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Advancing Austrian Economics, Liberty, and Peace

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Chapter 4—Binary Intervention: Taxation (continued)

     (4) The Capital Gains Problem

     Much discussion has raged over the question: Are capital gains income? It seems evident that they are; indeed, capital gain is one of the leading forms of income. In fact, capital gain is the same as profit. Those who desire uniformity of income-pattern taxation would therefore have to include capital gains if all forms of monetary profit are to be brought into the category of taxable income.[25] Using as an example the Star Corporation described above, let us consider Time1 to be the period just after the corporation has earned $100,000 net income and just before it decides where to allocate this income. In short, it is at a decision point in time. It has earned a profit of $100,000.[26] At Time1, its capital value has therefore increased by $100,000. The stockholders have, in the aggregate, earned a capital gain of $100,000, but this is the same as their aggregate profit. Now the Star Corporation keeps $60,000 and distributes $40,000 in dividends, and for the sake of simplicity we shall assume that the stockholders consume this amount. What is the situation at Time2, after this allocation has taken place? In comparison with the situation prevailing originally, say at Time0, we find that the capital value of the Star Corporation has increased by $60,000. This is unquestionably part of the income of the stockholders; yet, if uniform income taxation is desired, there is no need to levy a tax on it, for it was already included in the $100,000 income of the stockholders subject to tax.

     The stock market always tends toward an accurate reflection of the capital value of a firm; one might think, therefore, that the quoted value of the firm’s shares would increase, in the aggregate, by $60,000. In the dynamic world, however, the stock market reflects anticipations of future profit, and therefore its values will diverge from the relatively ex post accounting of the firm’s balance sheet. Furthermore, entrepreneurship, in addition to profits and losses, will be reflected in the valuations of the stock market as well as in business enterprises directly. A firm may be making slim profits now, but a farseeing entrepreneur will purchase stock from more shortsighted ones. A rise in price will net him a capital gain, and this is a reflection of his entrepreneurial wisdom in directing capital. Since it would be impossible administratively to identify the profits of the firm, it would be better from the point of view of uniform income taxation not to tax the business income of corporate stockholders at all, but to tax a stockholder’s capital gains instead. Whatever gains the owners reap will be reflected in capital gains on their stock anyway, so that taxation of the business income itself becomes unnecessary. On the other hand, taxation of business income while exempting capital gains would exclude from “income” the entrepreneurial gains reaped on the stock market.  In the case of partnerships and single enterprises that are not owned in shares of stock, the business income of the owners would, of course, be taxed directly. Taxation of both business income (i.e., profits accruing to stockholders) and capital gains on stock would impose a double tax on efficient entrepreneurs. A genuinely uniform income tax, then, would not tax a stockholder’s pro rata business income at all, but rather the capital gain from his shares of stock.

     If business profits (or capital gains) are income subject to tax, then, of course, business losses or capital losses are a negative income, deductible from other income earned by any particular individual.

     What of the problem of land and housing? Here, the same situation obtains. Landlords earn income annually, and this may be included in their net income as business profits. However, real estate, while not given to stock ownership, also has a flourishing capital market. Land is capitalized, and capital values increase or dwindle on the capital market. It is clear that, once again, the government has an alternative if it desires to impose uniform personal income taxes: either it can impose the tax on net profits from real estate, or it can forgo this and impose a tax on increases in the capital values of real estate. If it does the former, it will omit the entrepreneurial gains and losses made on the capital market, the regulator and anticipator of investment and demand; if it does both, it imposes a double tax on this form of business. The best solution (once again within the context of a uniform income tax) is to impose a tax on the capital gain minus the capital loss on the land values.

     It must be emphasized that a capital gains tax is truly an income tax only when it is levied on accrued, rather than on realized, capital gains or losses. In other words, if a man’s capital assets have increased during a certain period, from 300 ounces of gold to 400 ounces, his income is 100 ounces, whether or not he has sold the asset to “take” the profit. In any period, his earnings consist not simply in what he may use for spending. The situation is analogous to that of a corporation’s undistributed profits, which as we have seen, must be included in each stockholder’s accumulation of income. Taxing realized gains and losses introduces great distortions into the economy; it then becomes highly advantageous to investors never to sell their stock, but to hand it down to future generations. Any sale would require the old owner to pay the capital gains levy accumulated for an entire period. The effect is to “freeze” an investment in the hands of one person, and particularly of one family, for generations. The result is rigidity in the economy and failure of the hampered market to meet flexibly the continual changes in data that always take place. As time goes on, the distortive effects of the economic rigidity grow worse and worse.

