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B. Attempts at Neutral Taxation
So far, we have discussed the impact of a tax on an individual considered by himself. Equally important is the distortion of the market's pattern of factor prices and incomes, created by the way taxes bear down upon different people. The free market determines an intricate, almost infinite array and structure of prices, rates, and incomes. The imposition of different taxes disrupts these patterns and cripples the market's work of allocating resources and output. Thus, if firm A pays $5,000 a year for a certain type of labor, and firm B pays $3,000, laborers will tend to shift from B to A and thereby more efficiently serve the wants of consumers. But if the income earned at firm A is taxed $2,000 per annum, while income at B is taxed negligibly or not at all, the market inducement to move from B to A will totally or virtually disappear, perpetuating a misallocation of productive resources and hampering the growth and even the existence of firm A.
We have seen above that the quest for a neutral tax—a tax neutral to the market, leaving the market roughly as it was before the tax was imposed—is a hopeless venture. For there can be no uniformity in paying taxes when some people in society are necessarily taxpayers, while others are privileged tax-consumers. But even if we disregard these objections and fail to consider the redistributionist effects of government spending out of tax revenues, we cannot arrive at a system of neutral taxation.39 Many writers have maintained that uniformly proportional income taxes for all would yield a neutral tax; for then, the relative ratios of incomes in society would remain the same as before. Thus, if A received $6,000 a year, B earned $3,000, and C $2,000, a 10-percent tax on each man would yield a “distribution” of: A, $5,400; B, $2,700; C, $1,800—the same mutual ratios as before. (This assumes, of course, no disincentive effects of the tax on the various individuals or, rather, equiproportional disincentive effects on each individual in the society—a most unlikely occurrence.) But the trouble is that this “solution” misconceives the nature of what a neutral tax would have to be. For a tax truly neutral to the free market would not be one that left income patterns the same as before; it would be a tax which would affect the income pattern, and all other aspects of the economy, in the same way as if the tax were really a free-market price.
This is a very important correction; for we must surely realize that when a service is sold at a certain price on the free market, this sale emphatically does not leave income “distribution” the same as before. For, normally, market prices are not proportional to each man's income or wealth, but are uniform in the sense of equal to everyone, regardless of his income or wealth or even his eagerness for the product. A loaf of bread does not cost a multimillionaire a thousand times as much as it costs the average man. If, indeed, the market really behaved in this way, there would soon be no market, for there would be no advantage whatever in earning money. The more money one earned, the more, pari passu, the price of every good would be raised to him. Therefore, the entire civilized money economy and the system of production and division of labor based upon it would break down. Far from being “neutral” to the free market, then, a proportional income tax follows a principle which, if consistently applied, would eradicate the market economy and the entire monetary economy itself.
It is clear, then, that equal taxation of everyone—the so-called “head tax” or “poll tax”—would be a far closer approach to the goal of neutrality. But even here, there are serious flaws in its neutrality, entirely apart from the ineluctable taxpayer–tax-consumer dichotomy. For one thing, goods and services on the free market are purchased only by those freely willing to obtain them at the market price. Since a tax is a compulsory levy rather than a free purchase, it can never be assumed that each and every member of society would, in a free market, pay this equal sum to the government. In fact, the very compulsory nature of taxation implies that far less revenue would be paid in to the government were it conducted in a voluntary manner. Rather than being neutral, therefore, the equal tax would distort market results by imposing undue levies on at least three groups of citizens: the poor, the uninterested, and the hostile, i.e., those who, for one reason or another, would not have voluntarily paid these equal sums to the government.
Another grave problem in treating the equal tax as akin to a free-market price is that we do not know what “services” of government the people are supposed to be “purchasing.” For example, if the government uses the tax to subsidize a certain favored group, it is difficult to know what sort of “service” the payers of the head tax are reaping from this act of government. But let us take a seemingly clear-cut case of pure service, police protection, and let us assume that the head tax is being paid for this expenditure. The free-market rule is that equal prices are paid for equal services; but what, here, is an “equal service”? Surely, the service of police protection is of far greater magnitude in an urban crime center than it is in some sleepy backwater, where crime is rare. Police protection will certainly cost more in the crime-ridden area; hence, if it were supplied on the market, the price paid there would be higher than in the backwater. Furthermore, a person under particular threat of crime, and who might require greater surveillance, would have to pay a higher police fee. A uniform tax would be below market price in the dangerous areas and above it in the peaceful areas. To approach neutrality, then, a tax would have to vary in accordance with the costs of services and not be uniform.40 This is the neglected cost principle of taxation.
