Economic Perspectives on Ethical Taxation

[1] Ethical concerns about taxation typically cluster around two distinct questions. The first concerns the right of the government to tax individuals in the first place, while the second considers the ethical desirability of alternative tax schemes. Obviously, the first question needs to be settled, and in a particular manner, before proceeding on to the second. If no ethical case can be made for the government’s claim on tax revenues, then no tax scheme can ever rise to the ethical standard. But if we can establish the state’s right to tax its citizens, then presumably we can go on to consider those characteristics of tax systems that reflect adherence to ethical norms.

[2] Economics can offer several contributions to this deliberation. First, economists and the “worldly philosophers” that are their progenitors have a rich and evolving literature on the origin, the nature, the extent, and the limit of the property right. The economist’s perspective can prove informative to others grappling with the first-order concern of whether a government may ever ethically appropriate the property of its own citizens. Second, as taxation imposes costs on individuals across society, economics can provide information to those interested in considering whether the distribution of these costs comports to the ethical norm. This paper begins by describing those conditions under which government appropriation of heretofore-private property can be justified under the norms of the discipline. It then proceeds to consider the forms of the appropriation itself, with the goal of describing tax characteristics that are themselves more likely to meet an ethical standard. II. The Moral Basis of Taxation: Contributions from Economics

[3] To some, ethical taxation is an oxymoron. Robert Nozick equates the taxation of income with forced labor, arguing that “taking the earnings of n hours of labor is like taking n hours from the person; it is like forcing the person to work n hours for another’s purpose.”1 Nozick, a neo-Lockean, develops a concept of the property right as the inescapable result of self-ownership. If we own our own selves, then we have ownership of those goods acquired or received as remuneration (from Nature or from an employer) for the employment of our self-owned labor. A fish swimming in a river belongs to no one, but having landed it through my own efforts it belongs to me, even as my wages are as much mine as were the hours of my time I offered my employer in order to earn them.

[4] Viewed from this perspective, taxation is simply state-sponsored robbery, a tyranny of the elite who occupy the seats of power. In a society that grants individuals the right to call on the state to protect their property from uninvited seizure at the hands of fellow citizens, condoning state seizure of that same property accomplished in the name of taxation seems somewhat incongruous. Starting with the premise of self-ownership, the moral legitimacy of giving the state more rights than the individuals that comprise it is shaky at best. While taxation provides little ethical challenge to those inclined to take a collectivist view of society, or an organic view of government, it is challenging to construct an ethical argument for coerced taxation of self-owning individuals. A right to one’s property seems linked to one’s right of self-ownership. To limit the property right to allow for taxation seems to limit the rights of self-ownership; the two are tied together.

[5] With certain notable and important exceptions (Marx comes immediately to mind), economists have been happy to leave the debate over the moral legitimacy of the asserted property right to philosophers. Instead, to the vast majority of economists, the property right possesses an instrumental, and not an essential value. It is nearly axiomatic to economists that when property rights are clearly defined and secure, rational individuals will so steward their property as to put it to its highest valued use, an end-state known as efficiency. Efficiency is the one near-universal norm of traditional neoclassical economics. To the extent that western economics has any moral commitments at all, it is to this single standard.

[6] Since its appearance at the very beginning of the 20th century in the works of Vilfredo Pareto and others of the Lausanne School, efficiency has captivated economists as an end-state achievable by decentralized actions that nonetheless represents the best of all possible worlds for free, self-owned individuals and the society they inhabit.2 Efficiency as an end-state is characterized by goods and services allocated across society in such a way that no person may be made better off without someone else being made worse off. It is also the state of the world that we would obtain if individuals who possessed well articulated and secure property rights to a set of goods were free to trade these goods among themselves. Clearly, as no person would engage in a trade that made him or her worse off, voluntary exchange would continue only until all gains from voluntary trade were exhausted, that is, until no one could be made better off without making someone else worse off. The efficient state represents the best we can do without coercion.

[7] Efficiency is appealing as much for the process by which it is theoretically achieved as for its end-state. While the “New Welfare Economics” of the 1930s and beyond went on to describe how the government might be able to mimic an efficient end-state by forced reallocations, the blueprint for the end-state is created by positing the allocations that would result if individuals were free to exchange property to which they held secure rights.3 Thus, efficiency is an end-state cast in a mold etched by individual freedom and self-ownership. These etchings lend efficiency whatever moral legitimacy it may claim. The instrumental appeal of property rights to economists is that they facilitate the achievement of the efficient, and morally justifiable, outcome.