     Another serious hampering of the capital market results from the fact that, once the capital gain is “taken” or realized, the income tax on this particular gain is actually far higher and not uniform. For the capital gains accrue over a long stretch of time, and not simply at the point of sale. But the income tax is based only on each year’s realized income. In other words, a man who realizes his gain in a certain year must pay a far bigger tax in that year than would be “justified” by a tax on his actually acquired income during the year. Suppose, for example, that a man buys a capital asset at 50 and its market value increases by 10 each year, until he finally sells it for 90 in four years’ time. For three years, his income of 10 goes untaxed, while in the fourth year he is taxed on an income of 40 when his income was only 10. The final tax, therefore, largely becomes one on accumulated capital rather than on income.[27] The incentive for keeping investment rigid, therefore, becomes even greater.[28]

     There are, of course, grave difficulties in any such tax on accrued capital gains, but, as we shall see, there are many insuperable obstacles to any attempt to impose uniform income taxes. Estimates of market value would pose the greatest problem. Appraisals are always simply conjectures, and there would be no way of knowing that the assessed value was the correct one.

     Another insuperable difficulty arises from changes in the purchasing power of the monetary unit. If the purchasing power has fallen in half, then a change in capital value of an asset from 50 to 100 does not represent a real capital gain; it simply reflects the maintenance of real capital as nominal values double. Clearly, a constant nominal value of capital when other prices and values double would reflect a high capital loss—a halving of real capital value. To reflect gains or losses in income, then, a person’s capital gain or loss would have to be corrected for changes in the purchasing power of money. Thus, a fall in purchasing power tends to result in the overstatement of business income and hence leads to a consumption of capital. But if a man’s capital gains or losses must be corrected for changes in the purchasing power of money in order to state his true income for a certain period, what standards can be used for such a correction? For changes in purchasing power cannot be measured. Any “index” used would be purely arbitrary. Whichever method is adopted, therefore, uniformity in income taxation cannot be achieved, because an accurate measurement of income cannot be attained.[29]

     Thus, to the controversial question, “Are capital gains income?” the answer is emphatically yes, provided that (1) a correction is made for changes in the purchasing power of the monetary unit, and (2) the accrued rather than the realized capital gain is considered. In fact, whenever businesses are owned by stockholders (and bondholders), the gains on these stocks and bonds will provide a fuller guide to income earned than the actual net income of the firm. If it is desired to tax incomes uniformly, then taxes would have to be levied on the former only; to tax both would be to level a “double” tax on the same income.

     Professor Groves, while agreeing that capital gains are income, lists several reasons for giving capital gains preferential treatment.[30] Almost all of them apply, however, to taxation on realized, rather than on accrued, capital gains. The only relevant case is the familiar one that “capital gains and losses are not regularly recurrent, as are most other incomes.” But no income is “regularly recurrent.” Profits and losses, of course, are volatile, being based on speculative entrepreneurship and adjustments to changing conditions. Yet no one contends that profits are not income. All other income is flexible as well. No one has a guaranteed income on the free market. Everyone’s resources are subject to change as conditions and the data of the market change. That the division between income and capital gains is illusory is demonstrated by the confusion over the classification of authors’ incomes. Is the income in one year resulting from five years’ writing of a book “income” or an increase in the “capital worth” of the author? It should be evident that this entire distinction is valueless.[31]

     Capital gains are profits. And the real value of aggregate capital gains in society will equal total aggregate profits. A profit increases the capital worth of the owner, whereas a loss decreases it. Moreover, there are no other sources from which real capital gains can come. What of the savings of individuals? Individual savings, to the extent that they do not add to cash balances, go into investments. These purchases of capital lead to capital gains for stockholders. Aggregate savings lead to aggregate capital gains. But it is also true that profits can exist in the aggregate only when there is aggregate net saving in the economy. Thus, aggregate pure profits, aggregate capital gains, and aggregate net savings all go hand in hand in the economy. Net dissavings lead to aggregate pure losses and aggregate capital losses.

