I wrote last time about why the need for taxes is uncontroversial among economists. Virtually all economists agree that there are some goods and services, like public safety, that are more efficiently provided on a collective basis, and that getting people to pay their shares voluntarily is impractical due to the incentive to “free ride.” Compelling everyone to pay a share through taxation, with democratic decisions on what services will be provided and how the burden will be shared, allows the required goods and services to be provided in a manner potentially beneficial to all.
Some readers thought I was arguing that we need higher taxes. But that was in no way my point. I was simply saying that the case for taxes is uncontroversial among economists, even if taxes don’t get a very good rap with the public.
How high should taxes be? That depends on how much of which public goods we value relative to the private goods we also want to consume. It’s not that different from asking how much we want to spend on food versus clothing, except that public goods like national defense, public security, and pharmaceutical and workplace safety are on one side of the scale, and private goods like food, clothing, houses, and electronics products are on the other. Do we want to spend more to bring down the pothole count in our roads, or more on upkeep of the cars we drive over them? If our ideal consumption basket, at prices that cover the relevant costs of production, consists of, say 30% public and 70% private goods, then in the long run and on average we need to capture about 30% of GDP as tax and other revenues to pay for the public goods share of the overall basket, leaving the rest to spend on ordinary goods and savings.
A complication, of course, is that tastes differ. If I prefer more food and you more clothing, we can each make our own decisions with no need to compromise. The same doesn’t apply when people share a budget, such as married couples do—do we prefer having a larger house, or taking more vacations? We may have to compromise. All the more so when a decision on the share of funds spent on public versus private goods is taken by a whole state or country. I might prefer more well-maintained national parks while you prefer more privately maintained golf courses. An effective democratic process should work out a compromise that pleases the voter with the median preference, leaving about half of the population thinking we’re putting too much into public goods provision and the other half thinking that we’re putting too little into such goods. In a country of three hundred million people, having about half thinking government too large and another half thinking it’s too small is thus to be expected, and is indeed a sign that our democracy is working. If having almost no one be perfectly pleased sounds grim, it might provide consolation that the chosen size of government may at least be in the ballpark of many voters’ ideal choices, and that total amounts of disappointment should be both roughly minimized and shared as equally as possible by this process of compromise. If your tastes seem to differ too dramatically from those of your fellow voters, there’s always the option of moving to a different jurisdiction, just as married partners who differ too much on their priorities have the option of parting company.
But now back again to the harder part. Just how much should each person pay as his or her fair share? Since incomes vary widely, it would be impossible to have everyone pay the same absolute amount without driving many on the bottom rungs of the income ladder into penury. So how about equal proportions of income? This is more feasible and on first blush, it has a ring of fairness.
The equal proportions solution indeed serves as a benchmark against which other ways of dividing up the tax burden are routinely judged. A system that makes poor individuals pay a higher proportion of their incomes than the rich is called regressive, one in which rich individuals pay a higher proportion is called progressive, and one in which all pay the same proportion, proportional. Modern industrial societies exhibit some taxes of each kind. Sales taxes are regressive because poorer individuals devote a larger share of their earnings to purchasing taxable items whereas richer ones devote relatively larger shares to saving. Abstracting from loopholes and the additional legal assistance with which to take advantage of them, income taxes tend to be progressive, requiring richer individuals to pay a higher share of their incomes than poorer ones.
A principle commonly invoked in favor of making taxes progressive is that of equalizing the sacrifice: the things a wealthy individual much forego to pay a proportionately higher tax bill seem objectively less critical to their attainment of well-being than those that a poor individual would have to forego at the same proportionate tax rate. In fact, if the value of the last dollar spent tends to fall for all individuals as their total expenditure rises—a standard assumption in economic theory—then the sacrifice from the last dollar of taxation will be equal only when tax progressivity is high enough to make after-tax incomes fully equal. Even in countries with the most progressive tax rates, progressivity stops far short of equalizing after tax incomes. Observed progressive tax rates can be seen as a compromise between the proportionality rule and the notion of equal sacrifice. This compromise reflects a sense that both the proportionality and the equal sacrifice rules have some moral appeal. It also reflects the recognition that eliminating all income differences would have a severely deleterious effect on incentives to work hard, invest in skills, and innovate.
The compromises that we make on the sharing of the tax burden are likely to perfectly satisfying few, just as do the compromises we make about the total size of government or the composition of its spending. Each issue involve a continuum of views within which, if democracy works well, it’s roughly the median preference that will prevail. But the compromise on the bearing of the tax burden tends to be particularly contentious because variation of opinions tends to align to some degree with incomes, and not simply with tastes. From a purely material standpoint, those whose income is below the average of all incomes in society stand to gain from a more progressive tax scheme, while those whose incomes are above the average stand to lose from more tax progressivity. To the extent that publicly funded programs like food stamps, job retraining, and school lunch subsidies disproportionately aid poorer households, progressive taxation will have an added element of redistribution from rich to poor, and some high income individuals are sure to resent this. Finally, if rich and poor turn out with equal numbers at the polls, those with incomes below the average will have the upper hand, because the average income is well above the median one that exactly divides the electorate: around 65 – 70% of voters typically earn less than the average. That’s because the average income is pulled considerably above the median one by the presence of some very high end incomes among a small share of the electorate.
It’s no wonder that there’s much controversy about tax progressivity, but also no wonder that large majorities of Americans these days express agreement that it’s fair to tax the highest 2% of income earners more. Even many top 2%-ers favor higher taxes on the richest, however, although its equally true that some average and even below-average income earners are less than sold on the desirability of progressive taxes. These deviations from strictly economic determination of views on tax progressivity exist because notions of fairness play a part in determining people’s views to some extent independently of their strictly material interests.
The question of optimal progressivity is unlikely to ever be fully resolved. What seems likely, however, is that the pendulum swing against both taxes and tax progressivity in the United States has begun to run its course, and that we’ll be seeing some movement back to the levels common in the 1990s, if not earlier decides, in the years ahead. Tax progressivity exists in every high income democracy because it’s a natural outgrowth of combining political democracy with economic arrangements that cause most to earn well below the arithmetic average income, a natural outgrowth also of the need to compromise between the principle of equalizing pain at the margin and the need to retain incentives for hard work, investment and innovation.