Worstall @ the Weekend To break with tradition: this week let's see if we can propose something sensible rather than doing our usual liverish snarling at whatever it is that grips my goat this week. So, let's see if we can work out how we should actually be taxing capital and the returns to it.

This, of course, involves the taxation of corporations as well. Our guide here is Sir James Mirrlees, which is useful as he has the Nobel and he got it largely for his study of taxes and tax systems. He did this review for the Institute for Fiscal Studies and it's all, from a certain point of view, most interesting.

One thing I should note is that Sir James should really be described as being on the political left. He's recently been an advisor to the Scottish National Party (SNP), for example, which is no one's idea of a right-wing outfit.

However, his solutions may strike many as being, well, rather right-wing. Which is an interesting insight as many to most economists are rather lefty, it's just that they then go on to propose solutions that actually achieve the goals they want to reach rather than whatever pays well in the student union talk shops.

I would regard myself as pretty much a lefty, for example: I certainly share the goal of wanting the poor to get richer. Which is why I'm so pro-markets and globalisation. The things that actually seem to work in making the poor richer.

Mirrlees does tackle the basic problem in designing any tax system. Which is that we've got a tension between what is efficient and what is regarded as equitable, or fair. For example, it's a definitional statement that companies and corporations do not pay tax: some combination of shareholders and workers actually pay the corporate income tax. But we'll never manage to make everyone think that no tax on firms is “fair”. So we'll have to do something of a workaround.

Similarly, we're pretty sure (so, only similar, because we're pretty sure, this is not definitional) that we want to tax capital incomes at lower rates than labour based incomes. Because capital is what increases productivity, increased productivity make all richer and we like that. However, an economy in which the rentiers pay no tax at all on their incomes will not be regarded as fair, however efficient it is. So, another workaround required.

There's one piece of economics we need here, which is the concept of the “normal return to capital”. We can and do derive this from political economist Adam Smith, who noted that there is, obviously, an average rate of profit made across the economy. And what every capitalist is doing is looking around for a way to make better than that. If and when someone finds out how to do that (new gizmo, finds a law that protects their profits, whatever) then other capitalists will spot that and copy the innovation.

At some point this new trade will find that the competition reduces profits back to the normal market level and everyone goes off to look again for the next opportunity. This happens pretty quickly too: high frequency trading in stock markets has been hugely profitable this past decade: the returns are looking pretty slim these days, though.

Enough new capital has come in that those doing the HFT (high-frequency trading) aren't making margins that are anything special, but we customers of the financial markets are enjoying the lower spreads that our pension funds must pay to buy and sell stock. Great, innovation pays the innovators excess profits, those get competed away and the consumer benefits after a time.

Smith thought the whole economy was constantly on the prowl for these opportunities. We like it when they're found and we like it when those profits are competed away.

Mirrlees takes this and moves on one stage further.

If above that normal level of profits persists for very long, then that's prima facie evidence that competition isn't working how we'd like it to. It might actually be because of the existence of other things that we've done elsewhere. Smith would have pointed to the monopolies enjoyed by the guilds and government chartered companies, for example. Mirrlees points rather more to the patents and copyrights by which we protect innovation.

OK, this is fixing a problem we've caused, but then we also all know that a pure free market won't deal well with a public good like innovation. We have to protect the innovation from being copied for a bit so that innovators can profit so that people innovate.

So, we've this idea that we don't want the returns to capital to be taxed, because of investment in productivity. We've the idea that we can't, on equitable grounds, allow the capitalists to pay nothing on their incomes and we've the obvious truth that it's never been the companies paying tax anyway. How to thread the camel through those needles, then?

The answer being, well, let's only tax profits above the normal rate of profits. Either they're lucky bastards with a new way to do something and they know that will be competed away anyway, or they're clever bastards who have found some manner (maybe in patents, maybe in the law, maybe just out-and-out bribery, who knows?) to get the system to protect their excess profits. So, we'll tax that bit, but not the normal return which is what we need to fund investment in the future.