Thoughts on economics and liberty

A liberal perspective on taxes – Part I

[This write-up was published in Freedom First, November 2009]

Sanjeev Sabhlok

This month and the next I will outline a liberal theory of taxation: something that, surprisingly, does not yet exist (indeed, there are may arbitrary assertions about taxes in the liberal literature but nothing that is fully integrated with the liberal social contract). Before I propose such a theory, let me thank Mr. S.V. Raju for his generous review of my book, Breaking Free of Nehru, in Freedom First last month. I’d also like to remind you that the book, as published, is now available as a free e-book at http://bfn.sabhlokcity.com/.

Paying for the social contract

The idea of a liberal social contract to defend our life and liberty harks back to Thomas Hobbes. The contract authorises governments to provide us with public goods like defence, police, justice, and infrastructure.[1] Taxes are then the fees paid for these goods. The liberal thus considers the proper funding of government activity as an integral part of the free society. This perspective is dramatically different from the ‘New Classical’ or anarchic approaches which consider government activity to be a waste. The liberal notes that it is citizens who, implicitly or explicitly, authorise the social contract (and not companies or other legal entities). Therefore citizens, individually, must pay taxes: not companies or other such entities. Second, it must be mandatory on all citizens to pay taxes except when someone is simply too poor to pay.

How much should these citizens pay? Should there be one flat fee per citizen (poll tax) or should different citizens pay a different amount? There are basically two different price models in the marketplace. (1) In a perfectly competitive market everyone pays the same unit price (such as for a kilo of onions) irrespective of his or her willingness or ability to pay. (2) Monopolistic control, however, allows circuses to fix different prices for different seats for the same performance. Price discrimination (PD) of this sort is based on consumers’ differential willingness to pay (note that willingness to pay is the same as the ability to pay under most circumstances). PD is commonly used in markets, and includes student discounts and different fees charged from Indians and foreigners to enter the Taj Mahal.

Price discriminating taxation by the monopoly state Economic analysis (made from the demand side) of public goods provision leads us to “Lindahl prices” as the proper solution. According to this each person must pay a different price equal to the worth of the public good to him.[2] From the supply side the opposite problem becomes: what should the monopoly state (Leviathan) charge for its services to ensure that everyone gets what they really want?

The theory of monopoly tells us that where PD is feasible, the monopoly will increase its output to accommodate all preferences and thus produce “the same level of output as would a competitive industry”[3]. It does so by skimming off all consumer surplus.[4] Both these analyses lead us to reject outright the poll tax solution: thus, a “tax structure that levies the same tax on all citizens cannot in general be Pareto efficient”.[5]

But which of the two: flat tax or progressive tax is a better way to deliver the optimal level of public goods? Consumer surplus generally increases disproportionately with income for (as illustrated by auctions) the rich are willing to pay disproportionately more than the poor for a given product, since each incremental unit of money has a relatively lower value for them. A flat marginal tax will therefore lead to sub-optimal provision of public goods by not capturing the entire consumer surplus of the rich. A level of progression is therefore more appropriate. In general, tax levels should be set at the point where the rich and poor get equal disutility from taxes.

A few other arguments reinforce this conclusion. First, the liberal requirement of a social minimum (basically a universal insurance scheme funded through the tax system) adds an apparent measure of progression to the liberal tax system. More commonly, progressive taxation is needed to offset the many indirect taxes usually imposed, such as consumption and excise taxes which are highly regressive, hitting the poorest the hardest in relative terms. Even F.A. Hayek, the great advocate of flat taxation, accepted that a modicum of progression would be needed for these two reasons.

But there is one more very important reason that is often neglected. PD is optimal only when the same good is provided by a government. If an extra product is delivered to the rich, then a further increment must be charged. It is self-evident that the rich do receive a greater share of government services than the poor do. For instance, they use the court system disproportionately more. They also receive a higher quality of services. Thus, if a rich person’s daughter is kidnapped, the head of Police gets involved, but a similar complaint from a poor slum-dweller may not even get registered. Governments treat the rich as being of value, and the poor of no value. That is totally contrary to the social contract, and even the slightest such discrimination means the rich must be charged progressively.

