A Tax Day question: Why does our government have more than two taxes?
Let’s assume that the government needs money. Even a country full of highly educated hard-working efficient people such as Singapore spends about 18 percent of GDP on government (source). But why not raise this money via only a couple of taxes, thus keeping administrative costs to a minimum?
For example, our government could have a value-added tax (consumption tax) similar to our current state sales taxes but at a higher rate and with European-style policies that make it tough for anyone to cheat. To get at wealth and recover the costs of protecting property, we could have a property tax similar to the current tax but with some of the money going to the federal government as well. If the government needs more money in any given year, just crank up the rates on these two taxes.
It would be a lot tougher for lobbyists to prosper in this environment because, with only two taxes any exceptions for government cronies would be more noticeable. Perhaps citizens would also be less happy. Right now the government raises money in lots of different ways so nobody sees one huge bill. Taxes on businesses are especially good for our mood because we never see the bill at all. We pay higher prices for stuff than we otherwise would have, but we aren’t sure why.
On the other hand, there are a lot of voters who express hostility toward the complexity of U.S. local, state, and federal taxation. You’d think at least these folks would support cutting back the number of taxes to just two or three, even if the rates on those taxes went up.
[Separately, does anyone know how many different taxes we do have in the U.S.?]
As the instapundit likes to say: “Insufficient opportunities for graft”
This will never come to pass since laser focused lobbyists 100% of whose income depends on labyrinthine tax-code will sway lawmakers in maintaining the status quo. Millions of voters that believe the existing system is stupid and wasteful won’t be able to overcome that.
Also, should it ever come to pass, it would immediately be chipped away at by easy to swallow taxes like rental car tax, occupancy tax…
I think you already answered your own question. But H.L. Mencken was much funnier: “Democracy is the theory that the common people know what they want, and deserve to get it good and hard.”
Japan sends all workers who earn a pay check a post card size statement that shows what the government believes that worker owes in taxes. If the worker agrees, they mail the form back (with a check or request for refund) and they are done.
The system isn’t too good for tax preparer’s, but the individuals don’t seem to mind.
Well, there are many people for whom 100% of their income is needed to merely live on. What you propose for them would be disastrous.
It would be a lot tougher for lobbyists to prosper in this environment because, with only two taxes any exceptions for government cronies would be more noticeable.
And it would put a lot of CPAs, tax attorneys, and tax preparers out of business. But, ont he other hand, it might stymie some of the income, sales and other tax scams.
we could have a property tax similar to the current tax but with some of the money going to the federal government as well.
I guess rents would drastically increase.
Taxes on businesses are especially good for our mood because we never see the bill at all. We pay higher prices for stuff than we otherwise would have, but we aren’t sure why.
Just like property taxes are passed on to renters.
The govt does not just want to collect money. It wants to control people. The income tax works well for that. Look at how it now uses IRS to control health insurance.
@Andrew Shouldn’t the people you’re talking about already be dead because we already have sales tax and property tax?
Much of Congress’ power is in the power to tax, with discretion. Take away that discretion and you take away their power. So, absent a constitutional convention, it probably won’t happen.
As far as different taxes, there are lots of obscure taxes (especially at the local level) but the big four money makers are state and federal income tax (including corporate and social security), property tax and sales tax – those are the big moneymakers. At the Federal level, all the other taxes (excise taxes on alcohol, tobacco, estate tax, etc.) account for only 9% of revenue. Of course 9% of 3 TRILLION dollars is still a lot of money.
Warning, potentially erroneous economics ahead:
Deadweight loss represents the societal cost of a tax, and as the tax rate increases, the deadweight loss increases at a greater rate than the incremental revenue raised. Aggregate deadweight loss is minimized for a given revenue requirement by having taxes on different activities such that no single tax needs to be extremely distortive. E.g., if we eliminated all taxes but the personal income tax, it would likely need to be 10-20 points higher, dramatically distorting the labor market.
Optimally, one would have higher taxes on activities for which little to no behavior adjustment is possible (e.g., a higher estate tax, yes I know it encourages avoidance/more advisors but so do all taxes). Alternatively, have a bunch of taxes so you are not excessively distorting the market for each one.
There is a fairly strong majority view of economists on both sides of the political spectrum that certain taxes (corporate tax especially) are too high and distortive, while others are far too low (estate tax probably, gas tax almost definitely).