     To sum up, if it is desired to tax uniformly (this goal will be analyzed critically below), the correct procedure would be to consider capital gains as equivalent to income when corrected for changes in the purchasing power of the monetary unit, and to consider capital losses as negative income. Some critics charge that it would be discriminatory to correct capital for changes in prices without doing the same for income, but this objection misses the point. If the desire is to tax income rather than accumulated capital, it is necessary to correct for changes in the purchasing power of money. For example, capital rather than pure income is being taxed during an inflation.

     (5) Is a Tax on Consumption Possible?

     We have seen that attempts to tax consumption via sales and excise taxes are vain and that they inexorably result in a tax on incomes. Irving Fisher has suggested an ingenious plan for a  consumption tax—a direct tax on the individual akin to the income tax, requiring annual returns, etc. The base for the individual’s tax, however, would be his income, minus net additions to his capital or cash balance, plus net subtractions from that capital for the period—i.e., his consumption spending. The individual’s consumption spending would then be taxed in the same way as his income is now.[32] We have seen the fallacy in the Fisher argument that only a tax on consumption would be a true income tax and that the ordinary income tax constitutes a double tax on savings. This argument places greater weight on savings than the market does, since the market knows all about the fructifying power of saving and allocates its expenditures accordingly. The problem we have to face here is this: Would such a tax as Fisher proposes actually have the intended effect—would it tax consumption only?

     Let us consider a Mr. Jones, with a yearly income of 100 gold ounces. During the year, he spends 90 percent, or 90 ounces, on consumption and saves 10 percent, or 10 ounces. If the government imposes a 20-percent income tax upon him, he must pay 20 ounces at the end of the year. Assuming that his time-preference schedule remains the same (and setting aside the fact that there will be an increased proportion spent on consumption because an individual with fewer money assets has a higher time-preference rate), the ratio of his consumption to investment will still be 90:10. Jones will now spend 72 ounces on consumption and eight on investment.

     Now, suppose that instead of an income tax, the government levies a 20-percent annual tax on consumption. Fisher maintained that such a tax would be levied only on consumption. But this is incorrect, since savings-investment is based solely on the possibility of future consumption. Since future consumption will also be taxed, in equilibrium, at the same rate as present consumption, it is evident that saving does not receive any special encouragement.[33] Even if it were desirable for the government to encourage saving at the expense of consumption, taxing consumption would not do so. Since future and present consumption will be taxed equally, there will be no shift in favor of savings. In fact, there will be a shift in favor of consumption to the extent that a diminished amount of money causes an increase in the rate of preference for present goods. Setting aside this shift, his loss of funds will cause him to reallocate and reduce his savings as well as his consumption. Any payment of funds to the government necessarily reduces the net income remaining to him, and, since his time preference remains the same, he reduces his savings and his consumption proportionately.

     It will help to see how this works arithmetically. We may use the following simple equation to sum up Jones’ position:


     With Gross Income equal to 100, and solving for these three equations, we get this result: Net Income = 85, Tax = 15, Consumption = 76.

     We may now sum up in the following tabulation what happened to Jones under an income tax and under a consumption tax:

           

We thus see this important truth: A consumption tax is always shifted so as to become an income tax, though at a lower rate. In fact, the 20-percent consumption tax becomes equivalent to a 15-percent income tax. This is a very important argument against the plan. Fisher’s attempt to tax consumption alone must fail; the tax is shifted by the individual until it becomes an income tax, albeit at a lower rate than the equivalent income tax.

     Thus, the rather startling conclusion is reached in our analysis that there can be no tax on consumption alone; all consumption taxes resolve themselves in one way or another into taxes on incomes. Of course, as is true of the direct consumption tax, the effect of the rate is discounted. And here perhaps lies a clue to the relative predilection that free-market economists have shown toward consumption taxes. Their charm, in the final analysis, consists in the discounting—in the fact that the same rate in a consumption tax has the effect of a lower rate of income tax. The tax burden on society and the market is lower.[34] This reduction of the tax burden may be a very commendable objective, but it should be stated as such, and it should be realized that the problem lies not so much in the type of tax levied as in the over-all burden of taxes on individuals in the society.

     We must now modify our conclusions by admitting the case of dishoarding or dissaving, which we had ruled out of the discussion. To the extent that dishoarding occurs, consumption is tapped rather than income, for the dissaver consumes out of previously accumulated wealth, and not out of current income. The Fisher tax would thus tap spending out of accumulated wealth, which would remain untaxed by ordinary income taxation.

