who do unusually high harm to the environment, for example by living unusually far from work, and commuting by car, would pay higher net taxes, but that is the point of the tax change – such people should pay a fair cost for the harm that they do, and should have an economic incentive to work out how to do less harm! This shouldn’t even be viewed like a tax – it is simply fair payment for damage done, like paying for breaking a neighbor’s window!)

Now consider an entrepreneur who takes a very small investment and some good ideas and builds a successful, valuable business. The business is worth far more than the money invested, so where did the increase in wealth come from? The conventional idea of free-market economists is that the entrepreneur has created the new wealth, just as a great painter creates a painting worth far more than the paint and the canvas used to create the painting. The most capable entrepreneurs will, on average, create the most wealth from the least initial investment, because they are skilled like artists, placing investment and managing labor so that it will deliver the very most value to eager consumers, who will happily pay for more for that artfully-created value than it cost to produce. Now, for a company to create value where none existed, before, is surely nothing to discourage, or to penalize, so should government tax creation of investment wealth, for example by having a tax on corporate profit? The simplistic answer, I think, is that corporate income tax seems counterproductive to economic growth.

This view of profit as wealth created solely by the corporation, from nothing, is simplistic, though. If corporations truly stood alone, then they ought to prefer countries with the very least government, and with no corporate income tax, yet a large fraction of successful corporations prefer to operate in the United States, with its substantial corporate income tax and huge government, and they thrive in spite of those supposed disadvantages. Why do these companies not relocate to Somalia, for example, with its almost complete lack of government, if the Republican Party ideal of least government being best is really true? The answer, I think, is that a moderately strong federal government actually provides many highly valuable services to corporations. A reasonably strong military provides security against the corporate wealth being stolen by an invading country, security that is necessary for long-term investments to make business sense. A good education system provides a pool of knowledgeable workers, workers who do not need to be trained from a position of ignorance. A strong legal system will enforce contracts and provide a predictable legal framework, so corporations need not fear that the rules will change drastically in the middle of the game. A strong democracy, with all its overhead costs, will tend to hold down costs from corrosive corruption. A central government can provide a solid infrastructure of roads, bridges, safe food and water, and predictable, well-regulated utilities that makes operating a business far more efficient. A reasonable set of “social safety nets” that protect the least-fortunate from too much harm will tend to reduce the dangers of crime and internal revolution, which would be obviously harmful to successful businesses. All of these government services provide an indispensible environment for successful business.

American businessmen might flatter themselves that they have built the largest economy in the world through their superior personal cleverness and hard work, but I don’t believe it – in the US, we have enjoyed, for centuries, an excellent environment for business development, and without that infrastructure, provided largely by our government, we would be no more successful economically than the average. This government-supplied business environment does not come free, however! Who should pay for this environment that makes it possible to build such profitable businesses? If workers pay for all the costs of government, from personal income taxes, but businesses, and therefore business owners, enjoy the growth in business values made possible by that expensive government, then this amounts to just the sort of “redistribution of wealth” that the Republicans claim to abhor, except this redistribution of wealth is from the poorer workers to the richer (on average) business owners! This would be obviously unjust, so it is only fair that something like the current corporate income tax should exist so that businesses pay for their fair share of the cost of the excellent business environment provided by the US government. This is not a penalty, or a tax to rob from the rich to give to the poor; it is merely the fair payment due on the valuable service provided by the government! (American businesses love to complain about the burdens imposed on them by our federal government, and surely there is room for improvement, but on the whole, American business success, and the strength of our economy makes it clear that the US government does not provide a hostile business environment!) So investment wealth that grows should be taxed as it grows, in fair payment for the services provided to American business, but ideally, corporate income tax (if it is the right amount) takes care of most of this need in a fair way, with no need to tax the individuals holding growing investment wealth, as well.

I view individual income as similar to corporate income; it is something made possible, in America, by the infrastructure provided by the American government. To the extent that an American manages to make a larger income than the minimum necessary for survival, for most Americans a far larger income than the world average, it is appropriate to pay rent on that infrastructure, proportional to the value of the infrastructure in supporting our ability to earn such an income. This value we get from the infrastructure in earning a sufficient living is probably roughly proportional to the amount we are able to earn over what we need for basic necessities, so a flat percentage tax for income over some minimum income is probably a fair rate to pay for this rent due on the infrastructure. There is plenty of room to argue what the fair market value of that rent is, as a percentage of income, but it seems perfectly sensible to say that some percentage of our income ought to go toward paying for the infrastructure our government provides to make that income possible, and this is not theft, or even a necessary evil, just fair rent due on value received. Such a fair rent is reasonable to charge, for the overhead cost of government, regardless of how we use the income, regardless of how much we consume, since we never would have made as much without that infrastructure.

