By Matthew Nolan*
Each time we get a payslip, or look at our receipt at the supermarket, we see tax showing up.
Given that we know that the government uses tax to pay for goods and services, and we know we are the ones paying the tax, issues about taxation lead to a lot of heated debate.
Over a series of five articles, I’m aiming to help frame this debate, by discussing what tax is and the trade-offs involved with ways of taxing.
The goal is not to say what tax system we should have, instead I’m just aiming to show what tax is, why we tax what we do, and raise some of the points society needs to be aware of when it decides who and how much to tax.
In today’s article, the goal is simply to ask “why do we tax”?
Isn’t this a simple question?
Saying what tax is might seem simple on the face of it.
It is the GST added to my morning coffee, it is the income taken out of my fortnightly pay slip.
The government takes this money and provides me with roads, healthcare, the education I received when I was younger, the superannuation I get when I’m older, and a series of other goods and services.
Now all this is true, in a sense. However, like most simple stories it is a half-truth, capturing part of the story of how tax works but hiding other important elements that help us think about the cost of taxation and where the burden falls.
Tax, government spending, and the role of government
The government taxes so it can spend.
At a point in time, they may run a deficit (where they borrow from the private sector or from overseas and run up gross public debt) or a surplus (when they pay off interest or run down gross public debt).
At the end of the day the government looks to balance its books – often pinned to a view about what “long-run public debt as a percentage of GDP” should be.
The overarching aim of the tax system is to make all of this square up in the cheapest way possible.
However, talking about all these things in terms of money is misleading. In truth, the government is taxing and spending in order to change the allocation of goods and services.
If the government did not tax and spend, your income would not end up rising by the size of your tax bill and the price of goods and services would not end up lower by the amount of the GST that was charged.
In truth, changes stemming from more or less government are a lot more complicated than that.
By adjusting spending and taxes, the government is trying to achieve certain aims based on what they believe is fair – which is based on the principles we elect them in for. .
If the government can manage it, it would like to raise the revenue to reach these equity goals in a way that doesn’t dampen efficiency – in other words in a way where people will work as hard and utilise resources as effectively as they would in the absence of a tax. However, this is usually not possible – implying that we end up with a trade-off between equity and efficiency. We will get into this issue further when we discuss actual tax policies in a later article.
The way of redistribution
Essentially, at a point of time an economy has a set of capital, labour, and land , which when used together can create the goods and services people want to use.
When people trade voluntarily, they will supply inputs (eg the time we spend working) and trade outputs (the goods and services that we consume) and the prices of these relevant factors, goods, and services will bear some relation to their underlying value to people.
Now, we can’t appropriately measure, co-ordinate, or control these inputs and outputs through government – although as individuals we have an idea about what our preferences and values are, it is impossible for anyone to gauge what the whole of society’s preferences truly are. We don’t have the knowledge of the trade-offs involved, or the values people place, to do this.
However, as a society we may have an inclination that either:
1. Certain goods and services are underprovided, either due to their value not being caught in trade (an externality) or because the good is a public good.
2. We believe the opportunities available due to who “holds the resources” or who “has the ability” create a situation are unfair.
3. There is some minimum living standard that someone deserves, which would not be provided without government intervention.
In all of these case, the government wants to redistribute goods and services away from the way capital, land, and labour would be utilised in the absence of their redistribution.
Where the burden falls with tax
However this is where things get tricky. When we tax something, how the price of that good changes, and who ends up sacrificing goods and services (and so fundamentally paying the tax) is often unclear.
Fundamentally it depends upon the incidence of tax.
When I see a tax payment fall out of my payslip, this implies that there is a difference between what my workplace pays me to work and what it costs my workplace to hire me. This leads my firm to hire fewer workers than they would without the tax, and implies that employees get less remuneration than they would without the tax.
However, in order to understand who bears the burden of the tax we have to ask how people will respond when they face these costs.
Will workers be willing to work for the lower wage, will employers be willing to hire for the higher cost.
The truth is that part of the burden of income tax does fall on you as an employee, but the employer is also paying part of it, and the person who doesn’t get hired by your firm also bears part of the cost of the tax. We will discuss this issue in more detail in the next article.
And the burden of spending
Another point comes from looking at how the government spends the funds they raise in tax.
When we are looking at this question in terms of redistribution given capital, labour, and natural resources the impact of spending is not as clear as we might like. Fundamentally, when the government goes to spend, we can’t just take prices as given in order to figure out the impact of this spending in terms of the real goods and service that we care about.
For example, say we heavily taxed high income nations, and sent that tax money over to low income nations for food.
In that case, the current availability of food is relatively fixed, so we would see the price of food rise sharply – as a result, we would see the quantity of food consumed by everyone else would need to decline.
Furthermore the increase in food consumption in low income countries will be smaller than we would have anticipated for that level of spending, if we had expected the price to remain unchanged.
In time, the amount of food produced would rise but overall food prices relative to all other goods and services would stay higher – and this is part of how the “redistribution” with taxes and spending is supposed to work!
In net terms these issues are very complicated. There is no way of truly knowing how a tax change will impact on society. The closest we can get at the moment is though economists armed with CGE (computable general equilibrium) models, and other similar devices, who can help us partially understand how the allocation of goods and services between people really will change with adjustments to tax and spending.
So why do we tax?
As we described above, tax and spending are a way of redistributing goods and services and providing public goods.
The more we tax and spend, the more we are attempting to redistribute resources within society.
The government can do this through an income tax, a consumption tax, a height tax, an inflation tax, a tax on the number of windows you have, or even a tax on the number of fingers your mother had – in truth we haven’t said anything about what a “good” tax system involves.
All we have shown so far is that it is very hard to judge exactly who pays in a given system.
In the next article we will discuss some ideas around what an “ideal” tax involves, and the trade-offs involved in setting that. However, given that idealised taxes do not exist we will follow that up with articles on other forms of taxation – and the trade-offs we face as a society by doing that.