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

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.

-------------------------------------------------------------------

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