Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

That a large percentage of individuals in the US do not paying income tax is a matter of concern, and not just to conservatives.  There is an underlying  sense that the paying of taxes is a duty, an act of solidarity with the collective goals of a democratically constituted nation.  While fairness requires that those best able to do so provide more of the financial support for those collective goals, fairness also requires everyone provide a share, even if that share is small.

In fact, this decline in tax-paying is partly connected with one of the programs often argued to be the most effective at reduction of poverty–the earned income credit.  Under this program, recipients’ credits are often greater than the total taxes they would have paid.

Many of the features of the earned income credit are desirable from the point of view of economic theory. The program entails virtually no overhead costs for its running. Its relatively low marginal rates distort decisions less than many alternatives (such as a minimum wage or food stamps). It can be targeted fairly accurately to those it is intended for (the working poor with children).

From the point of view of the economist, there is no difference between having a program in which an individual receives $5,000 from the government and pays $500 in taxes, or a program which just nets it all out and pays the individual $4,500.  From the point of view of the voters, and possibly from the point of view of the recipient, there is a big difference between the two. 

Beside the moral, even quasi-religious, sense to this–that paying taxes imparts a dignity to the payer (like the “widow’s mite”; also compare the rabinnic teaching that the poor are also required to give charity), there is of course also an astute political sense to this: if government coffers are filled by “others,” there is no limit to what we demand of government; if they are filled by “us” then we weigh the costs versus the benefits.

We probably need a name for the psychological quirk that causes us to regard such two-way passage of moneys as different from a one-way passage of a net amount. I recommend the term “budgeting illusion” — the sense that when sums are arbitrarily divided into different accounts, the separate pots take on a reality of their own.

Budgeting illusion also lies behind some of the difficulties we have in dealing sensibly with social security. Ultimately the money goes into the government in whatever form–payroll tax, income tax, gasoline tax–and the money comes out in national defense, social security, highways.  There is no economic sense in which the dollars collected “for” one purpose are separable from the dollars collected “for” another. For social security recipients the fungibility is fortunate, since, in particular, the present value of most people’s social security contributions is not sufficient to pay for their benefits.  Nonetheless,  most taxpayers feel that the social security payments are “their” money and the benefits are “their” compensation for it.

Even if there is no economic distinction between different dollars, there is a political distinction: Having the social security’s trust fund in a separate pot allows the social security administration some political autonomy.  It enables SSA to pay benefits without resort to the Congress even in years when they are not bringing in enough revenue to cover their costs.  The system was intentionally set up this way, of course, to ensure that changes would be close to politically impossible.  But the problem that arises is just the flip side of the earned income credit problem: in each case our awareness of the magnitudes of the payments are altered when we separate or combine the different pots of funding. 

Or, alternatively, “Why I Love Teaching”!  First, teaching lets me grandstand a bit, if that help students really think about the world around us.  Second, it lets me pretend to be an expert in fields other than economics, even fields such as philosophy (see below).  Third, trying to teach about a topic forces me to think hard about that topic myself!  A case in point is the standard lecture on “Justifications for Government Policy to Redistribute Income”, otherwise known as “Robin Hood”, otherwise known as government “theft” from the rich to give to the poor.   

One thing currently happening in the world around us is a heightened political debate about whether the top income tax rate is too low or too high.  See the diagram below.  So this “lecture topic” is not just textbook irrelevance.  It might even help YOU to think about what you read in the newspaper!  Then please decide for yourself.

I see four possible justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, however, then perhaps a different justification is more appealing. 

1.)    As described below, some in the field of “moral philosophy” have found ethical justifications for extra help to the poor.

2.)    Even if the poor are not deemed special in that way, and all individuals receive equal weight, it may still be that 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 (higher marginal utility).  If so, then equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor. 

3.)    If incomes are generally uncertain, so that any individual might do well in some years and not in other years, then government might actually make all of us happier by the provision of implicit “insurance” – taking premiums in good times in order to help any person who suffers bad times.