4. The Incidence and Effects of Taxation

Part II:
Taxes on Accumulated Capital

     In a sense, all taxes are taxes on capital. In order to pay a tax, a man must save the money. This is a universal rule. If the saving took place in advance, then the tax reduces the capital invested in the society. If the saving did not take place in advance, then we may say that the tax reduced potential saving. Potential saving is hardly the same as accumulated capital, however, and we may therefore consider a tax on current income as separate from a tax on capital. Even if the individual were forced to save to pay the tax, the saving is current just as the income is current, and therefore we may make the distinction between taxes on current saving and current incomes, and taxes on accumulated capital from past periods. In fact, since there can be no consumption taxes, except where there is dissaving, almost all taxes resolve themselves into income taxes or taxes on accumulated capital. We have already analyzed the effect of an income tax. We come now to taxes on accumulated capital.

     Here we encounter a genuine case of “double taxation.” When current savings are taxed, the charge of double taxation is a dubious one, since people are allocating their newly produced current income. Accumulated capital, on the contrary, is our heritage from the past; it is the accumulation of tools and equipment and resources from which our present and future standard of living derive. To tax this capital is to reduce the stock of capital, especially to discourage replacements as well as new accumulations, and to impoverish society in the future. It may well happen that time preferences on the market will dictate voluntary capital consumption. In that case, people will deliberately choose to impoverish themselves in the future so as to live better in the present. But when the government compels such a result, the distortion of market choices is particularly severe. For the standard of living of everyone in the society will be absolutely lowered, and this includes perhaps some of the tax consumers—the government officials and the other recipients of tax privilege. Instead of living off present productive income, the government and its favorites are now dipping into the accumulated capital of society, thereby killing the goose that lays the golden egg.

     Taxation of capital, therefore, differs considerably from income taxation; here the type matters as well as the level. A 20-percent tax on accumulated capital will have a far more devastating, distorting, and impoverishing effect than a 20-percent tax on income.

A. Taxation on Gratuitous Transfers: Bequests and Gifts

     The receipt of gifts has often been considered simple income. It should be obvious, however, that the recipient produced nothing in exchange for the money received; in fact, it is not an income from current production at all, but a transfer of ownership of accumulated capital. Any tax on the receipt of gifts, then, is a tax on capital. This is particularly true of inheritances, where the aggregation of capital is shifted to an heir, and the gift clearly does not come from current income. An inheritance tax, therefore, is a pure tax on capital. Its impact is particularly devastating because (a) large sums will be involved, since at some point within a few generations every piece of property must pass to heirs, and (b) the prospect of an inheritance tax destroys the incentive and the power to save and build up a family competence. The inheritance tax is perhaps the most devastating example of a pure tax on capital.

     A tax on gifts and bequests has the further effect of penalizing charity and the preservation of family ties. It is ironic that some of those most ardent in advocating taxation of gifts and bequests are the first to assert that there would never be “enough” charity were the free market left to its own devices.

B. Property Taxation

     A property tax is a tax levied on the value of property and hence on accumulated capital. There are many problems peculiar to property taxation. In the first place, the tax depends on an assessment of the value of property, and the rate of tax is applied to this assessed value. But since an actual sale of property has usually not taken place, there is no way for assessments to be made accurately. Since all assessments are arbitrary, the road is open for favoritism, collusion, and bribery in making them.

     Another weakness of current property taxation is that it taxes doubly both “real” and “intangible” property. The property tax adds “real” and “intangible” property assessments together; thus, the bondholders’ equity in property is added to the amount of the debtors’ liability. Property under debt is therefore doubly taxed as against other property. If A and B each own a piece of property worth $10,000, but C also holds a bond worth $6,000 on B’s property, the latter is assessed at a total of $16,000 and taxed accordingly.[35] Thus, the use of the credit system is penalized, and the rate of interest paid to creditors must be raised to allow for the extra penalty.

