Why does a government impose taxes? Which ones are beneficial? How much of it must be imposed to prevent evasion? This article focuses on taxation – from a classical liberal perspective.
What Is a Tax?
First of all, a tax is payment for a social contract between citizens and their governments. That is, the government promises to provide defense, law & order, justice and infrastructure in return for the taxes citizens pay it. To the liberal, the proper funding of the government is essential for its proper functioning. And this is where liberals differ from new age “libertarian” anarchists, who consider the very presence of the government to be a hindrance. Actually the libertarian viewpoint is wrong in several ways, which I will discuss later. Except in cases where the citizen is too poor to pay taxes, citizens must compulsorily pay taxes. And it’s citizens alone who have to pay them, not corporate or other non-living entities.
How Much Taxes Must Citizens Pay the Government?
Ideally citizens must pay enough for both the government to function properly and also that doesn’t affect their business. And for this, there are two price models:
i. Flat taxes – Everyone pays the same irrespective of their willingness or ability. For instance, paying for a kilogram of flour or a few kilograms of vegetables. An example is poll tax.
ii. Price Discrimination (PD), which brings us to Lindahl prices for the optimal solution. For instance, a software company charges different prices for different people: students get discounts while professionals pay the full price. Of course, their features also differ. Lindahl equilibrium is a state of economic equilibrium under Lindahl taxes and a means to find the optimum level for the supply of public goods/services when the total per-unit price people pay equalizes the total per-unit cost of the public goods. According to the theory of monopoly, wherever PD is feasible, the monopolistic entity will increase its output to accommodate all preferences and produce the same output as a competitive industry. It does so by skimming off consumer surplus.
However, flat taxes are not Pareto efficient. In other words, they make citizen A worse off in the process of making citizen B better off. And they don’t provide economic equilibrium – a balance between demand and supply. Because too much demand and little supply will lead to high prices sold to ones who can pay, and too much supply with little demand means producers/wholesalers/retailers will have to charge higher to retain their profits.
Which Tax Is Better – Flat or Progressive?
Usually consumer surplus increases disproportionately with income. For instance, the rich will pay much more than the poor for a particular service. Also see how auctions are held, wherein the highest bidder wins. A flat marginal tax will fail to capture the entire consumer surplus of the rich, thus leading to below par provision of public goods/services. In other words, both the rich and the poor must get equal discomfort from taxes.
The liberal requirement of a social minimum (basically universal insurance via taxes) adds progression to the tax system. Moreover, progressive taxation is essential to offset indirect taxes like consumption and excise duties which hit the poor the hardest. For these two reasons, even the greatest advocate of flat taxation, FA Hayek, insisted on the need for progressive taxation. But another important fact is that PD is optimal only when the government provides the same goods/services to everyone. For extra products delivered, the government must impose further increments. And this is how the rich people use the government more, like the police and justice systems, than the poor, and also get higher quality services.
The Rich Never Pay a Flat Tax
Yes, that’s true. It’s not the rich who pay the highest taxes, but the salaried upper middle class who do. The rich people simply goad politicians to provide tax shelters. And the rich people never pay a flat tax, nor the worse tax of them all – inflation tax – as they own shares/real estate, immune to inflation.
An improvement would be to bring in an overall low flat tax. But other hurdles exist for the government to impose progressive taxes. First, the government can never determine the best progression in the tax system to capture the entire consumer surplus. Second, the unfair part of it is when some people pay the highest marginal rate during the years they get higher incomes (cine/sports stars), while others who receive the same total income distributed evenly over the years pay lesser. Another problem is, if the highest marginal rate is too high, the rich will simply evade taxes and smuggle out their capital. And this is where Hayek’s rule of thumb comes into play: Where income taxes are the primary source of taxation, the highest marginal rates must be just above the proportion of taxes to GDP, with two brackets equal to and below this proportion. In other words, the middle class should pay taxes equal to the proportion of overall taxes to GDP, the rich slightly higher than this. Those below poverty line shouldn’t pay taxes. Instead, they should receive negative income tax as part of the social insurance scheme, which we will discuss later.
What Amount of Taxation is Right?
The total amount of taxes should neither be too low nor too high. They should be just enough to effectively deliver the government goods/services needed. When governments restrict themselves to their proper role, they provide us with crucially needed services. A society with more honest people will need less taxes, while those with less honest people need more. India’s socialist governments in the past have not just imposed lesser taxes, but also wasted them on worthless activities. And this is why India’s systems – be they law & order, justice, defense or infrastructure – are all broken. The present government has gone to the other extreme imposing crippling taxes and also wasting them even more.
As we’ve seen before, the upper middle class pays the highest taxes. The rich and those getting richer pay lesser and lesser taxes, while the poor pay heavy taxes, who shouldn’t be paying taxes. In other words, regressive taxation is the norm across the world. But in the long run, even the rich will eventually suffer the consequences of regressive taxation. For instance, they might have palatial buildings, but need to hire private armed guards to protect them when the broken police system fails. Not to mention traveling through broken roads and costs due to unclean air/water.
Other Tax Principles
1. Taxation only with representation.
2. Principle of subsidiary: taxes for relevant government services.
3. No inheritance taxes. Let assets transfer from one generation to the next.
4. The government must only own land for courts, defense establishments, roads, infrastructure, police stations, parliaments and assemblies. The government should sell other lands and use the revenue earned to keep taxes low.
5. No deficit funding except in rare circumstances like war. Inflation is a regressive form of tax.
6. Cost recovery principle: For instance, to process a permit/license/document, the government should recover the cost from the concerned individual or industry.
7. Only citizens pay taxes, so taxes on goods must be avoided, except Pigovian taxes, to internalize negative externalities. However, market-based instruments must be deployed wherever possible to counter negative externalities.
From this post, we derive the following principles:
1. Citizens must pay taxes, not non-living entities like corporations.
2. Unless not able to pay, taxes must be made mandatory.
3. Taxes should be based on the annual average of the lifetime worth of an individual.
4. Price-discrimination with modest progression is necessary, with marginal rates nearly equal to the total share of taxes in GDP.
5. Taxes must be just enough to effectively deliver necessary services. Not too high, not too low.