[8] But property rights cannot always be secure or well defined. Anne’s right to earn a living as a hog farmer is constrained by Bruce’s right to enjoy an odor-free evening on his own back porch. The returns Cathy stands to receive from her contributions to public radio are diminished by others’ incentives to free-ride. In the presence of these distortions, which are the results of the existence of externalities and public goods, respectively, the process of voluntary exchanges of goods and services among free people will not result in efficient outcomes. In the presence of these distortions, free exchange will result in an allocation from which it is theoretically possible to improve the welfare of at least one individual without making the others worse off. The blueprint furnished by the efficiency standard remains, but the edifice cannot be constructed by the process of voluntary exchange among free people.

[9] The economics discipline’s reaction to this problem is revealing. While the moral justification for efficiency derives from its being the outcome of the exercise of the moral goods of freedom and self-ownership, most economists would willingly sacrifice both freedom and self-ownership to obtain a result that mimics the efficient end-state. Efficiency as an end justifies, it appears, the means necessary to achieve it, even if the means require abolishing the very roots that gave efficiency its bona fides. Economists from the “New Institutionalists Schools,” who argue for privatization as a cure for the inefficiencies created by externalities, suggest that the government settle disputes arising from the presence of externalities – such as those emanating from hog farms – by creating a new property right and awarding it to the party which stands to put it to its highest valued use.4 While a Lockean approach to disputes between neighbors arising from externalities might consider claims of first occupancy, or the right to reasonable enjoyment of one’s property, existing property rights under this approach have no such standing. Neighbors wishing for a reduction in odors may not sue for nuisance, nor call on the government to enforce any relief. Instead, neighbors may offer to pay the hog farmer to reduce the odors; they may purchase a property right to defend their property right. The neighbors’ property rights are diminished in the pursuit of efficiency. Absent that payment, it’s the hog farmer’s right to do as he or she pleases.

[10] Although the New Institutionalists have little to say about how to resolve impediments to efficiency resulting from the existence of public goods, for the purposes of this paper, it is only important to note before proceeding that the “private property” solution offered by some economists to the externality problem allows for the state to rearrange property rights if the new arrangement serves the goal of promoting efficiency. As such, it displays an arguably consequentialist ethic. If the existing distribution of property rights (which convey, presumably, not simply the right to own but also the right to enjoy one’s property) should be altered in order to promote the goal of efficiency, then property rights are simply means to an end, and the government’s seizure of those rights, whether in the form of coerced tax contributions or redistributed rights to the enjoyment of one’s property, is not in itself an ethical concern.

[11] Other economists follow a more openly consequentialist approach to property. While still embracing efficiency as the moral standard, the utilitarian economists championing the New Welfare Economics argue for the redistribution of property among society’s members with the goal of maximizing social welfare.5 Rather than remain constrained by the limited opportunities presented by voluntary exchange, the utilitarians allow for redistribution of property across society constrained only by the proviso that those who gain as a result of this action gain more than the losers lose. This condition moves the process towards an efficient end-state, as those gaining from the redistribution could theoretically more than compensate those who lose by this redistribution. The moral justification offered for this sort of redistribution has a hypothetical foundation: If this theoretical exchange could actually take place, the exchange would occur voluntarily, as both parties would be made better off. Thus, the end-state envisioned by the economic utilitarians, efficiency, is derived from the same blueprint employed by all the others.

[12] In all cases examined, economics has created a norm, efficiency, out of what was simply the predicted consequence of a scenario in which the actors possessed the ethically defensible goods of freedom and self-ownership. But in making the consequence the norm, economics is frequently forced to sacrifice these morally relevant goods in order to achieve the consequence.

[13] Among economists, then, efficiency provides the end that justifies taxation as its means. Economists can justify taxes in the service of efficiency. While economists often applaud property rights, they do so only insofar as the existence of property rights facilitates the achievement of efficient allocations of goods across society. Property rights can be jettisoned in order to achieve efficiency. Taxation can be morally justified if it promotes efficiency, and if efficiency is itself morally justified. III. Efficiency Promoting Taxation Systems