The practical implementation of PD: hurdle pricing A monopoly can only price discriminate if it has complete information about consumer preferences and is able to keep transaction costs (of calculating different prices for each consumer) low. Without these preconditions, it will prefer to impose hurdle pricing by placing hurdles between ‘seats’ and pricing them differently. “[T]he more finely the monopolist can partition her market under the hurdle model, the smaller the efficiency loss will be.”[6] Governments generally follow a hurdle model with tax brackets based on citizens’ ability to pay.

The rich never pay a flat tax The reality all over the world is that only the salaried upper middle classes end up paying the highest marginal tax rates. The rich pay much less than an overall flat tax rate would require, by influencing politicians to create tax shelters, exceptions, exemptions, and loopholes. Thus, Warren Buffet noted in June 2007 that in 2006 he paid only 17.7% of his $46 million income as tax, while his employees paid 32.9%. And the rich never pay the worst tax of them all: inflation; because they own real estate and shares which are inflation-proof.

Modest progressive taxation recommended Since the rich don’t even pay a flat tax, introducing a genuine overall flat tax will always be an improvement. But other factors prevent the practical implementation of progressive taxation, as well. First, a government can never determine the precise level of progression that captures everyone’s consumer surplus perfectly. Second, progressive taxation can lead to injustice when those with variable income flows (e.g. sports celebrities) are taxed at the highest marginal rate during the few years when they receive high incomes, while others who receive the same total income that is distributed more evenly are possibly (not necessarily) taxed less (in theory, this should not happen as the annualised lifetime worth of individuals must be used as the base of taxation; but this requirement can’t be implemented precisely). The third problem is that if a country sets its highest marginal rate too high, its rich will promptly abandon it or smuggle out their capital. Practical difficulties with progression and the reality that the rich never pay even a flat tax mean that only a modest level of progression can be recommended. Hayek’s prescription on taxation[7] can now be extrapolated to yield a broad rule of thumb, namely: that where income taxes are the primary source of taxation (as should be the case), then the highest marginal tax rates should be just above the proportion of taxes to GDP, with two tax brackets equal to, and below, this proportion. In India, this could mean the highest marginal tax of (say) around 21 per cent with two brackets at 18 and 15 per cent each. Of course, such low rates will demolish our tax collections because of our narrow income tax base. But in this article I’m only discussing the theory; the practicalities will be dealt with the next month.

Freedom Team of India You are hopefully aware of the work of the Freedom Team of India (http://freedomteam.in/) to find leaders to contest elections on a liberal platform. A new concept called Adharshila has also been proposed (http://adharshila.freedomteam.in/) to promote liberal discussion and advocacy across India. I hope you will participate in these important efforts to reform India’s governance.


[1] Details in chapter 4 of my draft manuscript, The Discovery of Freedom, http://discovery.sabhlokcity.com/. [2] Joe Stevens, The Economics of Collective Choice, Westview, 1993, p. 106.
[3] Hal Varian, Microeconomic Analysis, W. W. Norton and Company, 3rd edition, 1992, p. 243.
[4] The amount over and above the market price for a product that that different consumers would be willing to pay if its supply were significantly reduced.
[5] Robert Frank, Microeconomics and Behaviour, Irwin McGraw Hill, 3rd edition, 1997, pp.622-23.
[6]Ibid, p.418.
[7]In his book, Constitution of Liberty, Routledge & Kegan Paul,1960, p.323.

ADDENDUM

1. Minimising tax a rich man’s game, by CLARE MARTIN, November 16, 2009. The Age.
2. Captains of industry or pirates? Private investors flee without paying taxes. 3. Australia: tax-free for foreigners. The Age 16 Nov 09
3. These slides summarise some of the traditional issues in public finance.

Sanjeev Sabhlok

View more posts from this author
2 thoughts on “A liberal perspective on taxes – Part I
  1. Panduranghari

    i am afraid, your point of view is not libertarian. You still believe in control of the state to ensure progressive taxation. Though it’s theoretically great, practically it takes away the incentive to become a super producer.

    The world is changing. The future is- separation of unit of account and medium of exchange functions from the store of value function of money. Taxation via bank deposits frees up the need for banks. Remember banks are middlemen pure and simple. Keeping them in business is not net beneficial to the society.

     
  2. Sanjeev Sabhlok

    I’m not libertarian. I detest libertarians who are a bunch of lunatics with no knowledge of public policy but mere rants on a wide range of issues.

    I am classical liberal and largely follow **standard** economic analysis. A proper analysis of taxes involves **modest** level of progressivity on incomes.