     One peculiarity of the property tax is that it attaches to the property itself rather than to the person who owns it. As a result, the tax is shifted on the market in a special way known as tax capitalization. Suppose, for example, that the social time-preference rate, or pure rate of interest, is 5 percent. Five percent is earned on all investments in equilibrium, and the rate tends to 5 percent as equilibrium is reached. Suppose a property tax is levied on one particular property or set of properties, e.g., on a house worth $10,000. Before this tax was imposed, the owner earned $500 annually on the property. An annual tax of 1 percent is now levied, forcing the owner to pay $100 per year to the government. What will happen now? As it stands, the owner will earn $400 per year on his investment. The net return on the investment will now be 4 percent. Clearly, no one will continue to invest at 4 percent in this property when he can earn 5 percent elsewhere. What will happen? The owner will not be able to shift his tax forward by raising the rental value of the property. The property’s earnings are determined by its discounted marginal value productivity, and the tax on the property does not increase its merits or earning power. In fact, the reverse occurs: the tax lowers the capital value of the property to enable owners to earn a 5-percent return. The market drive toward uniformity of interest return pushes the capital value of the property down to enable a return on investment. The capital value of the property will fall to $8,333, so that future returns will be 5 percent.[36]

     In the long run, this process of reducing capital value is imputed backward, falling mainly on the owners of ground land. Suppose a property tax is levied on a capital good or a set of capital goods. Income to a capital good is resolvable into wages, interest, profit, and rental to ground land. A lower capital value of capital goods would shift resources elsewhere; workers, confronted with lower wages in producing this particular good, would shift to a better-paying job; capitalists would invest in a more remunerative field; and so forth. As a result, workers and entrepreneurs would largely be able to slough off the burden of the property tax, the former suffering to the extent that their original DMVP was higher here than in the next-highest-paying occupations. Consumers would, of course, suffer from a coerced misallocation of resources. The man bearing the major burden, then, is the owner of ground land; therefore, the process of tax capitalization applies most fully to a property tax upon ground land. The incidence falls on the owner of the “original” ground land, i.e., the owner at the time the tax is first imposed. For not only does the landlord pay the annual tax (a tax he cannot shift) so long as he is the owner, but he also suffers a loss in capital value. If Mr. Smith is the owner of the above property, not only does he pay $83 per year in taxes, but the capital value of his property also falls from $10,000 to $8,333. Smith openly absorbs the loss when he sells the property.

     What, however, of the succeeding owners? They buy the property at $8,333 and earn a steady 5-percent interest, although they continue to pay $83 a year to the government. The expectation of the tax payment attached to the property, therefore, has been capitalized by the market and taken into account in arriving at its capital value. As a result, the future owners are able to shift the entire incidence of the property tax to the original owner; they do not really “pay” the tax in the sense that they bear its burden.

     Tax capitalization is an instance of a process by which the market adjusts to burdens placed upon it. Those whom the government wanted to pay the burden can avoid doing so because of the market’s resilience in adjusting to new impositions. The original owners of ground land, however, are especially burdened by a property tax.

     Some writers argue that, where tax capitalization has taken place, it would be unjust for the government to lower or remove the tax because such an action would grant a “free gift” to the current owners of property, who will receive a counterbalancing increase in its capital value. This is a curious argument. It rests on a fallacious identification of the removal of a burden with a subsidy. The former, however, is a move toward free-market conditions, whereas the latter is a move away from such conditions. Furthermore, the property tax, while not burdening future owners, depresses the capital value of the property below what it would be on the free market, and therefore discourages the employment of resources in this property. Removal of the property tax would reallocate resources to the advantage of the consumers.

     Tax capitalization and its incidence on owners of ground land occur only where the property tax is partial rather than universal—on some pieces of property rather than all. A truly general property tax will reduce the rate of income earned from all investments and thereby reduce the rate of interest instead of the capital value. In that case, the interest return of both the original owner and later owners is reduced equally, and there is no extra burden on the original owner.

     A general, uniform property tax on all property values, then, will, like an income tax, reduce the interest return throughout the economy. This will penalize saving, thereby reducing capital investment below what it would have been and depressing real wage rates further below their free-market level.[37]

     Finally, a property tax necessarily distorts the allocation of resources in production. It penalizes those lines of production in which capital equipment per sales dollar is large and causes resources to shift from these to less “capitalistic” fields. Thus, investment in higher-order productive processes is discouraged, and the standard of living lowered. Individuals will invest less in housing, which bears a relatively heavy property tax burden, and shift instead to less durable consumers’ goods, thus distorting production and injuring consumer satisfaction. In practice, the property tax tends to be uneven from one line and location to another. Of course, geographic differences in property taxation, in impelling resources to escape heavy tax rates,[38] will distort the location of production by driving it from those areas that would maximize consumer satisfaction.

