Misconceptions about taxes By Scott Sumner

In various comment sections, and also in the media, I am seeing lots of misconceptions about taxes. For instance, lots of people wonder why I focus so much on efficiency, and not on “who pays what”.

I recall once chatting with my wife about our flexible benefits plan, which causes her lots of aggravation. She was surprised to hear me say I wish they would abolish it, as in her view we “benefit” from the program. Let me use an analogy to explain exactly how we “benefit” from this tax break.

Imagine a government that took 10% of each person’s income, and put in in a wooden box. The box was placed at the end of a 10-mile gravel road. Each citizen was given a knife, and told then could crawl on their hands and knees down the road, and then use the knife to cut a hole in the box, and retrieve their money.

Now let’s view these two policies in isolation. There is the 10% tax on income, and the “knife, gravel road and box program.” Considered in isolation, we clearly benefit from the knife, gravel road and box program, as we are free to either try to get our money back, or not. That’s more options than if the program didn’t exist. I’m sufficiently lacking in self-respect to actually crawl down the road, knife in hand, to get back 10% of my income. Thus it seems like I’d be worse off if they eliminated the knife, gravel road, and box program. That’s the sense in which my wife thought we benefited from the flexible benefits tax break.

But that’s not how I see things. I see the original 10% tax on income and the subsequent tax breaks as being linked. The gravel road just seems like a big deadweight loss to me. This is how they do things in Venezuela, not Sweden.

I can certainly understand how others might see things differently. Some want to crawl down the gravel road, fearing that if they abolish the program the government will not reduce their tax rates, instead the money in the box will be diverted to welfare for the poor, or higher salaries for teachers. I can’t deny that this might occur, but if we don’t even TRY to build a good country, how can we possibly succeed? Isn’t it better to try and fail, rather than not even try?

BTW, it’s not at all clear to me that we wouldn’t get some of it back in the form of lower taxes, if they closed loopholes. Note how the GOP is doing the current tax bill—a specific deficit target in mind, and trade-offs between tax rates and number of loopholes.

Another group wonders why I oppose taxes on capital income, or (what amounts to the same thing) estate taxes. Assume the estate tax is 40%. Also assume a 10% sales tax (or VAT.) How do those two taxes impact decisions on buying an expensive yacht?

Under this tax regime, the rich face the following choice:

1. Consumption now is taxed at 10%

2. Consumption later (by heirs, after death) is taxed at 50% (40% + 10%)

That distorts people’s choices, encouraging more consumption today, and less future consumption, i.e. less saving and investment.

Some people wrongly assume that I oppose the estate tax because I’m somehow sympathetic to wealthy people. Not so. I have no problem with a 50% tax on all big yachts. I’m a utilitarian. My problem is with taxes that tax future consumption at higher rates than current consumption. That’s just dumb. There is no excuse for this sort of tax.

Now it just so happens that we once had a big tax on yachts, and other luxury goods. But then something really strange happened—the luxury tax was abolished. And one reason it was abolished is that even Democratic politicians became opposed to the tax. Yes, even Democrats don’t want to tax really rich people who splurge on high living; they want to tax thrifty rich people who put their money back into investment projects that help the economy to grow.

And then it gets even weirder. The reason given for opposing the tax on yachts was that it hurt the shipbuilding industry. Just think about the implications of that argument. When a rich person pays a tax, the money comes out of either consumption, investment, or charity. Economists look at tax burdens in terms of consumption. If the tax doesn’t reduce your consumption, then you are not paying the tax, someone else is. So the only taxes that truly fall on the rich are taxes that reduce their consumption. Nothing else touches them. You can tax Larry Ellison, but you can’t tax Warren Buffett–he’ll consume the same (modest) amount no matter how high you raise his taxes.

Larry’s yacht:

So when we finally got a tax that truly hit the rich—a tax on yachts—it was repealed because it was felt that it would “cost jobs”. But the only reason economic inequality matters is because it leads to consumption inequality. If you are not reducing the consumption of the rich, then you are not reducing economic inequality. And any tax that reduces the consumption of the rich will cost jobs in industries that make things for rich people. If we are so terrified about costing jobs in the maid and butler industry, the spa industry, the luxury car industry, the yacht industry, the mansion building industry, etc., then there is literally no way that we can ever touch the rich.

So come back to me when the progressives have a sensible proposal to make the tax system more progressive. I’d be glad to support it. Until then I’ll oppose estate taxes and more generally all taxes on investment income.

PS. Tax avoidance is a problem for all taxes (income, estate, and consumption)—there are ways to minimize the problem without creating a hugely inefficient income tax regime.

PPS. After my previous post a commenter pointed out that the Senate bill seems to abolish the marriage penalty. I believe it just makes the penalty smaller, but nonetheless I should have pointed that out.