4.)    A reduction in income equality could be a “public good”, like the classic example of a lighthouse that benefits all ships whether they have helped to pay for it or not.  Everybody’s individual incentive is therefore not to pay (to “free ride”).  The private market never exists.  But government can raise welfare for all shippers by taxing all ships and using the funds to build and operate the lighthouse.  Similarly, if many people would LIKE to have more income equality in society, they could “free ride” on others who do give voluntarily to help the underprivileged. If so, then government could fix that market failure by taxing everybody and using the funds to improve income equality.

Having used up several paragraphs already, I will miss the chance to explain all four of these important points adequately in this one blog, and so I’ll save a few for the next blog.  Let’s just start with the first one.

In the field of moral philosophy, some libertarians such as Robert Nozick believe that theft itself is ethically wrong, that each person is morally entitled to the fruits of their own labor.  No person is allowed to steal from a rich neighbor, even to give to the poor, so why would government be allowed to do so?  If theft is morally wrong in itself, then government should not be redistributing from rich to poor, no matter how needy the poor nor how worthy the cause.  On the other hand, by the way, government steals from individuals through taxes in order to build highways and provide for national defense, and so one may wonder why theft is justified for some purposes and not others.  One way out of that problem is to decide that a tax for public purposes is not in fact “theft”.

In contrast, John Rawls argues that the moral choice is to help the poor.  Actually he has two important ideas.  One is that those who are already rich have no moral justification to argue for reducing taxes on the rich, just as those who are poor have no moral justification to argue for raising taxes on the rich.  Such positions are merely self-interested.  Therefore, a useful thought experiment is to put yourself in what Rawls calls the “Original Position”, at the beginning of the World, before places have been assigned in the wide distribution of incomes and well-being.  That is, suppose resources are limited, and that the world will inevitably have a distribution of different human abilities and disabilities.  You don’t yet know your IQ, or whether you will have any particular talents in music, sports, the arts, or management.  Our job in this “original position” is to write a constitution, a set of rules for government and human interaction.

The purpose of this thought experiment is to try to strip away self-interest and think about how rules “ought” to be designed.  And then, Rawls’ second idea is about what any of us would likely decide to do in such a position.  He argues that the only natural choice, indeed the only logical choice, is to be extremely risk averse.  We are not talking about twenty bucks you might lose at the Casino, where risk is fun.  Instead, we are talking about your entire life’s prospects, where risk is not fun.  It must be great to be Brad Pitt, but what if you end up with little talent or ability.  You could end up homeless, or worse.   Given that risk, he argues, one should design the rules such that society would take good care of those who are disadvantaged, unlucky, or disabled.  You might well be the person on the bottom of the totem pole.

His treatise, called “A Theory of Justice” is 600 pages, so I haven’t even read it all!  So I won’t try to explain all the reasoning, but the interesting point is the connection between risk aversion and redistribution.  Rawls himself is extremely risk averse, saying we ought to maximize the welfare of the poorest person with the minimum income – the “maximin” strategy.  That does not mean perfect equality, as he points out that the poorest person’s welfare might be improved by giving the most talented individuals plenty of incentive to work hard and invent new technology that generates plenty of profits, market success, and economic growth.  But cutting the tax rate on the rich is only justified for Rawls if that really does improve the welfare of the poorest.

Well, out of space for today, so I’ll save the other justifications for next time.  But in case you don’t like the justifications of Rawls, those other justifications (#2 through #4) are completely different!

April 15 – tax filing day.  Undoubtedly, the newspapers will be full of the usual debate about whether the rich pay too much or too little in taxes. 

A Washington Post article (reprinted here) written by my fellow economists Rosanne Altshuler and Roberton Williams last week has received a fair amount of press coverage by pointing out that “about 45 percent of households will owe no federal income tax in 2010.”  This has led to the usual debates about whether this is “fair” or not.  But “fairness” is not a particularly well-defined notion, and your view of it probably depends a lot on whether you are one of those paying taxes, or one of those not. 