[14] Since efficiency as an end-state provides the economic justification for the government’s seizure of otherwise private property and its redistribution to others who lack an articulated rights-based claim, it is not surprising to see that efficiency is the standard which economists use when evaluating tax systems. The efficiency of a system designed to redistribute property among the members of society has at least two component parts. First, there is what economists refer to as the efficiency of the tax itself. An efficient tax collects a given amount of revenues at the lowest cost to society, as measured in terms of the resources sacrificed as a result of the tax’s imposition. Here we aren’t talking about resources devoted to the tax-collection bureaucracy, but rather the reduction in social output caused by taking resources away from productive and valuable uses as a result of the higher prices or lower remuneration offered by the tax. The second efficiency consideration concerns the disposition of the transferred property itself, what the government should spend it on and how it should spend it, that is, whether the transfer should take the form of direct cash, vouchers, or provision of the goods and services themselves. Obviously, no matter how efficiently the tax is collected, if it is squandered on wasteful programs, efficiency is not served. However, an evaluation of government expenditure programs is well beyond the scope of this paper. Suffice it to say that when citizens object to taxation, it is difficult to separate those who object to the seizure of private property from those who object to the uses to which this property is ultimately directed.

[15] Economists view taxation as an intra-societal transfer of property from one unit of society to another unit of the same society. From this perspective, taxes are costless as no resources – land, labor, or capital – are consumed by the tax, they are simply transferred. Depending on how the tax is collected, and on what it might be levied, taxes do generate certain losses to the economy as their existence distorts the price and cost signals transmitted by the market.6 A tax on labor income, for example, lowers the payment a worker actually receives and therefore reduces the worker’s incentive to provide labor to the marketplace. Insofar as the work effort is reduced as a result of the tax, society loses a valued service.7 Economists refer to these tax-induced losses alternately as the dead-weight loss or the excess burden of taxation, and as their names imply, these losses are not viewed favorably by at least those in the profession with naming rights.

[16] The problem facing the economist who favors redistribution but abhors inefficiency is that the deadweight losses associated with taxation decrease with the taxpayer’s inability to avoid the tax. That is, since the excess burden of a tax is equal to the value of the goods not provided or not consumed as a result of the potential taxpayer’s attempts to avoid paying the tax, the deadweight loss is minimized if the tax is levied on those goods which the individual is likely to go on acquiring or demanding even if they are subject to a tax. This means that while a tax on yachts is likely to generate a large excess burden (as would-be sailors decide to become pilots instead), a tax on insulin will generate a very small excess burden, as the diabetic’s consumption of insulin is unlikely to change as a result of the tax. Similarly, while progressive taxes potentially generate a large excess burden as higher income employees shift to other forms of compensation, a regressive “head tax” that simply charges every citizen the same fee, regardless of income, will generate no deadweight loss. Citizens will hardly remove their valuable heads in order to avoid the head tax.

[17] As deadweight losses increase with the ability of the potential taxpayer to avoid the tax, it follows that deadweight losses increase when the tax is levied on goods and activities pursued by those, like the rich among us, who are able to avail themselves of a greater potential array of goods and activities. The unfortunate consequence is that, in attempting to minimize deadweight losses, we are likely to pursue tax policies that place proportionately greater burdens on those in our society with fewer available choices. While cost-minimization is certainly a fine goal, it certainly lacks a compelling moral argument. The lack of an ethical argument for cost minimization as a criterion for ranking alternative tax schemes, coupled with the likely distributional consequences of pursuing the low-cost tax strategy, argue against placing too strong an emphasis on deadweight losses as guides to tax policy.

[18] Unfortunately for some, this argument does not seem to have swayed some state governments. Many states rely heavily on sales taxes for their revenues, extending the tax base to include even groceries. As groceries are necessities, a grocery tax generates little excess burden. An examination of tax payments by income group for these states reveals that in states that rely on sales taxes as their primary source of revenue, the poor bear a significantly greater share of the tax burden, as a percentage of their income, than do the wealthier citizens of these states.8 While one might argue that the rich have every bit as much right to their property as do the poor, and that a flat rate tax therefore qualifies as “fair,” it is hard to construct an ethical argument in support of forcing the poor to give a greater share of their income to the state.

