Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Aug 31, 2012
Here is the third in a series of blogs that I started on May 18. The first was called “Why YOU may LIKE Government ‘Theft’”. In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor. The point is to think about whether the top personal marginal tax rate really should be higher or lower than currently, as currently debated these days in the newspapers.
However, perhaps we should also remember what is wrong with government using high marginal tax rates to take from the rich in order to help the poor. The problem is that a higher personal marginal tax rate distorts individual behavior, particularly labor supply and savings behavior, by discouraging work effort and investment. Since those are good for the economy, high marginal tax rates are bad for the economy! In fact, economic theory suggests that the “deadweight loss” from taxation may increase roughly with the square of the tax rate. In other words, doubling a tax rate (e.g. from 20% to 40%) would quadruple the excess burden of taxes – the extent to which the burden on taxpayers exceeds the revenue collected.
The point is just that we face tradeoffs. Yes, we have four possible reasons that we as a society may want higher tax rates on the rich in order to provide a social safety net, but we also have significant costs of doing so. Probably somewhere in the middle might help trade off those costs against the benefits, but it’s really a matter of personal choice when you vote: how much do you value a safety net for those less fortunate that yourself? And how much do you value a more efficient tax system and economy?
In the first blog on May 18, I listed all four justifications, any one of which may or may not ring true to you. If one or more justification is unconvincing, then perhaps a different justification is more appealing. In that blog, I put off the last three justifications and mostly just discussed the first one, namely, the arguments of “moral philosophy” for extra help to the poor. As a matter of ethics, you might think it morally just or fair to help the poor starving masses. That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).
In the second blog on July 13, I discussed the second justification. Aside from that moral theorizing, suppose the poor are not deemed special at all: every individual receives the exact same weight, so we want to maximize the un-weighted sum of all individuals’ “utility”, as suggested by Jeremy Bentham, the “founding figure of modern utilitarianism.” His philosophy is “the greatest happiness of the greatest number”. Also suppose utility is not proportional to income, but is instead a curved function, with “declining marginal utility”. If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person. In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich to help the poor.
The point of THIS blog is a third justification, quite different in the sense that it does NOT require making anybody worse off (the rich) in order to make someone else better off (the poor). It is a case where we might all have nearly the same income and same preferences, and yet we might all be better off with a tax system that has higher marginal tax rates on those with more income, and transfers to those with little or no income. How? Suppose we’re all roughly equally well off in the long run, or in terms of expectations, but that we all face a random element in our annual income. Some fraction of us will have a small business that experiences a bad year once in a while, or become unemployed once in a while, or have a bad health event that requires us to stop work once in a while. To protect ourselves against those kinds of bad outcomes, we might like to buy insurance, but private insurance companies might not be able to offer such insurance because of two important market failures:
- Because of “adverse selection”, the insurance company might get only the bad risks to sign up, those who are inherently more likely to become unemployed or to have a bad year.
- Because of “moral hazard”, insurance buyers might change their behavior and become unemployed on purpose, or work less and earn less.
With those kinds of market failure, the private market might fail altogether, and nobody is able to buy such insurance. Yet, having such insurance can make us all better off, by protecting us from actual risk!
Potentially, if done properly, the government can help fix this market failure. Unemployment insurance is one such attempt. But the point here is just that a progressive income tax can also act implicitly and partially as just that kind of insurance:
In each “good” year, you are made to pay a “premium” in the form of higher marginal tax rates and tax burden. Then, anytime you have a “bad” year such as losing your job or facing a difficult market for the product you sell, you get to receive from this implicit insurance plan by facing lower tax rates or even getting payments from the government (unemployment compensation, income tax credits, or even welfare payments).
I don’t mean that the entire U.S. tax system works that way; I only mean that it has some element of that kind of plan, and it might help make some people happier knowing they will be helped when times are tough. But you can decide the importance of that argument for yourself.
Next week, the final of my four possible justifications for progressive taxation.