I’m politically conservative and agree with you most of the time, but not here. And every time I hear someone compare Singapore (a terrifically well-run country) to here, I throw up my hands in disgust. We spend 17% of our GDP on health care, they spend 5%.
Find me a universe in which Americans can muster the political will to drastically change health policy and reduce health care spending to the developed country average, and I’ll find you one in which taxes could be cut deeply and you probably would have far fewer complaints about government policy. Until then, we have to keep subsidizing innovation for the rest of the world.
Andrew: Thanks for the thoughtful contribution. I didn’t mean to suggest that Singapore could be a model for our tax rates. My point was that Singapore is a best-case scenario of an efficient government and they still need to collect about 18 percent of GDP as tax revenue (since they spend 18 percent of GDP).
To your main point, I’m not sure that I understand how spreading taxes around can reduce the deadweight losses.
Let’s say that there are just two taxes: income and consumption (VAT). In Scenario A, the income tax rate is 50 percent and VAT is 0. In Scenario B, the income tax rate is 25 percent and the VAT is 40 percent (not all income is spent so we need a higher VAT rate to compensate for the loss of 25 percent of income, right?). In Scenario A you can work for one extra $1 and keep 50 cents, with which you can buy an apple with a total cost of 50 cents. In Scenario B you work for one extra $1 and have a take-home boost of 75 cents. Then you go to buy the apple and have to pay 50 cents plus 40 percent VAT = 70 cents. In both cases that extra $1 of work yielded one net apple. So why isn’t the incentive to work or not work the same?
Thanks Phil.
It’s hard to demonstrate with actual numbers how this works, but essentially the deadweight loss is a function of the square of the tax rate and the elasticity of supply and demand.
Going to your example, for instance, reducing the income tax from 50% to 25% wouldn’t cut in half the revenue raised, it would probably cut it by more like 30 or 40% (you can demonstrate this with charts and measuring triangles, or just intuitively that it changes the work/leisure tradeoff, incentives for tax avoidance, etc).
Then, imposing the VAT to raise the missing revenue imposes a far lower distortion on the incentive to work because while it results in the same impact on current consumption as you illustrated, it does *not* distort future consumption the way an income tax does because it does not distort the decision to consume versus save the way an income tax does (by taxing investment income).
Mankiw demonstrates this well at http://gregmankiw.blogspot.com/2006/06/consumption-vs-income-taxation.html
A more theoretical/mathematical example of the argument for as broad a tax base as possible (not an identical claim, but a similar one) can be found in these lecture notes from a graduate economics class – https://gspp.berkeley.edu/assets/uploads/courses/notes/Lec2-DWL-Optimal-Tax.pdf
My point re: Singapore is that if you only need to raise 18% of GDP because you have a highly urbanized and educated society that is willing to make big tradeoffs on healthcare and other entitlements, you can do it easily with very low tax rates (Singapore imposes a 20% income tax and an 8% VAT, based on a Google search) and not distort much at all. So there are far fewer hard decisions in their case.
For us to raise what we need, and will need (which is going to be a lot more) based on the promises we have made (many of which are viewed as contractually binding or even constitutional rights, just look at the mixed results of pension litigation at the state level), we need to borrow a lot and also very carefully design taxes that will not result in massive deadweight losses and raise relatively little additional revenue. This is also an issue with federal budget policy, in which Congress needs to offset spending with revenue, but their revenue claims are far too optimistic, almost dishonestly so. At the high end you have the big lie that Obamacare would raise money, at the low end you can see some of their crazy revenue estimates for relatively narrow legislation that is unlikely to raise any meaningful amount.
Both the Democrats and Republicans (Cruz is especially likely to resort to this, to the extent he even tries to justify his tax policy) tend to do this to justify whatever policy ideas they are proposing. I can’t evaluate Trump because he does not express coherent policy ideas.
I am a Republican, I suppose, but I’ve gotten to the point where I have almost zero faith in either party to design policy that will not make things any worse than they are now. So I have a natural preference for candidates who will continue the status quo while maybe trying to make some minor improvements (Kasich, Ryan, Romney, etc), and beyond that would probably be more comfortable with Hillary than anyone else. It’s the establishment’s fault that they have allowed inequality to get to the point that so many people have little to nothing to lose that they would support someone like Trump or the “politically correct” Trump (Bernie).
