Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Wise Taxation

Written by johnleemk on 4:05:37 pm Jun 7, 2008.

There is a fallacy which pervades common thinking about tax policy — that we should allocate revenue and expenditure based on who or what has the most, rather than on the basis of what economic activity we want to encourage or discourage. This might sound a bit too abstract to understand, but it seems to underlie a lot of mistaken policies which harm the economy by inefficiently allocating resources. This abstract fallacy may be more understandable if we look at it in terms of two concrete examples: income and investment taxes, and carbon fuel pricing.

Fundamentally, we want people to spend their money in ways which will benefit society; we want them to create jobs, fund research in technologies which will improve our lives, save people from starvation, etc. The list goes on and on. The more money poured into these things, and the less poured into keeping up with the Joneses by buying a new luxury sedan or, at the greater end of the spectrum, buying a new luxury yacht, the better.

In spite of this, most governments tax people for earning and saving by taxing their incomes and investment dividends. When you invest or save, you are indirectly helping someone get a job; when you consume unnecessarily, you might create more jobs in the luxury automobile industry, but your overall contribution to society and its poorer strata is all but indisputably less than the person who invests in Microsoft or buys government bonds. Yet, many governments either refrain from taxing consumption while taxing salaries and investment, or they go ahead and tax both!

The principle behind this seems to be: "Who earns the most gets taxed the most." You might think this is fair. But rich people can do good and bad things with money. The more money you have, the more power you have to do good and evil. Why should we tax people for having this sort of power, when society has rewarded them by enriching them for their contributions? If I invent a cure for cancer, if I make something people want and buy, why should I be punished? Shouldn't I be punished only if I go ahead and blow it on drugs and prostitutes? If I choose to spend my money on investing in other people who want to do good, why should I have to take the same fall as that other guy? Indeed, if anything, I am punished more than him; drugs and prostitutes are generally not taxed since they are part of the black market, and while he might not have to pay consumption taxes on other components of his lifestyle, I will wind up paying taxes on my investments!

The logical solution, which many economists tout, is to tax people for consuming, and thereby reward those who save and invest. A consumption tax punishes those who use their money primarily for their own immediate self-gratification, and indirectly gives people an incentive to invest or save, either in private enterprises or in charitable ventures. Society wins, because we have given the rich an incentive to do good with their money, rather than simply disincentivising the act of earning money.

(To digress a little, the main obstacle to a consumption tax is usually practical; because poor people often do not earn enough to save and invest, a consumption tax would hit them the most, proportionally. Some governments resort to a consumption tax like the Value Added Tax, levied at the point of sale, but exempt goods the poor are likelier to consume such as food. One innovative proposal I recently heard of, though, is for the tax returns to simply be replaced with two questions: How much did you earn last year? How much did you save? Pay tax on the difference. Since this is a direct tax, it can be made as progressive as we like — that is to say, we can exempt the poor from the tax, while still nabbing the rich at high tax rates for their conspicuous consumption.)

Another good example of this same misguided thinking is often found when the discussion turns to carbon-based fuels; with oil prices at all-time highs, everyone has an idea for reducing the pain the common man suffers. There are two common proposals I hear: one is to subsidise fuel, especially in petroleum-exporting countries; the other is to levy massive "windfall profit taxes" on oil firms and channel this into public spending. Both proposals are flawed because they look at who has the most, and assume that entity deserves to pay; it pays little consideration to activities we want to encourage and discourage.

The notion of a subsidy on fuel is so ridiculous I am not even sure where to begin; in the first place, it helps middle and upper class consumers more than anything else. The rural poor often do not need fuel subsidies; the urban poor often take public transportation, and certainly cannot afford gas guzzlers. A subsidy on fuel amounts to nothing than a subsidy for consumption by the rich; in many countries around the world, we have reached the point where the rich simply do not need that additional SUV or to otherwise waste fuel, and subsidising this activity is the height of ludicrousness. Consider too the fact that carbon-based fuels contribute significantly to pollution — not just greenhouse gases, but even things like causing acid rain and spreading cancer-causing particulates. Why on earth would we ever want to subsidise an activity we should be discouraging?

The response typically is that we ought to do this because the poor will suffer if we do not subsidise fuel — anything that has to be transported will see price increases, and those few who can afford small cars will have to pay more. But it is honestly hard to conceive of a more inefficient policy if we really want to aid the poor — ultimately we are primarily subsidising the rich, with any benefits to the poor being an ancillary side-effect. What we ought to do is to let the price float, or even tax the sale of fuel to discourage pollution and unnecessary travel, and then rebate the revenues to consumers. Let the poor decide how they want to spend a subsidy; the rural poor now can enjoy that same subsidy without having to buy petrol, and the urban poor can decide whether the cost of keeping a car is really worth it. The impact of inflation will fall as well. The best part? Because we can allocate the rebate entirely to the poor and target their needs, we can take all that money we used to throw down the gas tanks of luxury gas guzzlers and give it to the poor; they will benefit even more than if we had maintained or implemented the subsidy regime.

How windfall profit taxes will affect the economy is harder to say, primarily because there are not many concrete proposals in this regard; there's a lot of bluster and rhetoric about it, but I have not seen a real proposal with specifics about how we would implement such a tax. In any event, it's clear what economic activity this tax would discourage: the mining and refining of a crucial good people want and need. Oil firms would avoid making too much profit by downsizing their operations, reducing the supply of oil and thereby driving the price even higher. Redistributionist tax policies can work, but not when they are as crude and blatant as this; a windfall profit tax would simply make carbon-based fuels even more expensive. It might punish the producers for their extravagant profits, but it does nothing to actually help the people who do need carbon-based fuels to get by.

If we want a redistributionist tax regime, here's my proposal: tax the sale of carbon-based fuels. This will primarily impact the rich and middle classes. Take the revenues and rebate them to the poor in the form of a negative income tax. And as for the "extravagant profits" of oil barons, a tax on consumption will appropriately punish people who decide to spend their money on gold-plated bathrooms, while rewarding those who decide to invest their money. If the oil barons take their profits and plow them into finding new sources of energy, more power to them, I say.

It is easy to come up with a tax policy that "makes sense". If you think about it long enough, however, the flaws become readily apparent. The effect of a tax is simple: to discourage a particular activity. If the government absolutely needs revenue, then kneejerk tax regimes may suffice for the short run. In the long run, however, a tax policy that makes sense must encourage activities which benefit the economy, and discourage activities which harm it. A tax policy with this goal in mind will be more effective than a policy which simply taxes whoever has the most.

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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

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