The cost principle, however, is hardly neutral either. Apart from the inexorable taxpayer–tax-consumer problem, there is, again, the problem of how a “service” is to be defined and isolated. What is the “service” of redistribution from Peter to Paul, and what is the “cost” for which Peter is to be assessed? And even if we confine the discussion to such common services as police protection, there are grave flaws. In the first place, the costs of government, as we shall see further below, are bound to be much higher than those of the free market. Secondly, the State cannot calculate well and therefore cannot gauge its costs accurately. Thirdly, costs are equal to prices only in equilibrium; since the economy is never in equilibrium, costs are never a precise estimate of what the free-market price would have been. And finally, as in the equal tax, and in contrast to the free market, the taxpayer never demonstrates his benefit from the governmental act; it is simply and blithely assumed that he would have purchased the service voluntarily at this price.
Still another attempt at neutral taxation is the benefit principle, which states that a tax should be levied equal to the benefit which the individuals receive from the government service. It is not always realized what this principle would mean: e.g., that recipients of welfare benefits would have to pay the full costs of these benefits. Each recipient of government welfare would then have to pay more than he received, for he would also have to pay the “handling” costs of government bureaucracy. Obviously, there would be no such welfare or any other subsidy payments if the benefit principle were maintained. Even if we again confine the discussion to services like police protection, grave flaws still remain. Let us again disregard the persistent taxpayer–tax-consumer dichotomy. A fatal problem is that we cannot measure benefits or even know whether they exist. As in the head tax and cost principles, there is here no free market where people can demonstrate that they are receiving a benefit from the exchange greater than the value of the goods they surrender. In fact, since taxes are levied by coercion, it is clear that people's benefits from government are considerably less than the amount that they are required to pay, since, if left free, they would contribute less to government. The “benefit,” then, is simply assumed arbitrarily by government officials.
Furthermore, even if the benefit were freely demonstrable, the benefit principle would not approach the process of the free market. For, once again, individuals pay a uniform price for services on the free market, regardless of the extent of their subjective benefits. The man who would “walk a mile for a Camel” pays no more, ordinarily, than the man who couldn't care less. To tax everyone in accordance with the benefit he receives, then, is diametrically opposed to the market principle. Finally, if everyone's benefit is taxed away, there would be no reason for him to make the exchange or to receive the government service. On the market, not all people, not even the marginal buyers, pay the full amount of their benefit. The supramarginal buyers obtain unmeasurable surplus benefit, and so do the marginal buyers, for without such a surplus they would not buy the product. Moreover, for such services as police protection, the benefit principle would require the poor and the infirm to pay more than the rich and the able, since the former may be said to benefit more from protection. Finally, it should be noted that if each person's benefit from government is to be taxed away, the bureaucrats, who receive all their income from the government, would have to return their whole salary to the government and so serve without pay.41
We have thus seen that no principle of taxation can be neutral with respect to the free market. Progressive taxation, where each man pays more than proportionately to his income, of course makes no attempt at neutrality. If the proportional tax embodies a principle destructive to the entire market economy and the monetary economy itself, then the progressive tax does so still more. For the progressive tax penalizes the able and efficient in even greater proportion than their relative ability and efficiency. Progressive rates are a particular disincentive against especially able work or entrepreneurship. And since such ability is engaged in serving the consumer, a progressive tax levies a particular burden on the consumers as well.
In addition to the two ways discussed above by which income taxation penalizes saving, the progressive tax imposes an added penalty. For empirically, in most cases, the wealthy save and invest proportionately more of their incomes than the lower-income groups. There is, however, no apodictic, praxeological reason why this must always be so. The rule would not hold, for example, in a country where the wealthy bought jewelry while the poor thriftily saved and invested.
