Matt Nolan explores what tax is and the trade-offs involved with different ways of taxing

Matt Nolan explores what tax is and the trade-offs involved with different ways of taxing
Part one of a six part series on tax

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.

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Matt Nolan is a senior economist at Infometrics. You can contact him here »

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18 Comments

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Need Accountants' view on this.
 
Economist's view is sometime a bit native.

Matt,
Good scene setter.
Will be interested in the conclusions/recommendations you reach in later papers.

The certainty of what each individual ought to pay is, in taxation,” according to Adam Smith, “a matter of so great importance, that a very considerable degree of inequality . . . is not near so great an evil as a very small degree of uncertainty.
 
Jean Baptiste Colbert The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.

Please before you write anymore articles please view one of L Randal Wrays Lectures on Monetary Policy. Maybe you have seen it already.  But take another look
I hate to suggest this but maybe it is time that we learnt about Monetary Policy.
The best , simplest, easiest to understand explanation I have found is here.
http://www.youtube.com/watch?feature=player_embedded&v=0zEbo8PIPSc
It was from a lecture at Columbia University given by L. Randall Wray, Research Director of the Center for Full Employment and Price Stability and Professor of Economics, University of Missouri-Kansas City
He starts at just after the 4 minute mark. There is a short test at the start. You will enjoy it.
Not being so brilliant myself I listened to it 3 times, the third with another person, we discussed it and I think I finally got it.
I think that at some point we all need to know how this stuff works or we just end up talking past each other so many of the posts on the site talk about taxing and spending and government borrowing but I wonder if they understood how it actually functions it would help the level of discussion.
It is a US lecture but it relates to countries like ours with their own currency.
You could get someone else to provide a different view of Monetary Policy. I like this one because is has a few laughs in it and is not political- it tells it how it is- or at least thats what he says.
 
 

Here are some observations regards the tax I pay and peoples attitude to taxation
1) I spend the money I earn much more carefully than the Government spends the money I earn and takes away from me
2) I am astounded that Kiwis are openly advocating Capital Gains Tax .(CGT)  For the reason cited above.
3)  The reason why any sane human  would want to pay more tax  eludes me .
4)  Regarding CGT, it seems that Kiwis believe there is some largesse in the hands of the rich list that are easy pickings,   Well let me tell you something there is no largesse , the wealthy  will never pay the capital gains tax on these assets because they are unlikely to be sold . Most of the assets  are income generating and paying CGT becomes a trade -off as to whether to hold or sell
5) Fundamentally I believe that transfer payments to the unemployed should be better managed , and the Government should have a clear strategy to wean these people form the benefit.
The reason is because it is better to have people spending money they have  earned themselves  than to spend the money someone else has earned
 

kimy,
 
having live in Australia where there is a CGT regime in place I'm pretty confident most of your arguments are incorrect.
 
While I'm sure there will be a bunch of people who try to get around it you just have to hang a few (by taking all their assets) to concentrate the minds of the rest.
To take a couple of your points
1. The amount collected is unpredictable from year to year. You would look rather silly when you budget for tax revenue and get it wrong dramatically.
 
That happens under the current regime so why would it stop you doing it with CGT?.  Australia found that in the early years they collected more than expected. The NZ Govt/IRD would be wise to under-estimate the first estimates....
 
3. You have to index the tax over the period of ownership.
 
No you don't. Australia started out that way then switched to a flat 25% of the nominal increase
 
4. You have to index a factor for inflation. Not fair to tax inflation rather than profits.
No you don't. same answer as 3. And I'm afraid that using the phrase "not fair" won't cut much mustard with the IRD if they set their mind to taking a certain path.
 
 

kimy,
how about toodling off the Australian ATO website and checking out this page ?
 
That should support the previous post of mine re your points about indexing for inflation
 
You can then check for yourself how the Australian CGT is calculated.
 
A deloitte's article explain's some of the vagaries around main residence exemptions
That should help with your points about renting it to granny.
 
Though there appear to be a few developers who are taking advantage of the concessional nature of CGT Vs income tax for Australian resident's but it appears that practice is getting a bit of focus from the ATO. In other words, up to this point, it appears a bunch of developers have been benefiting from the concessional nature of CGT when a property is brought for "Long term purposes" Vs "for deveopment and flick" purposes.
 
 
 

They do not need to "get it past" IRD.   IRD have a right - indeed a duty - to advise Ministers of the likely consequences and implementation difficulties of a CGT, and no doubt they would do so, but if a Labour-Green Government decided it still wanted to go ahead with a CGT, IRD would be obliged to implement it. 
 
Would you want it any other way?

I don't disagree with any of that.  The point I was making is that Government departments, including IRD, do not have a veto on Goverment policy.  No matter how much they hate it and/or think it won't work, and no matter how justified they are in hating it and/or thinking it won't work, their duty is to implement the policy of the elected Government.

Our tax system is broken and needs replacing. The old system relied on people being fair and accepting the need to pay their share towards a common good. Now tax seems to be a thing you pay if youi haven't structured your income V write-offs properly. Scrap income and company tax altogether. The latter especially being something that multi-nationals dont pay so why hit local enterprises? The former is something that individuals only pay if they don't have an investment property, holiday home , yacht, or a complicated trust.
I favour a GST and FTT replacement. No doubt there are other ideas, but as I have said the cuurent system is broken.