C. A Tax on Individual Wealth

     Although a tax on individual wealth has not been tried in practice, it offers an interesting topic for analysis. Such a tax would be imposed on individuals instead of on their property and would levy a certain percentage of their total net wealth, excluding liabilities. In its directness, it would be similar to the income tax and to Fisher’s proposed consumption tax. A tax of this kind would constitute a pure tax on capital, and would include in its grasp cash balances, which escape property taxation. It would avoid many difficulties of a property tax, such as double taxation of real and tangible property and the inclusion of debts as property. However, it would still face the impossibility of accurately assessing property values.

     A tax on individual wealth could not be capitalized, since the tax would not be attached to a property, where it could be discounted by the market. Like an individual income tax, it could not be shifted, although it would have important effects. Since the tax would be paid out of regular income, it would have the effect of an income tax in reducing private funds and penalizing savings-investment; but it would also have the further effect of taxing accumulated capital.

     How much accumulated capital would be taken by the tax depends on the concrete data and the valuations of the specific individuals. Let us postulate, for example, two individuals: Smith and Robinson. Each has an accumulated wealth of $100,000. Smith, however, also earns $50,000 a year, and Robinson (because of retirement or other reasons) earns only $1,000 a year. Suppose the government levies a 10-percent annual tax on an individual’s wealth. Smith might be able to pay the $10,000 a year out of his regular income, without reducing his accumulated wealth, although it seems clear that, since his tax liability is reduced thereby, he will want to reduce his wealth as much as possible. Robinson, on the other hand, must pay the tax by selling his assets, thereby reducing his accumulated wealth.

     It is clear that the wealth tax levies a heavy penalty on accumulated wealth and that therefore the effect of the tax will be to slash accumulated capital. No quicker route could be found to promote capital consumption and general impoverishment than to penalize the accumulation of capital. Only our heritage of accumulated capital differentiates our civilization and living standards from those of primitive man, and a tax on wealth would speedily work to eliminate this difference. The fact that a wealth tax could not be capitalized means that the market could not, as in the case of the property tax, reduce and cushion its effect after the impact of the initial blow.

5. The Incidence and Effects of Taxation

Part III:
The Progressive Tax

     Of all the patterns of tax distribution, the progressive tax has generated the most controversy. In the case of the progressive tax, the conservative economists who oppose it have taken the offensive, for even its advocates must grudgingly admit that the progressive tax lowers incentives and productivity. Hence, the most ardent champions of the progressive tax on “equity” grounds admit that the degree and intensity of progression must be limited by considerations of productivity. The major criticisms that have been leveled against progressive taxation are: (a) it reduces the savings of the community; (b) it reduces the incentive to work and earn; and (c) it constitutes “robbery of the rich by the poor.”

     To evaluate these criticisms, let us turn to an analysis of the effects of the progression principle. The progressive tax imposes a higher rate of taxation on a man earning more. In other words, it acts as a penalty on service to the consumer, on merit in the market. Incomes in the market are determined by service to the consumer in producing and allocating factors of production and vary directly according to the extent of such services. To impose penalties on the very people who have served the consumers most is to injure not only them, but the consumers as well. A progressive tax is therefore bound to cripple incentives, impair mobility of occupation, and greatly hamper the flexibility of the market in serving the consumers. It will consequently lower the general standard of living. The ultimate of progression—coercively equalized incomes—will, as we have seen, cause a reversion to barbarism. There is also no question that progressive income taxation will reduce incentives to save, because people will not earn the return on investment consonant with their time preferences; their earnings will be taxed away. Since people will earn far less than their time preferences would warrant, their savings will be depressed far below what they would be on the free market.

     Thus, conservatives’ charges that the progressive tax reduces incentives to work and save are correct and, in fact, are usually understated, because there is not sufficient realization that these effects stem a priori from the very nature of progression itself. It should not be forgotten, however, that proportional taxation will induce many of the same effects as, in fact, will any tax that goes beyond equality or the cost principle. For proportional taxation also penalizes the able and the saver. It is true that proportional taxation will not have many of the crippling effects of progression, such as the progressive hampering of effort from one income bracket to another. But proportional taxation also imposes heavier burdens as the income brackets rise, and these also hamper earning and saving.