While the progressive principle is certainly highly destructive of the market, most conservative, pro-free-market economists tend to overweigh its effects and to underweigh the destructive effects of proportional taxation. Proportional income taxation has many of the same consequences, and therefore the level of income taxation is generally more important for the market than the degree of progressivity. Thus, society A may have a proportional income tax requiring every man to pay 50 percent of his income; society B may have a very steeply progressive tax requiring a poor man to pay 1/4 percent and the richest man 10 percent of his income. The rich man will certainly prefer society B, even though the tax is progressive—demonstrating that it is not so much the progressivity as the height of his tax that burdens the rich man.
Incidentally, the poor producer, with a lower tax upon him, will also prefer society B. This demonstrates the fallacy in the common conservative complaint against progressive taxation that it is a means “for the poor to rob the rich.” For both the poor man and the rich man have, in our example, chosen progression! The reason is that the “poor” do not “rob the rich” under progressive taxation. Instead, it is the State that “robs” both through taxation, whether proportional or progressive.
It may be objected that the poor benefit from the State's expenditures and subsidies from the tax proceeds and thus do their “robbing” indirectly. But this overlooks the fact that the State can spend its money in many different ways: it may consume the products of specific industries; it may subsidize some or all of the rich; it may subsidize some or all of the poor. The fact of progressivity does not in itself imply that the “poor” are being subsidized en masse. Indeed, if some of the poor are being subsidized, others will probably not be, and so these latter net taxpayers will be “robbed” along with the rich. In fact, since there are usually far more poor than rich, the poor en masse may very well bear the greatest burden of even a progressive tax system.
Of all the possible types of taxes, the one most calculated to cripple and destroy the workings of the market is the excess profits tax. For of all productive incomes, profits are a relatively small sum with enormous significance and impact; they are the motor, the driving force, of the entire market economy. Profit-and-loss signals are the prompters of the entrepreneurs and capitalists who direct and ever redirect the productive resources of society in the best possible ways and combinations to satisfy the changing desires of consumers under changing conditions. With the drive for profit crippled, profit and loss no longer serve as an effective incentive, or, therefore, as the means for economic calculation in the market economy.
It is curious that in wartime, precisely when it would seem most urgent to preserve an efficient productive system, the cry invariably goes up for “taking the profits out of war.” This zeal never seems to apply so harshly to the clearly war-borne “profits” of steel workers in higher wages—only to the profits of entrepreneurs. There is certainly no better way of crippling a war effort. In addition, the “excess” concept requires some sort of norm above which the profit can be taxed. This norm may either be a certain rate of profit, which involves the numerous difficulties of measuring profit and capital investment in every firm; or it may refer to profits at a base period before the war started. The latter, the general favorite because it specifically taps war profits, makes the economy even more chaotic. For it means that while the government strains for more war production, the excess profits tax creates every incentive toward lower and inefficient war production. In short, the EPT tends to freeze the process of production as of the peacetime base period. And the longer the war lasts, the more obsolete, the more inefficient and absurd, the base-period structure becomes.
- 39. This is true if we also disregard the grave conceptual difficulties of arriving at a definition of “income,” in accounting for the imputed monetary value of work done within a household, of averaging fluctuating incomes over various years, etc.
- 40. We are not here conceding that “costs” determine “prices.” The general array of final prices determines the general array of cost prices, but then the viability of firms is determined by whether the price that people will pay for their particular products will be enough to cover the costs, which are determined throughout the market.
- 41. Ever since Adam Smith, economists have tried, fallaciously, to use the benefit principle to justify proportional, and even progressive, taxation, on the ground that people benefit “from society” in proportion, or even more than in proportion, to their incomes. But it is clear that the rich benefit less from such services as police protection, since they could more afford to pay for their own than the poor. And the rich derive no benefit from welfare expenditures. Therefore, the rich derive fewer benefits, absolutely, from government than the poor, and the benefit principle cannot be used to justify proportional or progressive taxation.
But, it might be objected, can't we say that everyone derives proportional benefits to his income from “society,” though not from government? In the first place, this cannot be established. In fact, the opposite argument would be more accurate: for since both A and B participate in society and its benefits, any differential income between A and B must be due to their own particular worths rather than to society. Certainly equal benefits from society cannot be used to imply a proportional tax. And, furthermore, even if the argument were true, by what legerdemain can we say that “society” is equivalent to the State ? If A, B, C, producers on the market, benefit from each other's existence as “society,” how can G, the government, use this fact to establish its claim to their wealth?