The trouble with tax

(featured image credit: Archives of Ontario CC BY)

Taxation affects the economy, because it affects our behaviour. Is that impossible to avoid?

Taxes are generally considered to be an inevitability, as the words of Benjamin Franklin, written in 1789, remind us: “…in this world nothing can be said to be certain, except death and taxes.” Governments need money to fund a wide variety of stuff, and discussions about taxation are mostly not about whether to tax, but about what to tax and how much.

It should be straightforward, really. You decide what thing you’re going to tax, you work out how much of that thing there is, you set a taxation rate, and by simply multiplying these two figures, you know what your revenue is going to be.

Of windows and geese

Say you’re the ruler of a country, and you toy with the idea of taxing windows. Sounds like a clever thing to do: everyone needs windows and they’re hard to hide, so evasion is going to be minimal. It is even a fair tax: bigger houses have more windows, so people who can afford to live in a mansion will pay more than people who live in a small cottage. Count the number of windows in your fiefdom, multiply that by the tax you’re planning to levy on each window, and hey presto, you know what will hit your coffers.

Not quite. People don’t take taxes lying down. 350 years ago, Jean-Baptiste Colbert, Louis XIV’s Minister of Finance already knew this: “The art of taxation consists in so plucking the goose as to procure the largest quantity of feathers with the least possible amount of hissing.”

But it’s not just the hissing that is a problem. Taxes also change behaviour. People may not be entirely rational, some say, but when what they do or what they buy is being taxed (and all taxes are ultimately paid by people), they will, all else being equal, do or buy less of it. Your window tax works as a disincentive. Your subjects will seek to reduce the cost by building houses with fewer windows, or by bricking up existing windows, so your revenue will be less than expected. And your tax will also depress economic activity: bricklayers may have a bit more work, but carpenters will certainly see their business diminish.


It’s a bit dark, but with the tax we save, we can buy lots of candles! (photo: Elliot Brown CC BY)

Window taxes went out of fashion quite a while ago, but the taxes that are commonly raised today likewise weigh on the economy. Let’s look at the biggest chunks: income tax and payroll taxes (such as National Insurance), and VAT (or similar sales taxes). According to Eurostat, together these represent between two thirds and three quarters of the total tax revenue (respectively 46% and 21% in the UK, 60% and 15% in Belgium, and 55% and 18% across the EU).

Payroll taxes make hiring employees more expensive to employers, so they will use less staff. Income tax makes an hour’s work worth less to people who work, so they will work less. Sales tax makes the goods and services households buy more expensive, so they will buy less of it.

If taxation reduces both the demand for and the supply of labour, and the demand for goods and services, there will be less economic activity than would otherwise be the case. This makes taxation – as Colbert observed – troublesome: in a complex economy, finding the optimum is, in practice, an impossible task.

Insensitive to disincentives

Are there any things where the extra cost of tax has little effect on the demand? Maybe the necessities of life, like housing, food, or clothing? We need a roof over our heads, something to eat, and something to wear after all. But of course we can still reduce our consumption of necessities as the cost goes up, as the we’ve seen with taxing windows: a smaller house, eating less expensive stuff and wearing our clothes until they’re no longer fashionable. What about petrol? We’ve been driving ever more frugal cars for decades, and now there is not much left to gain, we get people in yellow vests protesting against high fuel duties. The geese are hissing.

And all the while the economy is running more slowly.

Tobacco and alcohol are perhaps a better idea: some people keep on consuming them, despite rising taxes on them. But aside from the dubious ethics of governments relying on the weaknesses of addicts for their revenue, there is the risk of smuggling. A 2002 report for the World Health Organization estimated the UK’s annual tax revenue lost to smuggling at £2.5 billion (£4.2 billion in today’s money, around €4.5 billion or $5.5 billion). So we can forget that too.

Maybe there is stuff we cannot avoid, that governments could tax? Inheritance tax or estate tax, sometimes called a “death tax”, seems a good candidate. What could people do – refuse to die? They could of course try to dispose of their assets before they die, and so still escape the tax. (It is also a very unpopular tax.)

Less politically controversial is the idea of taxing luck (as long as it is the good fortune of an inheritance). Clearly Bill Gates and Jeff Bezos, the richest two people in the world, have been pretty lucky to amass so much wealth. We may not be able to tax good fortune directly, but how about taxing the assets their luck got them? Seems like a genius idea, were it not for the fact that Gates, Bezos, and most other rich, lucky entrepreneurs didn’t get rich by sitting on their backside all day. Taxing their wealth would not really be taxing their luck, but their labour. Entrepreneurs are no less insensitive to disincentives than the rest of us, so this kind of tax would also harm economic activity.

Is there no way to accumulate wealth by sitting on one’s backside? We already had to dismiss inheriting, but another one is the lottery – can we not tax lottery wins without detriment to the economy? Let’s see. You’ve just become a lottery winner and they call you up: “Congratulations! You’ve won more than eight million! But wait, don’t order that yacht just yet – first we’re going to take away half in tax!” If that was how it worked, many people would lose interest in the lottery, and if raising money was really that easy, governments would already be doing it. (And of course, they are taxing lotteries – only not quite so blatantly. It is not a large proportion of the wins, but a large proportion of the ticket price that goes to the state. Here too, it’s not luck that is being taxed, but the activity of trying to be lucky.)

So is there really nothing that can be taxed without inevitably also suppressing economic activity? Could we get people to pay tax voluntarily, and not surreptitiously through levies on what they do?

Conspicuous taxation

Joshua Gans, an economist at the university of Toronto, has made an intriguing proposal: take a leaf out of commercial companies’ book. Airlines manage to sell first class seats for a large multiple of those at the back of the plane, credit card companies charge eye watering annual fees for an exclusive platinum card. Their customers happily pay good money because it allows them to signal their status quite openly.


Albert and Bill, the licence plate brothers

Governments could award people who have contributed at least a billion in taxes over the last decade with, say, Rhodium (even more precious than Platinum!) status, with commensurate lower tiers for more modest taxpayers. Who knows, just like people taking an extra flight to move up a tier or maintain their status, people would even voluntarily pay more taxes too.

Far-fetched, perhaps, but a tax on signalling already exists. In the UK, the Driver and Vehicle Licensing Agency sells and auctions personalized licence plates for cars. You can buy a plate that vaguely spells your name (AL66ERT sold for £2,000 earlier this month) – just search the site for something that tickles your fancy. Everyone will know that you’ve got the dosh to pay for a private plate, while your money ends up in the government coffers.

A few years ago, the Belgian government introduced an even fancier scheme: much like in the US you can (within limits) specify any combination of letters and digits. You do pay for the privilege, though: it’ll set you back a one-off fee of €1000 (£900, $1150). Unfortunately, even this is not a miracle solution. When the government raised the fee to €2000, the number of applications fell by nearly than 75%. Even here the geese are hissing.

No wonder taxation remains a contentious affair, in which various interest groups argue about what should be taxed and how much. But whatever choices the government of the day makes, somebody somewhere in the economy will be doing less than they otherwise would.


About koenfucius

Wisdom or koenfusion? Maybe the difference is not that big.
This entry was posted in Behavioural economics, Economics, Ethics, Psychology, Society and tagged . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s