Rather than get into a debate about fairness, I want to make a point about economic efficiency, and a point about the interaction of politics and economic policy.  

The economic efficiency point is straight out of introductory public finance.  Most taxes have two impacts.  First, they redistribute resources in some way.  Second, they usually change relative prices and therefore distort economic decision-making.  These distortions in economic decision-making lead to real economic costs.  There are many names for it – the deadweight loss of taxation, including the excess burden of taxation, the efficiency cost of taxation, even the Harberger Triangle (named after the eminent economist who rigorously made this point). 

Whatever name you use, the point is simple: when you tax an activity, you not only raise revenue, but you also destroy some economic value along the way.  In other words, to raise a dollar of revenue, you may destroy another 25 or 30 cents of activity in the process of raising the dollar.  These excess burdens are not always easy to see with the naked eye because often it is in the form of something that did not happen – a transaction that never occurs, an hour of labor withheld from the market, an investment not made, and so forth.  Think of the “dog that did not bark in the night.”       

What is particularly important about this is that the size of this excess burden grows with the square of the tax rate.  That means, essentially, that if you double the tax rate, you significantly more than double the excess burden.  In short, each dollar of revenue gets a more expensive to collect.

As a result of this, most economists agree that the most efficient way to raise a given amount of revenue is to have a smaller tax rate applied to a larger tax base.  The Tax Reform Act of 1986 was a particularly good example of tax policy designed to do exactly that – including more sources of income in the tax base, removing special exclusions and exemptions, and then lowering the marginal tax rate.    

The fact that 45% of households face no income tax is one of many indications that we may have too narrow of a tax base, and therefore too high of a tax rate.  (There are many other examples, most of which are even more quantitatively important, including things like the exemption of home mortgage interest or health care insurance premia). When we leave one person untaxed, the tax burden on the remaining individuals must be higher.  And, importantly, the deadweight loss is higher. 

The second point I would make is that when nearly half of the population pays no income tax, what incentive does that half have to control government spending?  As we have learned over and over again in numerous contexts (including 3^rd party insurance payments), people are a lot more likely to spend money when the money they are spending is somebody else’s.  After all, who wouldn’t like more public spending if somebody else is going to foot the bill?  

So whatever your views about the “fairness” of who pays taxes, let’s be clear that it has real economic and political consequences.  

Economists have tools to analyze the distributional effects of income taxes, payroll taxes, property taxes, and corporate income taxes.  Some existing research even looks at distributional effects of environmental or energy taxes used to help control pollution or energy consumption.  Yet most pollution policy does not involve taxation at all!  Instead, we use permits or command and control regulations such as technology standards, quotas, and quantity constraints.  Existing studies of energy policy are mostly about effects on economic efficiency, addressing questions such as: how to measure the costs of reducing pollution or energy use, how to measure benefits of that pollution abatement, what is the optimal amount of protection, and what is the most cost-effective way to achieve it.

Yet environmental mandates do impose costs, and an important question is who bears those costs.  Moreover, those restrictions provide benefits of environmental protection, so who gets those benefits?  Full analysis of environmental policy could address all the same questions as in tax analysis.  Perhaps it could use the same tools to address distributional effects – not of taxes, but of these other policies that are used to protect the environment.

Thinking about the distributional effects of environmental policy is interesting and difficult.  For example, a standard tax analysis would point out some complex implications of an excise tax: not only does it affect the relative price of the taxed commodity, and thus consumers according to how they use income, but it also impacts factors intensively used in the production of that commodity, and thus individuals according to the sources of their income.  Yet an environmental mandate can have those effects and more!  Consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota.  This type of mandate is a common policy choice, and it has at least the following six distributional effects.

First, it raises the cost of production like a tax, so it may raise the equilibrium price of output and affect consumers according to spending on electricity.

