Matt Nolan looks at tax systems and how we can focus on fairness while keeping them efficient

Matt Nolan looks at tax systems and how we can focus on fairness while keeping them efficient
Part three of a six part series on tax

By Matthew Nolan*

So far while discussing tax we have looked at why we tax, and a way of trying to work out some of the costs and burdens associated with tax (with some additional explanation over on the linked blog). 

Now that we have this background, we can get our hands dirty trying to look at different types of tax regimes.

Remember, our goal here isn’t to say that any tax regime is better than the other – it is just to look at the costs and benefits associated with them.

Last time we concluded with the following paragraph: when a tax is imposed, we need to think carefully about who the burden falls on. Furthermore, we should take into account this idea of “dead-weight loss” (distortion/inefficiency) and as a result we should attempt to keep the overall loss of efficiency from taxation as small as possible for a given target level of government revenue/spending.

Now, the concept of thinking where the tax burden falls, and the aim of redistributing through government spending, are both forms of redistribution.

When we set up the level of taxes and where the government spends we will explicitly want to take redistribution into account as a matter of fairness.

However, if we are willing to put the idea of fairness to one side for a moment (I promise to come back to it) we can focus on the second issue here, the one of efficiency.

If all we care about is the efficiency of the tax system then the tax we should use is fairly straightforward – we should institute a poll or lump-sum tax. This is a tax where every individual pays a fixed sum in tax each year.

A poll tax does not lead to the type of direct distortions we suggested that we were concerned about earlier in this article. It does not create a direct “wedge” between the price paid and the price received for labour or capital or goods and services.

As a result, the change in behaviour we get is solely due to the shift in income from private individuals towards government – there are no additional distortions due to the dead-weight loss of the tax.  Easy!

Society is uncomfortable with that

However, very few people like the idea of a poll tax. It violates something that we value as a society. As a result, we are now coming back to the idea of fairness.

If we instituted a poll tax, then the level of tax paid by the poorest person would be the same as the very wealthiest person in society – and that doesn’t seem fair. The burden of the tax in this instance appears to violate society’s view of fairness.

We could try to deal with the fairness directly through government spending and transfers, but doing it this way seems equivalent to taxing all of the population just to give money back to most of them.  Although this method is doable, society at present is unwilling to look into it.

Given that society has stated that it doesn’t like poll taxes we can ask ourselves, why?  What is the principle of fairness is being violated by this tax?  One such principle is a more subtle version of Marx’s old statement “From each according to his ability, to each according to his need”.

Part of the idea here is to ask, what sort of society would we want if we were asked to pick the distribution of resources from behind a “veil of ignorance”, as suggested by John Rawls.

If we did not know whether we would be born into society as a king or as a pauper, but we could set up the way that redistribution worked beforehand, how would we do it?  In economics we call this the principle of vertical equity.

The idea that we would redistribute, and that it would be from those with the “ability” to earn to those who do not have such an endowment of resources, opportunity, luck, skill, and physical prowess, has been taken as a guiding principal for thinking about tax policy and broader government spending. 

We can use this idea to discuss other types of tax systems that are close to ideal in this sense.

Greg Mankiw articulates this point nicely when he states the following:

the social planner [government] has to come to grips with heterogeneity [differences] in taxpayers’ ability to pay. If the planner could observe differences among taxpayers in inherent ability, the planner could again rely on lump-sum taxes, but now those lump-sum taxes would be contingent on ability. These taxes would not depend on any choice an individual makes, so it would not distort incentives, and the planner could achieve equality with no efficiency costs.

If we can lump-sum tax “underlying ability”, we do not distort people’s incentive to invest in skills, we do not create a wedge between the price paid and the price received in any market, and as a result we can redistribute according to ability without the efficiency cost!

We get the benefits of a poll tax, but the underlying burden of where taxation falls is fairer according to our fairness principle.

Of course, ability in this abstract sense is unobservable.  The idea of “ability” here includes ideas of capability, talent, effort, and opportunity – making it virtually impossible to measure. However, there are some things that are observable, non-falsifiable, and are very closely related to our conception of ability.

One such attribute is height.