     A second argument against the progressive income tax, and one which is perhaps the most widely used, is that, by taxing the incomes of the wealthy, it reduces savings in particular, thus injuring society as a whole. This argument is predicated on the usually plausible assumption that the rich save more proportionately than the poor. Yet, as we have indicated above, this is an extremely weak argument, particularly for partisans of the free market. It is legitimate to criticize a measure for forcing deviations from free-market allocations to arbitrary ones; but it can hardly be legitimate simply to criticize a measure for reducing savings per se. For why does consumption possess less merit than saving? Allocation between them on the market is simply a matter of time preference. This means that any coerced deviation from the market ratio of saving to consumption imposes a loss in utility, and this is true whichever direction the deviation takes. A government measure that might induce more saving and less consumption is then no less subject to criticism than one that would lead to more consumption and less saving. To say differently is to criticize free-market choices and implicitly to advocate governmental measures to force more savings upon the public. If they were consistent, therefore, these conservative economists would have to advocate taxation of the poor to subsidize the rich, for in that case savings would presumably increase and consumption diminish.

     The third objection is a political-ethical one—that “the poor rob the rich.” The implication is that the poor man who pays 1 percent of his income in taxes is “robbing” the rich man who pays 80 percent. Without judging the merits or demerits of robbery, we may say that this is invalid. Both citizens are being robbed—by the State. That one is robbed in greater proportion does not eliminate the fact that both are being injured. It may be objected that the poor receive a net subsidy out of the tax proceeds because the government spends money to serve the poor. Yet this is not a valid argument. For the actual act of robbery is committed by the State, and not by the poor. Secondly, the State may spend its money, as we shall see below, on many different projects. It may consume products; it may subsidize some or all of the rich; it may subsidize some or all of the poor. The fact of progressive income taxation does not itself imply that “the poor” en masse will be subsidized. If some of the poor are subsidized, others may not be, and these latter will still be net taxpayers rather than tax-consumers and will be “robbed” along with the rich. The extent of this deprivation will be less for a poor taxpayer than for a rich one; and yet, since usually there are far more poor than rich, the poor en masse may very well bear the greatest burden of the tax “robbery.” In contrast, the State bureaucracy, as we have seen, actually pays no taxes at all.[39]

     This misconception of the incidence of “robbery,” and the defective argument on savings, among other reasons, have led most conservative economists and writers to overemphasize greatly the importance of the progressiveness of taxation. Actually, the level of taxation is far more important than its progressiveness in determining the distance that a society has traveled from a free market. An example will clarify the relative importance of the two. Let us contrast two people and see how they fare under two different tax systems. Smith makes $1,000 a year, and Jones makes $20,000 a year. In Society A taxation is proportionate for all at 50 percent. In Society B taxation is very steeply progressive: rates are ½ percent for $1,000 income, 20 percent for $20,000 income. The following tabulation shows how much money each will pay in taxes in the different societies:

      Now, we may ask both the rich and the poor taxpayers: Under which system of taxation are you better off? Both the rich man and the poor man will unhesitatingly pick Society B, where the rate structure is far more progressive, but where the level of taxation for every man is lower. Some may object that the total amount of tax levied is far greater in Society A. But this is precisely the point! The point is that what the rich man objects to is not the progressiveness of the rates, but the high level of the rates imposed upon him, and he will prefer progressiveness when rates are lower. This demonstrates that it is not the poor who “rob” the rich through the progressive principle of taxation; it is the State that “robs” both through all taxation. And it indicates that what the conservative economists are actually objecting to, whether they fully realize it or not, is not progression, but high levels of taxation, and that their real objection to progression is that it opens the sluice gates for high levels of taxation of the rich. Yet this prospect will not always be realized. For it is certainly possible and has often occurred that a rate structure is very progressive and yet lower all around, on the high brackets and on the low, than a less progressive structure. As a practical matter, however, progressiveness is necessary for high tax rates, because the multitude of lower-income citizens might revolt against very steep tax rates if they were imposed on all equally. On the other hand, many people may accept a high tax burden if they are secure in the knowledge or belief that the rich pay a still higher rate.[40]

