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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 1/2 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 entrepreneur-ship, 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.