In a 2009 paper by Mankiw and Weinzierl, they find that according to standard measures a tax based on height makes sense.  Height is strongly related to an individual’s ability to make income, and there is no cheap way to adjust your height in order to avoid the tax. As a result, if all we care about is efficiency and vertical equity, a lump-sum tax on height may make sense. A similar argument could be applied to sex, race, and even measures of attractiveness!

Society is still not comfortable with that

I have to admit that I am not particularly fond of targeting people with tax based on their height, race, sex, or any of these types of factors.

It is the social will that stands against the imposition of these types of discriminatory taxes, and is part of the reason we have moved towards taxes that are more distortionary, such as income taxes and consumption taxes.

Mankiw and Weinzierl also make this point – that since we can’t observe ability directly and these “other factors” are imperfectly related to ability, taxing these types of factors implies that people with the true ability to earn the same amount will pay differing amounts of tax.

This violates another fairness principle that economists have noted is important, the idea of horizontal equity (that those with the same ability to pay should pay the same amount of tax).

Furthermore, as a society we are justifiably uncomfortable with discrimination, and with legitimising discrimination by government – which is what these “ideal” schemes involve.

However, society does use forms of ability tax.  These are called factor taxes (income and capital taxes) and consumption taxes.

Although they do fall on ability, these types of taxes are distortionary – as they create a gap between the price paid, and the price received, for labour, capital, and goods and services.

We will discuss these taxes in more detail in the next article.

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

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In a comment letter to Mary Holm in Saturday  NZ Herald
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10885991
one commentator goes to some length to show how property investors are unfairly advantaged over other investments and certainly occupier buyers.
To summarise investors can take advantage of gearing their purchase without taxation being used to balance the equation.
The system is, of course, totally OK tax wise.
What is needed is the means to even up the playing field. CGT will not do it because it will apply only when the property is sold which may be the equivalent of ''never'' for some investors.
It seems that no politician is prepared to stick their neck out and certainly most of them have an unhealthy interest in keeping to the staus quo.

Matt,
Very happy to see you mention Rawls in this piece. The Law of Peoples is very good on this, specifically the concept of distributive justice. 

Cheers.  It is fundamental - and it is contensious.  Better to be up front about it, especially as it is an assumption that we use whenever we discuss government policy.

Why are governments still focused on taxing incomes, especially when incomes are so easy to hide or redistribute? The more legislation there is to stop this, the more loopholes are found - revenue gathering departments are chasing tales.
The second downside is that it punishes both ends of the income earning spectrum - the harder you work, the more you are taxed. Yet the lower income earners do not have the resources or know-how to rort the system as some of the wealthier institutions do (for example Apple).
I propose instead that we look at abolishing income tax all together and focus on a value added or goods and service tax. The tax could be as high as 20-25%. The advantages:
-Reduce administration and audit costs associated with chasing income tax avoidance and evasion.
-You pay (tax) as you spend. The more you spend, the more you pay. The individual has total control over the amount of tax they pay.
-Real disposable income will increase.
-Having control over the tax they pay, people may just think twice before wasting money on unnecessary goods, and instead focus on savings.
A flat company tax (say 25-30%) should also be introduced. This may push the incomes back into the hands of individuals, who again - cannot escape paying tax on the things they buy.
 
Just my two cents worth. Too simple?
 

Yes, its regressive...we already have enough wealth distribution to the top 1% as it is.  As well as that international corps dont spend their profits here...so would pay less tax...
regards

Only suckers pay tax.
Scrap company tax. - it only hits your domestic businesses, multi-nationals pay nothing.
Scrap income tax. - it's a joke and voluntary if you have a rental property,yacht,holiday home or trust.
A combination of gst 10% (beyond that the incentive to avoid is too high), and financial transaction tax @ 2% can replace the above. This tax is collected every time $ changes hands (- not you shifting funds from your savings to cheque account for e.g.)