     We have seen that coerced egalitarianism will cause a reversion to barbarism and that steps in that direction will result in dislocations of the market and a lowering of living standards. Many economists—notably the members of the “Chicago School”—believe that they champion the “free market,” and yet they do not consider taxation as connected with the market or as an intervention in the market process. These writers strongly believe that, on the market, every individual should earn the profits and marginal value productivity that the consumers wish to pay, in order to achieve a satisfactory allocation of productive factors. Nevertheless, they see no inconsistency in then advocating drastic taxation and subsidies. They believe that these can alter the “distribution” of incomes without lowering the efficiency of productive allocations. In this way they rely on an equivalent of Keynesian “money illusion”—a tax illusion, a belief that individuals will arrange their activities according to their gross rather than net (after-tax) income. This is a palpable error. There is no reason why people should not be tax-conscious and allocate their resources and energies accordingly. Altering relative rewards by taxation will disrupt all the allocations of the market—the movement of labor, the alertness of entrepreneurship, etc. The market is a vast nexus, with all strands interconnected, and it must be analyzed as such. The prevailing fashion in economics of chopping up the market into isolated compartments—“the firm,” a few “macroscopic” holistic aggregates, market exchanges, taxation, etc.—distorts the discussion of each one of these compartments and fails to present a true picture of the interrelations of the market.



[25]It must not be inferred that the present author is an advocate of uniform taxation. Uniformity, in fact, will be sharply criticized below as an ideal impossible of attainment. (An ethical goal absolutely impossible of attain ment is an absurd goal; to this extent we may engage, not in ethical exhortation, but in praxeological criticism of the possibility of realizing certain ethical goals.) However, it is analytically more convenient to treat various types of income taxation in relation to uniform treatment of all income.

[26] For the sake of convenience, we are assuming that this income is pure profit, and that interest income has already been disposed of. Only pure profit increases capital value, for in the evenly rotating economy there will be no net savings, and the interest income will just pay for maintaining the capital income structure intact.

[27]For a discussion of taxation on accumulated capital, see below.

[28]See Due, Government Finance, p. 146.

[29]Another problem in levying a tax on accrued capital gains is that the income is not realized in money directly. Uniform taxation of income in kind, as well as of psychic income, faces insuperable problems, as will be seen below. Just as there may be taxes on the imputed monetary equivalents of income in kind, however, there may also be taxes on accrued capital gains.

[30]Harold M. Groves, Financing Government (New York: Henry Holt, 1939), p. 181.

[31]Irregular income poses the same problem as irregular realized capital gain. The difficulty can be met in both cases by the suggested solution of averaging income over several years and paying taxes annually on the average.

[32]Fisher and Fisher, Constructive Income Taxation, passim.

[33]Neither does hoarding receive any special encouragement, since hoarding must finally eventuate in consumption. It is true that keeping cash balances itself yields a benefit, but the basis for such balances is always the prospect of future consumption.

[34]In the same way, the charm of the sales tax lies in the fact that it cannot be progressive, thus reducing the burden of income taxation on the upper groups.

[35]See Groves, Financing Government, p. 64.

[36] The final capital value is not $8,000, since the property tax is levied at 1 percent of the final value. The tax does not remain at 1 percent of the original capital value of $10,000. The capital value will fall to $8,333. Property tax payment will be $83, net annual return will be $417, and an annual rate of return of 5 percent on the capital of $8,333.

The algebraic formula for arriving at this result is as follows: If C is the capital value to be determined, i is the rate of interest, and R the annual rent from the property, then, when no tax enters into the picture:

iC = R

When a property tax is levied, then the net return is the rent minus the annual tax liability, T, or:

iC = RT

In this property tax, we postulate a fixed rate on the value of the property, so that:

iC = RtC,

     where t equals the tax rate on the value of the property.

Transposing,

C = R / i + t; the new capital value equals the annual rent divided by the interest rate plus the tax rate. Consequently, the capital value is driven down below its original sum, the higher are (a) the interest rate and (b) the tax rate.

[37]On tax-capitalization, see Seligman, Shifting and Incidence of Taxation, pp. 181–85, 261–64. See also Due, Government Financing, pp. 382–86.

[38]This distortion of location would result from all other forms of taxes as well. Thus, a higher income-tax rate in region A than in region B would induce workers to shift from A to B, in order to equalize net wage rates after taxes. The location of production is distorted as compared with the free market.

[39]On the extent to which the lower-income classes actually pay taxes in present-day America, see Gabriel Kolko, Wealth and Power in America (New York: Frederick A. Praeger, 1962), chap. 2.

[40]Cf., Bertrand de Jouvenel, The Ethics of Redistribution (Cambridge: Cambridge University Press, 1952).

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