Andrew Gilmartin – “Well, there are many people for whom 100% of their income is needed to merely live on.” Another way to say that is that there are many people who spend 100% of their income (or more).
Andrew – “Optimally, one would have higher taxes on activities for which little to no behavior adjustment is possible.” Isn’t this why people with big bucks pay big bucks to get around estate/inheritance taxes through ‘estate planning’? I think you would only capture the taxpayers whose estates were worth aren’t worth spending enough money to ‘protect’ them from high tax rates.
Philg – One of my takes from Andrew’s comment is that more types of taxes make it more difficulty to carve out exceptions/exemptions that net an effective tax rate of 0% for certain well-connected people/corporations (which are people, too). In Scenario A, a lobbyist could carve out an income tax exemption and his interested party could pay 0%. In Scenario B, a lobbyist would have to get 2 laws changed – the income and VAT to achieve the same result. Add more tax types, and there’s less chance his client would be able to effectively achieve the same 0% result.
To your original question, my answer is that the gov’t sees value in a diversified portfolio, perhaps in part for the above reason.
Sam –
Yes, it encourages spending on estate planning. I spent the first part of my career working in this world.
But even with a large exemption (to exclude, say, sub-$20 million estates) it still can raise meaningful revenue without materially distorting peoples’ behavior during their lifetimes. There are plenty of legal techniques to reduce or defer estate tax for massive estates but none to really eliminate it. There are still some huge estate tax bills being paid on large estates, even though our current exemption is very high (about $11m for a married couple).
In addition, this is also a huge factor as to why philanthropy among the ultra-rich is so high, even among those with little current income (e.g., Gates and Buffett). That doesn’t directly raise revenue but is at least marginally socially productive. Of course, the inherent hypocrisy of their calls to raise taxes on those who have not accumulated massive untaxed capital like theirs can be grating.
Andrew + philg,
I mostly agree with Andrew. Given a choice between a 60% income tax, and a 20% income tax + 10% VAT + 1% real estate tax + $0.25 gas tax, the latter has few distortions. In contrast, the former (60% income tax) encourages underground economy, labor force exit, and the oft-discussed alimony/child support seeking behaviors.
Public finance theory says that many small taxes are better than one large tax, as most taxes become increasingly distortionary as rates go up. Generally 50%+ for income taxes, and 30%+ for capital taxes, start to reduce revenue as avoidance behaviors kick in.
I differ slightly from Andrew in the sense that the only area where Americans are “under-taxed” (I use the term advisedly since I am referring to distortions, not fairness or size of government) is the sales/VAT/business flat tax. In that sense Cruz has a better tax plan than anyone else.
In contrast, Kasich is a fan of means testing social security, which is the most weaselly of taxes, since it is really an income tax of ambiguous incidence. The tax avoidance behavior, and income-structuring industry, and potential for lobbying/corruption among public pensioners, are all off-the-charts yuge in a Kasich means-test world. Not to mention the additional power granted to the IRS to collect data on our “assets”.
But I completely agree with Andrew that health care at 17-18% of GDP is the central problem. Obamacare is yet another means-tested entitlement, which means it, too, is a weaselly income tax of ambiguous incidence an distortionary behavior. Health costs are central to both the federal budget, and municipal pension liabilities. With a more efficient health system, the tax burden would be much more manageable.
“Aggregate deadweight loss is minimized for a given revenue requirement by having taxes on different activities such that no single tax needs to be extremely distortive. E.g., if we eliminated all taxes but the personal income tax, it would likely need to be 10-20 points higher, dramatically distorting the labor market.”
It seems that the tax code is a rather sparse vector in the infinite-dimension space of possible taxations. Perhaps we are seeing drastically high rates already, compared to some optimal case?
Though to be honest, this technocratic discussion of tax rates seems a bit like a yellowed photograph from some nostalgic age which may never have been in the first place. I know Sweden has a top bracket income tax rate that is too high, in the sense of not even maximizing revenue. Yet it is retained, apparently just in order to symbolically punish political enemy classes. Not to mention that taxes should really be motivated by incentives, though the modern way is to briefly genuflect in this direction in order to hide the bureaucrato-political process behind it.
It will also be interesting to see what happens to tax rates once spendthrift governments no longer can borrow at easy easy easy rates of 0%, or less.