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How to Analyze Taxes

March 8, 2013

Taxes can be broken down by when they are collected, so for example, sales, payroll, income, capital, inheritance, etc. But this approach lends itself to endless confusion over how much taxes someone pays. Politicans call some groups parasites for not paying income tax, forgetting that those groups still pay payroll and sales taxes. Warren Buffet claims that his tax rate is lower than his secretary, forgetting to include his initial income tax in his overall tax rate.

1000 Cuts
Let’s start in a world where everyone’s labor is worth the exact same and there is no capital. (The only thing missing from this Marxist’s paradise is mass executions) In a tax free version of this world, I would have to work 1 hour in order to purchase 1 hour of someone else’s effort. The value of what I put into society would equal what I took out. If you add in variable labor value, such as doctor’s hourly work being worth five times what a laborer’s work is worth, you get to a similar outcome. A doctor would have to work one hour to buy goods produced by 5 hours of effort by an unskilled worker. In this world, analyzing taxes is done by figuring out what each person put in and comparing it to what each person took out. If I worked 1 hours and was able to use the money I earned to purchase half an hour worth of goods from someone else, the effective tax rate would be 50%. You’d still need to determine the impact of supply side taxes on prices, so tax incidence would still need to be accounted for.

Now let’s add in capital. Most of the time, you can increase your wealth by investing. How do we compare goods now from goods in the future for the purposes of taxation? To get an equal tax, the ratio of how much you could get today should be the same as the proportion of what you could get in the future, relative to what you contributed. So an equal tax rate of 50% should allow you to get 50% of what you contributed today, or 50% of what you could have gotten in the future, relative to a tax free world.

Equal Tax Rates
50% Current tax
50% Future Tax

Capital Gains Tax
Capital gains taxes, which tax investment, result in creating two different tax rates depending on when someone consumes. If you consume right away, you are taxed equal to the income tax. If you wait to consume, you are taxed by both the income and the capital gains tax. Investments generate positive externalities and so taxing investment more than immediate consumption is a bad idea. The graph below shows how capital gains taxes work:
Capital Gains Tax
Area 1 is the amount collected by the income tax. The Area 3 is the investment return that would have accrued had there been no income tax. The investment grows from 50 to 100 instead of 100 to 200. It never exists, so it is not a collected tax. Area 2 is the amount collected by the capital gains tax. The capital gains tax is levied on the increase from 50 to 100, and so collects 25. The person is able to consume 75 in the future. Under a consumption tax, the taxpayer would have been able to consume 100, or half the amount they would have been able to in a tax free world. Under a combined income and capital gains tax of 50% each, they are only able to consume 75.

My Opinion
I favor a consumption tax. It has the advantage of taxing all income, no matter the source, at an equal rate. It also encourages investment, relative to a income and consumption tax. Capital gains taxes are often framed as affecting only the rich, but this is not true. Capital taxes affect middle class savers as well as workers, by reducing investment and thus labor productivity. If you want to target the rich, it is far better to do that directly through a progressive consumption tax, which only targets those who are actually consuming more than the average person. The quirmy super rich will always find a way to avoid paying the rat’s nest of taxes that America currently has. The experience in Europe has been that consumption taxes are very easy to collect and very hard to evade. As the saying goes, even drug dealers pay the VAT.

Further Reading:
Garett Jones on taxing capital
Robert Frank on the Progressive Consumption tax
Scott Sumner on the optimal tax
My post on land taxes

2 Comments leave one →
  1. March 12, 2013 4:09 pm

    If you eliminate the cap on IRA contributions you can have a progressive consumption tax. If you make all the other taxes individual you greatly simplify taxation. We could put all of our income into an IRA and pay a progressive consumption tax on the money that we draw out of the IRA. You can already borrow from an IRA to buy a house so that works also. Now if one wants to fund a business startup there would need to be a way to do that pretax perhaps through a lborrowing from the IRA.

    • March 13, 2013 4:08 pm

      That sounds reasonable. I think one reason why our tax code is so complex is to hide the burden of taxation, so people don’t get upset about it.

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