(Imagine that you have a son-in-law, and you lend him, rent-free, some large tract of fenced-in land that you own to build a business. He sets some goats loose on that land to graze and to breed more goats, and every so often he sells a goat to a slaughterhouse, making a steady, easy “profit” on his investment in his first goats. Has he built a successful, profitable business that is as profitable as he believes? Obviously, much of his profit comes from your generous provision of good, rent-free land, and his true profit, if there is any true profit at all, is whatever would be left over after he paid you a fair market rent on the land you are lending him, including any penalty for any lasting damage the goats may be doing, if the land is being overgrazed. Without making payment on that land, at best, your son-in-law is making a profit that is partly true profit, and partly charity from your rent-free generosity. (Perhaps you would both do better if you simply rented the land to someone else for its market value and split the rent between you!) By charging some fair tax to pay for the infrastructure provided by government, on both personal and corporate incomes, we simply uncover the true incomes that exist after paying a fair rent on that infrastructure – this is not government-sponsored theft, or redistribution of wealth, just fair rent on value received! If rent was not charged, that would be a redistribution of wealth!)

Now, if the only thing that the federal government provided was an infrastructure that aided our economic productivity, we would have the outlines of a complete system of fair taxation – corporations would pay a fixed fraction of their profit as rent on that infrastructure, and individuals would pay the same fixed fraction of their personal incomes, above some minimum income for survival, as rent on that same infrastructure. As long as the government’s investments in our infrastructure were cost-effective, the value of that infrastructure would be greater than the taxes due, and the federal budget could balance. If taxes ever seemed higher than the value provided, this would be a sign that some of the infrastructure investment was not cost-effective, and that wasteful parts of the federal budget should therefore be trimmed.

A well-run government does not protect only our ability to make money, however; it also helps protect our pursuit of happiness, as the American Declaration of Independence put it, in 1776. An adequate military does not just provide business insurance that a rich man will not lose his fortune to invaders, it provides insurance that a rich man will continue to be able personally to enjoy spending his fortune, with freedom! The orderly rule of law, with effective law-enforcement, does not just ensure a good environment to make money; it ensures a good environment to enjoy an opulent lifestyle! When government regulation, and government-sponsored medical research make our lives safer, what are these benefits worth? If a poor man were asked how much he would pay to have his life-expectancy increased by one year, what would be his answer, compared to the answer of a rich man, asked the same question? In dollar terms, the personal benefits derived from government-provided security against external military threat, against the long-term threat of internal revolution, against violent crime, against property crime, against loss of freedom, against loss of health, are all worth vast sums of money to a rich person, who can easily spare vast sums of money, for such important benefits. With far less money to spare, these same benefits are worth far less, in dollar terms, to a person in the middle class, and less still to a poor person. (I am not saying that a rich person’s life is worth more than a poor person’s, in some sort of cosmic sense, but obviously a rich person would willingly pay more (even as a percentage of wealth), because a rich person can pay much more, while giving up less, to have a higher likelihood of living longer, or to have a healthier, safer life. However much we consider a life to be “without price,” in some sort of abstract sense, there is nevertheless a limited price we would each be willing and able to pay for greater personal safety, and that price would obviously be much higher for a sensible rich man than for a sensible poor man.)

Much is written about the unequal distribution of wealth, why it happens, and whether it is unfair. I would propose that it is actually an altogether good thing that investment wealth should be very unequally distributed! If you believe the argument, as I do, that well-run businesses create wealth, then we need businesses to be run by the very best business minds, and the best way to ensure this is that people with the best business minds should own most of the business wealth, and should therefore have a personal interest in making those businesses thrive! There is no better way to do this than to let the same people who successfully build fortunes keep on building those fortunes! This would place most business wealth in the hands of persons who have proven ability to make money, so redistributing that business wealth to unproven owners, or to government bureaucrats will only make the economy less efficient and slower-growing, hurting the economy and therefore hurting us all, in the end!