Matt,
The premise in your first paper, as to why we tax, or at least why should we tax, is in my view flawed, and influences in sub optimal ways then how we tax.
You said then:
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.
I accept this is the conventional paradigm, and practiced religiously by our governments probably since they started. Some other foreign governments practices since the GFC have had me questioning why this is, given sovereign countries can always, if they wish, print some of the money to balance the books.
The current approach generally has the government trying to get as much money as they can from the citizenry in whatever plausible ways possible; and the people being as creative as they can be in avoiding the taxes the government has come up with. If government taxes are too high, do they give it back, or do they find new ways to spend it? Spending it usually wins, and I accept the last Labour government overdid it in that regard. Conversely when government revenues dry up; should the government stop spending money just because it is struggling to make things balance, even where stopping such spending has material negative effects? Should it borrow the money from say foreigners (as has been the National government’s preferred approach), even though that will have damaging effects on the exchange rate, and leave us with genuine debt; or should it print some money?
The US, UK, Japan and others it seems to me are consciously or not now following Modern Monetary Theory. (E.g. The Republicans in the US will never allow tax increases; the Democrats will insist on at least minimal welfare; they will not borrow the difference from foreigners; and they will most certainly never pay themselves back the $2 Trillion plus they have printed and loaned to themselves the last few years)
See a couple of links here showing it is not just me inventing this in my office:.
http://neweconomicperspectives.org/p/modern-monetary-theory-primer.html
Krugman gets MMT
Simplistically following this theory would then give you the following reasons to tax:
1)     Some income redistribution from  high income to low income people.
2)     Ways to encourage or discourage certain behaviour- cigarette taxes etc
3)     One of the tools to manage inflation. Without taxes we would not suddenly all be better off. The price of everything would rather quickly go up, all else being equal.
The resulting tax structure may end up being similar to what we have now; but wouldn’t be driven by a need to balance the books, but by a preference to keep inflation in check.
The discipline on the government not spending too much would be both the inflation check; and more importantly, measuring their spending by category as a share of GDP, and not overdoing that, or crowding out will occur. Among other things, funding a government deficit by foreign borrowing would only make sense if the exchange rate was too low and would be inflationary. Similarly selling assets to fund government spending becomes absurd, if that is the only reason for selling them.
Your explanation of how we tax still makes sense; but in this paradigm wouldn’t be driven by a need to get as much revenue as possible, but to meet the other objectives above. Some of the really negative or inefficient taxes then could be dispensed with.
Good new photo by the way.
Cheers

"I accept this is the conventional paradigm, and practiced religiously by our governments probably since they started. Some other foreign governments practices since the GFC have had me questioning why this is, given sovereign countries can always, if they wish, print some of the money to balance the books."
 
I normally don't comment here as I don't have the time to give fair responses.  But I have been waiting for this specific comment.  Glad you asked, this is article number 5 and now I can point out that this was asked when I get to writing part 5 ;) .  As a result, I hope you'll forgive me if my response isn't particularly all encompasing here - as I will cover it then.
 
The general idea will be that, printing money to fund expenditure while we are otherwise following a monetary policy rule that closes the output gap, is equivalent to other forms of tax.  We don't even need to assume "measured inflation" to get this inflation tax - we just need to recognise the fact that, since we have a policy rule filling the output gap, the government is having to transfer inputs from other parts of the economy in order to create what they create (a version of crowding out which holds because of the monetary policy rule).  Personally, my main concern with this type of tax is that it is often "regressive" - we will hopefully have time to nicely define ideas of progressive, regressive etc etc in the next article (article 4) - but I am not going to write the article saying we should or shouldn't do it, it will be just discussing what it is.
 
Crowding out has a strange rap - it was misused at the start of the crisis, and so people feel it is a fallacy.  Actually all it is is a recognition that government policy and transfers do work at changing the distribution of goods and services, and that there are winners and losers from transfer policy - it isn't a good or bad thing unless we make an extra step and say "we think this change is good, or we think it is bad, because of how we value things".  Our dead weight loss uses the same sort of logic - it isn't inefficient because there is less or different stuff, but it is because transactions are not occuring that people would value due to the price received and the price paid being different.  You'll notice I never use the term GDP or any volume measure in any of this, as it is not about targeting or maximising that.
 
This is the main reason why economists talk about "monetary" and "fiscal" policy very separately, even though we fundamentally see them as intertwined. 
 
It will be sort of like this argument:
 
http://www.tvhe.co.nz/2013/05/27/a-tax-by-any-other-name/
 
Using this idea more directly:
 
http://www.tvhe.co.nz/2013/05/20/series-on-tax-part-2b-lets-experiment-w...
 