[19] Among non-economists, arguments in favor of reducing the tax burden of high-income taxpayers are commonly based on the largely unfounded assumption that leaving more income with these “prime movers” will stimulate the economy more than any redistribution effort or government program can. Proponents of decreasing the tax burden of the rich argue that high marginal income tax rates on high-income workers serve to decrease their incentive to work and save, thus depriving the economy of an important source of growth. Rawlsian arguments are made to justify the resulting disparities in wealth, as tax relief for the rich benefits the least well off who find employment in the growing economy. Interesting and plausible as the argument might be in theory, there exists no irrefutable evidence that this phenomenon occurs in reality. Taxes on income reduce the work incentive insofar as they reward work less, and therefore make leisure more attractive. On the other hand, taxes on income may increase the work effort as people work harder to achieve their income goals. Whether the net effect of a tax across a group of workers reflects the substitution of leisure for income, or the increased effort of workers seeking a particular income target, is an empirical, and not a theoretical question. At present, the empirical record indicates that the two effects offset each other for high-income, primary earners.9 The labor supply response to a change in the marginal tax rates is zero. Similar attempts to link increases in the marginal tax rate to reductions in the taxable income received by high income workers have proven equally fruitless.10 The result of all this effort is that attempts to justify favorable tax treatment of the wealthy by claiming that this is simply a means of either stimulating economic activity or enhancing tax revenues have failed to find empirical validity. While there may be an equity argument for awarding the rich a greater share of the recent tax cuts – they pay a greater share of the total tax – the economic argument for these tax cuts is hardly compelling. IV. Conclusions and Extensions

[20] Efficiency proves to be a problematic norm for the evaluation of government taxation programs. While claiming an ethical basis as the end-state that would result if self-owning individuals freely traded property among themselves – property whose right of ownership is established by the self-ownership of the individual possessing the property right – the realization of this end-state in a world where externalities and public goods exists requires that the property itself be confiscated by coercive means and the freedom of self-owning individuals constrained. Given the extremely tenuous claims of efficiency as a moral norm, it is difficult to build a case for employing it as a guiding principle, even among utilitarian economists who are less swayed by individualistic claims to a property right. The utilitarian reliance on benefit-cost criteria to evaluate government programs is simply another way of directing an economy to the efficiency norm embraced by many economists. The questionable merits of this activity directly relate to the questionable merits of the norm itself. If we do not accept efficiency as an ethical norm, economics cannot help make the case for the existence of a right to tax.

[21] Efficiency also proves problematic as a norm for evaluating alternative taxation schemes, due to the regressive distributional consequences associated with its pursuit. Efforts to minimize the social costs of a tax so as to promote efficiency require a greater reliance on taxing those goods with few substitutes. This means that the burden of efficient taxes falls disproportionately on the poor and the needy. It is difficult and even distasteful to argue for the moral superiority of such a norm.

[22] Fortunately, government does not exist to promote efficiency; it exists to promote justice. Taxes are just insofar as they promote a just distribution of income, goods, and services across society, and unjust insofar as they contribute to unjust distributions. By imposing efficiency as a norm, economists and their followers evaluate government endeavors on the basis of an extraneous and irrelevant criterion. The most valuable contributions economics can make to the public forum on taxation are those which enhance understanding of the distributional impacts of alternative tax schemes and benefit packages financed through taxation. These endeavors can help direct the government towards its primary goal of promoting justice among its people.

End Notes

1 R. Nozick (1974). Anarchy, State and Utopia. New York: Basic Books, p. 169.

2 V. Pareto (1971). Manual of Political Economy. Trasl. Ann S. Schwier. New York: A.M. Kelley.

3 N. Kaldor (1939) “Welfare Propositions in Economics and Interpersonal Comparisons of Utility”, Economic Journal, Vol. 69, p.549-52; J. Hicks (1939) “The Foundations of Welfare Economics”, Economic Journal, Vol. 69, p.696-712.

4 R.H. Coase (1960). “The Problem of Social Cost,” Journal of Law and Economics 3, pp. 1 – 44; H. Demsetz (1967). “Toward a Theory of Property Rights”, American Economic Review 57, pp. 347-359.

5 Kaldor (1939) and Hicks (1939).

6 J. Stiglitz (2000). Economics of the Public Sector. New York: Norton Publishers, pp. 518-548.

7 A. Okun (1975). Equality and Efficiency: The Big Tradeoff. Washington, D.C.: The Brookings Institution, pp. 96-98.

8 R. McIntyre, R. Denk, N.Francis, M.Gardner, W. Gomaa, F. Hsu, and R. Sims (2003). Who Pays? A Distributional Analysis of the Tax Systems in all 50 States. Washington, D.C.: Institute of Taxation and Economic Policy.

9 J. Slemrod, ed., (2000) Does Atlas Shrug? The Economic Consequences of Taxing the Rich. Cambridge, MA: Harvard University Press; Okun (1975), pp. 96-98.

10 A. Goolshee, R. Hall, and L. Katz, (1999) “Evidence on the High Income Laffer Curve from Six Decades of Tax Reform,” Brookings Papers on Economic Activity, Volume 1999, No. 2, pp. 1-64.