Let’s say a businessman had very little interest in an opulent lifestyle – he simply enjoys running a highly profitable and fast-growing business. Such a man might live almost like a monk, with very modest consumption of wealth, while he builds a vast fortune in his investments. It is reasonable that his company should pay a flat corporate income tax to pay its fair share for the value it gets from the government-provided infrastructure, because without paying this fair share, it would actually see exaggerated profits subsidized by that infrastructure. It is fair, too, that such a man should pay a flat tax on his personal income, also to pay his fair share for the infrastructure, although that income might be very low, since his wealth would increase mainly through his investments growing, not through income. Such a man should not, however, pay significant tax on his consumption of wealth, because he consumes very little. Such a man is actually providing a wonderful service to the country, by growing its wealth, and he ought to pay almost no tax for his consumption, which is very modest. Of course, such a man won’t live forever, so it is reasonable to ask what should happen to all that investment wealth when he dies? If he wants to will his fortune to charity, to benefit all of society, I think that is a wonderful thing, and should not be taxed. If he wants to pass it to his children, or to other individuals for their personal use, this is another matter; We have evidence that he was a brilliant investor, with excellent skills at creating wealth, so leaving the investment wealth in his hands helped us all, but we have no such evidence that his heirs will invest well for the economy. If he wishes his heirs to have a fortune they did not earn, that ought to be his privilege, but it is perfectly reasonable for government to tax that inheritance, and for that tax to take a high percentage of a very large estate.

If all tax is a sort of necessary evil, then surely the least-evil tax is a tax on a large inheritance that was wholly unearned by the heirs, and that would likely be badly used, from the perspective of economic growth, by those heirs! (I don’t think of this tax as a penalty paid by the deceased, who is after all dead, but as a share of an unearned windfall paid by the heirs! Should the heirs be taxed less (as they currently are in the US!) for an inheritance that they did not earn than a plumber is taxed for the sweat of his labor!? A side-benefit of such high estate taxes is that it becomes harder for wealth to be concentrated over generations into a few rich families of spoiled “old wealth” who know nothing of earning money, and who glorify privilege of birth and class immobility.

 Now, a wealthy person might object: “If I want to spend my wealth on my heirs, rather than consuming it myself, or giving it to my heirs while I remain alive, that is no one’s business except my own, and should not be penalized!” I would agree! For this reason, I think the fairest tax would also tax consumption of wealth (and gifting of wealth) at the same rate that it taxes inheritances, and this rate should be progressive, that is, it should be a higher percentage for very high consumption than for low consumption of wealth. Imagine that our hypothetical monk-like financial genius had a twin brother, equally brilliant, who consumed his wealth almost as fast as he made it. This twin would add far less to the economy (because he would re-invest less!) and would take far more resources for personal pleasure that otherwise could have gone to help others. The twin has a right to choose between re-investment and personal consumption, but the government has a right, too, to conclude that these two brothers should not be taxed equally, and that the brother enjoying the super-opulent lifestyle ought to pay a much larger share for the personal benefits (mentioned above) that rich people enjoy as a result of government-provided infrastructure and services. (In an ideal world, I think the tax code would do a much better job of distinguishing between income re-invested and income consumed (and even consumption based on borrowed income!), and a progressive income tax (higher percentage for higher amounts) would be applied only to wealth consumed, but so far I don’t know of a country that does a good job of this in their tax code – instead income is treated equally, and taxed progressively, whether consumed or re-invested, mostly. Since most people actually re-invest very little of their income, this actually works out about right for most taxpayers, though!) Therefore, a moderately progressive tax on high incomes made and consumed is not necessarily a form of redistribution of wealth at all – it is simply government charging rich people more for necessary and useful services and infrastructure that are worth much more, in personal benefits received, to the rich than they are worth to the poor!

Last 5 posts by Dan Tow

• New American Voters; Guilty Until Proven Innocent? - October 22nd, 2008
• Safety in “Big Daddy’s” Shadow? - September 8th, 2008
• Coping with Limits to Control in Politics, Life, and Bridge - August 26th, 2008
• The Right to Remain Silent - June 18th, 2008
• Living with Free Speech - June 6th, 2008