But, given I will actually have time to write the article and read and edit it (something I don't have the chance with on the blog) my answer by the time we are at part 5 will hopefully be clearer :)
 
I also see you linked to some MMT guys.  Those specific guys have always seemed really nice and interesting, and I actually think that much of what they write is just a version of current economic theory - I'm not even sure what the "mainstream" is that they are often against, but that is cool.  Some other MMT authors can be irritating (just like some mainstream ones) as the reason they attack is simply to try and say they know more - those guys have never been like that.

Matt,
Well done on coming back quickly; and glad you were expecting the question. Your response will also need some thought; so I will come back probably tomorrow night. Probably will just be me talking to you by then- as this thread seems to have already slipped off page 1. But if you are happy to indulge; that would be fine by me.

Matt,
Have read through most of your links; seems to me you are stuck in the mindset that taxes are required to fund government expenditure, and that government expenditure cannot happen without them. And even if that were true, given the government is currently short by $4-5 billion a year, what is the best way of meeting that gap?
Regardless, to challenge some of your points as they arise in your reply:
we are otherwise following a monetary policy rule that closes the output gap
At 0.9% inflation, and near 7% unemployment, we are in fact materially undershooting, while the single tool to achieve this end- the OCR - as we know is a very blunt and often ineffective tool with unintended consequences. Housing bubbles and the like. What if the goal was the same, but the tools were broader? Including direct funding of some government expenditure by the Reserve Bank? And separately, there was some control of private money expansion if necessary?
The general idea will be that, printing money to fund expenditure is equivalent to other forms of tax.
Am pleased you haven't relied on the tiresome Zimbabwe argument. In my view a "tax" happens with any government spending; and I believe your argument supports that view. So if the government has chosen certain spending (and this year it is $4 billion more than they plan on collecting in taxes) then the extra $4 billion is a tax on future generations. The National government chooses to fund pretty much all of that by borrowing offshore, and pay a premium to do so. So that the tax on future generations will be say $5 billion. This is in order to keep the exchange rate arguably too high. That in turn "taxes" exporters and import substituters now; while leaving the future tax bill in place. Absolutely double taxation; and a free gift to foreigners. (can point you to papers showing the fiscal multiplier in an open economy like NZ is zero, so funding the deficit offshore is a free gift offshore with no economic benefits to NZ). Without that effect we may well have a balanced budget already. All so that consumers now can enjoy overseas holidays more cheaply. In terms of progression/ regression, my view is that a high exchange rate hurts the less wealthy relative to the very wealthy, both in spending power and employment, especially if their employment is in the tradeable sector, and not the government one.
If alternatively some or all of this expenditure was directly funded by the Reserve Bank; yes that is also a tax- but where does it fall, time and demographically wise? Most likely there would be a modest lowering of the exchange rate; affecting consumption now. So the current generation would be paying. No intergenerational debt. And a more balanced current account.
In terms of inflation. I have noted above that inflation would remain a prime target. If say 2% or perhaps 3% was being threatened, then printing can be replaced by borrowing; or the OCR can rise (and it could be funded by local borrowing). Is 2-5% inflation regressive? The most indebted would benefit, assuming wages followed inflation up. But yes asset prices might rise, helping the already wealthy. But wait, they are already going through the roof. And I don't think some modest printing would materially change that. 
I understand you are addressing the topic later in your series; so by all means respond further then; or now. Up to you.
Regards
Steve

You are putting out some good pieces to generate thought, thankyou for that, keep doing it please.
regards

Just to note, Matt, that there Are some taxes which come quite close to the ideal Poll Tax.
 
In the TLA area, these taxes (because rates, fees, levies are Taxes, being compulsorily collected....) include:
 

  • Per-pan rates for sewerage
  • Per-household rates for water
  • HUE calculations for Development Taxes
  • Earnest common taters may well think of more such....

 
Each depends, finally, on an equivalence struck between Number of People, and Price Per.

The tax system we use now is outdated and is extremely unfair on those who have to bare the costs of collecting it all. 
The proposal below would offer signifant advantage. 
http://www.apttax.com/