Second, it may reduce production like a tax, reduce returns in that industry, and place burdens on workers or investors.

Third, a quota is likely to generate scarcity rents.  For simplicity, suppose pollution has a fixed relation to output, so the only “abatement technology” is to reduce output.  Then a restriction on the quantity of pollution is essentially a restriction on output.  Normally firms want to restrict output but are thwarted by antitrust policy.  Yet in this case, environmental policy requires firms to restrict output.  It allows firms to raise price, and so they make profits, or rents, from the artificial scarcity of production.  Just as tradable permit systems hand out valuable permits, the non-tradable quota also provides scarcity rents – to those given the restricted “rights” to pollute.

Fourth, if it cleans up the air, this policy provides benefits that may accrue to some individuals more than others.  The “incidence” of these costs and benefits usually refers to their distribution across groups ranked from rich to poor, but analysts and policy-makers may also be interested in the distribution of costs or benefits across groups defined by age, ethnicity, region, or between urban, rural, and suburban households.

Fifth, regardless of a neighborhood’s air quality improvement, many individuals could be greatly affected through capitalization effects, especially through land and house prices.  Suppose this pollution restriction improves air quality everywhere, but in some locations more than others.  If the policy is permanent, then anybody who owns land in the most-improved locations experience capital gains that could equal the present value of all future willingness to pay for cleaner air in that neighborhood. Similar capitalization effects provide windfall gains and losses to those who own corporate stock: capital losses on stockholdings in the company that must pay more for environmental technology, and capital gains on stockholdings in companies that sell a substitute product.

Capitalization effects are pernicious.  A large capital gain may be experienced by absentee landlords, because they can charge higher rents in future years.  Certain renters with cleaner air might be worse off, if their rent increases by more than their willingness to pay for that improvement.  Moreover, the gains may not even accrue to those who breathe the cleaner air!  If households move into the cleaner area after the policy change, then they must pay more for the privilege.  The entire capital gain goes to those who happen to own property at the time of the change, even if they sell it at the higher price and move out before the air improves.  Similarly, new stockholders in the burdened company may be “paying” for abatement technology in name only, with the entire present value of the burden felt by those who did own the stock at the time of enactment, even if they sell that stock before the policy is implemented.

Sixth, strong distributional effects are felt during the transition.  If workers are laid off by the impacted firm, their burden is not just the lower wage they might have to accept at another firm.  It includes the very sharp pain of disruption, retraining, and months or years of unemployment between jobs.  These effects are analogous to capitalization effects, if the worker has large investment in particular skills – human capital that is specific to this industry.  If the industry shrinks, those workers suffer a significant loss in the value of that human capital.  They must also move their families, acquire new training, and start back at the bottom of the firm hierarchy, with significant psychological costs.

The challenge here is that many of these effects of environmental policy are likely to be regressive.  Consider the six categories just listed.  First, it likely raises the price of products that intensively use fossil fuels, such as electricity and transportation.  Expenditures on these products make up a high fraction of low income budgets.  Second, if abatement technologies are capital-intensive, then any mandate to abate pollution likely induces firms to use new capital as a substitute for polluting inputs.  If so, then capital is in more demand relative to labor, depressing the relative wage (which may also impact low-income households).  Third, pollution permits handed out to firms bestow scarcity rents on well-off individuals who own those firms.  Fourth, low-income individuals may place more value on food and shelter than on incremental improvements in environmental quality.  If high-income individuals get the most benefit of pollution abatement, then this effect is regressive as well.  Fifth, low-income renters miss out on house price capitalization of air quality benefits.  Well-off landlords may reap those gains.  Sixth, transition effects are hard to analyze, but could well impact the economy in ways that hurt the unemployed, those already at some disadvantage relative to the rest of us.

That is a potentially incredible list of effects that might all hurt the poor more than the rich.  The challenge for those of us who want to claim to do policy-relevant research, then, is to determine whether these fears are valid, and whether anything can be done about them – other than to forego environmental improvements!