"No Capital Gains Tax "........ how about Land Taxes? Property Investors are shit scared of Land Taxes.
"The tax incentives
The way this works is that the tax system, by being biased in favour of housing (as regards to other investments) creates a wedge between the private return on housing and the total social return.
By favouring housing, and transferring funds to people willing to invest in housing, the tax system makes the private return from doing so higher than the actual value of the investment – leading to a situation with too much investment in housing.
In this way both Jones are the RBNZ governor are right – people are investing in housing because it gives them a “good return”, but the fact they are doing so isn’t good for us as a whole!"
http://www.interest.co.nz/opinion/64017/matt-nolan-says-current-account-...

Not quite right:
 
PM says 'no'
    Prime Minister John Key reiterated later a land tax and broader capital gains tax were still off the cards. Asked whether the implementation of one or the other could allow government to reduce income taxes to give people more income to spend, he replied:
    “At the risk of repeating myself from last year, we looked at a land tax, and land taxes, one, reduce the value of land in New Zealand, by definition, and it has an impact on every single homeowner in New Zealand."
 
http://www.interest.co.nz/news/52737/imf-recommends-govt-broaden-capital...

kimy, how big a part of things do you think the Accomodation Supplement is for guys in your line of work?
 

"
A tax on land could have non-trivial effects both on aggregate fiscal revenues and on individual households and firms (including farms). On the fiscal front, using 2006 figures, we show that a 1% p.a. tax on all non-government land could raise approximately $4.6 billion annually (rising to $6.7 billion annually by 2030 with 2% p.a. land inflation).
To place these numbers in perspective, $4.6 billion represents 20% of all income tax revenue forecast for 2009/10. The top personal tax rate of 38% applies above an income threshold of $70,000 p.a. Total income tax revenue raised on those earning above this figure is forecast to be $9.8 billion for 2009/10. If the top personal tax rate were reduced to 33%, the direct loss in income tax would be $491 million, which represents just 11%
of the revenue from a 1% p.a. land tax.
While a 1% p.a. land tax could result in significant fiscal revenues – so enabling material reductions in other tax rates – it would also have other major effects and its impact would fall more heavily on some sectors of society than on others. One currently untaxed sector that it would fall on is foreign-domiciled owners of New Zealand property, who otherwise pay no income tax and who pay no GST if they do not purchase goods and
services in New Zealand. A shift to a land tax would therefore widen the tax base not just in terms of the base of assets on which tax is raised but also in terms of the number of people (i.e. non-New Zealand residents) who become taxpayers. The tax paid by non- New Zealanders contributes a net benefit to the country that exists over and above any efficiency (productivity) benefits that might accrue from the tax shift.
The overall effects of a switch to land/property taxes would depend both on what other tax changes are made at the same time (e.g. to GST or income tax) and on the structure of the economy (which determines general equilibrium prices and allocations). Our partial and
In all our general equilibrium simulations, aggregate indebtedness of the economy declines with the introduction of a land/property tax, essentially because New Zealanders borrow less to finance domestic property holdings. At a conceptual level, the value of New Zealanders’ housing assets and liabilities fall but, at the margin, the liabilities are
sourced from foreign savers and a land/property tax reduces the amount of foreign capital that must be borrowed to fund domestic property.
Owners of existing property would incur a loss of wealth following introduction of a land/property tax unless there were perfectly elastic supply. Even in this latter case, if the owners retained the property they would face the present discounted value of the future land/property tax flow (although of course they would also be in receipt of tax reductions
from other sources). With a flat land/property tax, the wealth loss would be proportionate to the existing value of land/property. Owners of land-extensive residential properties (including lifestyle properties), farms and forests would be liable for the largest losses in proportion to their property holdings if a land tax were introduced (since improvements
would not be taxed in that case). Those with no property holdings would not face an immediate wealth loss. The effect on their rents would depend on the supply elasticity; the less elastic is supply, the less that rents would rise following introduction of the tax.
 
http://www.nzae.org.nz/conferences/2009/pdfs/ACAG_Property_Tax_Paper2. pdf
 

jh, so would it be like a rate (as we know councils to be), but they are on a gross values.
Or like the rental on a leasehold - unimproved value.
You see we understand a rate, as that is for services to the property - sort of.
A land tax seems like nationalising all land (turning it all to leasehold) making us tenants to the crown. So then we'd have discussion over what is unimproved value (something that does not exist in reality in our view).
 
We see large gaps in existing tax collection that we'd prefer plugged first before new taxes come in. When it comes to multi-nationals for example thin cap is not enough - look at the banks and major tech coys (google/apple etc).
We see the substitution of otherwise tax payments by bank interest payments in many places (its common to hear - I'd rather pay interest than tax).
 
Then there is govt spending to work thru.
 

thanks. yes and also from the same day:
http://www.slideshare.net/bernardchickey/deloitte-partner-mike-shaw-on-l...
back to brass tacks this is a good start:
http://en.wikipedia.org/wiki/Land_value_tax
buts in operation, we heard of it in OZ:
http://www.sro.vic.gov.au/SRO/sronav.nsf/childdocs/-3A87315B22BC23FFCA25...
http://www.osr.nsw.gov.au/taxes/land/
thou neither on farms or main residence. we'd think the chances of same being pretty high.
and we don't think its introduction will bring property prices down....
 

Alternative discussion of this question given here,
http://wwaet.blogspot.co.uk/2013/07/why-do-we-tax.html