Thoughts on economics and liberty

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The case for the progressive tax

 

To me the proof for a progressive tax (not on income which is a random cash flow issue, but on net worth – which contains both income and wealth) is open and shut. I will aim to record it in DOF. This is merely a sketch, and I’ll keep using this blog as part of my research.

‘No tax system can be evaluated without reference to a theory of political economy or public  choice’ [Cited in Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’,Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.485.] but ‘economic analysis has had a "long tradition" of obscuring the normative underpinnings of economic theories of tax’ [Cited in Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.486].

Hettich and Winer list the following essential elements required for a "complete normative theory of taxation":
1. a philosophical foundation which permits quantification of value judgements;
2. an explicit treatment of tradeoffs between major objectives in tax reform;
3. a well developed public choice analysis;
4. a complementary view concerning the private sector of the economy and;
5. an explicit treatment of partial tax reform [ [Cited in Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.481].

(1) There has only been one major contribution to the public finance model from liberals yet – that taxation should be through representation. We must get to vote on our own taxes.

2) a) As far as other contributions go, these include Bastiat and Nozick who oppose all forms of taxation in principle, calling it theft (thus contradicting (1) above, since they are supposed to vote on their taxes themselves).

b) The other is Rawls who has a very strong inheritance tax model that I reject in DOF with reasons why that is antithetical to freedom.

c) The one I advocate is essentially an Adam Smith-Milton Friedman model of taxation, but with much greater clarity on the foundational principles.

The liberal theory of public finance in a nutshell (based on 1 and 2c):
Once you sign up to the social contract and get to vote on your taxes then these principles must apply:
i) People (citizens) must pay for the services they want
ii) The taxation must be based on a price-discriminating monopoly model since the state is a the only monopoly the liberal deliberately creates through the social contract.

Note that if artificial entities like companies pay taxes, that would violate (i) and someone or some entity would be paying without representation. What should happen is this: All fully untaxed incomes should flow back to their owners through dividends/capital gains who should then pay the relevant tax. The government will get the same amount of money, but in the form of a tax on net worth (for foreign owners, you can have a flat and competitive corporation tax to attract investment and remain competitive with the world on this issue, say 25%).

The company is owned by real people. They get income. They pay tax. A citizen, not a company, signs the social contract. So what is our basis for asking a company to pay tax? Is it a citizen? Does it vote? Does it fight a war? Why does it pay taxes without representation? But the corporate tax is also a very high indirect tax. Let's say I'm a poor person with nothing but 1000 shares in a company on the dividend of which I run my life. Except where a franking (or imputation) system is followed (as in Australia), I end up paying huge amounts of tax: the corporate tax AND my income tax. On the other. I'm quite happy if we have an imputation system and corporation tax in India. That essentially comes down to the same thing – that individuals will pay tax, not companies.

The flat tax violates 2(b). It essentially amounts to MC=MR=P which would be legitimate if there were more than 10 competitive governments, and you could choose to buy the services of governance from any of these 10 or more. But we have a monopoly and we want a monopoly. We don't want to create 10 competitive governments with 10 defence forces and 10 police forces (Nozick's model is close to that, by the way!). Now, if we are a monopoly, then the monopoly's ideal solution is to price discriminate perfectly. Since it can't ever do that, it uses a variety of tools to raise differential prices from different consumers for the same service. That is what a government must do, ie. extract the entire consumer surplus (or as much as possible) from every citizen.

What I'm saying is that the theory of tax must be derived from first principles, else it is a whimsy not a theory. Progressive taxation, in my theory, sits as part of a broader theory of freedom. We need to run the economy on income and wealth taxes alone, since the citizen is the signatory to the social contract and must pay directly for the services he/she wants, not be hitting the poorest the hardest. Arguing against a net worth based tax (which includes income and wealth) is an advocacy for a feudal system.

The liberal model is thus: Maximise equal freedom subject to accountability where equal freedom comprises:

a) equal treatment (rule of law)
b) equal opportunity (absence of discrimination in public office, and a frugal social minimum as part of social insurance); and
c) equal disutility from taxes.

That makes up the entire theory of (equal) freedom, in a nutshell.

The basic question before us
The liberal must have a theory to help him choose between options. We need to know where we are going. Once we are agreed on roles of government, the big debates are over. But the small debate remains: how are we to actually collect the money needed for the performance of these roles. There are at least the following tax options to collect the money a government needs to perform its role. There are thus tens if not hundreds of ways to tax people. We need a model to tell us how we would (as free citizens) pick some in favour of others, and why.

PERSONAL TAX (direct tax)
1) Fixed amount per person taxes
– poll tax

2) Share of income (flow)
– Income tax
– chauth
– jaziya

3) Share of wealth/ assets (stock)
– land tax (including in some cases, capitalised value)
– land revenue (varying on a complex formula based on type of possession/ownership
– property tax
– municipal rates (usually based on asset value)

COMMERCIAL TAX (all are indirect taxes)
1) Production taxes (during production)

a) Registration of business and renewals
– registration fee
– license fee, e.g. license fee for access to public resources (e.g. fisheries)

b) Share of imported value
– customs tax

c) Share of payroll
– payroll tax

d) Share of output
– VAT (incremental output tax)
– excise

2) Trade taxes (on the final sale)
a) Sales taxes
– GST (goods and services tax)

b) A registration fee on completion of sale
– stamp duty
– annual (or periodic) registration fee

USER-CHARGES
– e.g. Fees for entering a national park, and so on.

INFLATION
– just print more money and reduce real wealth, through deficit financing

Once you've given me your answer which can theoretically discrminate between these and a range of other potential taxes, we can discuss.

Each of these taxes creates a range of specific outcomes, related to incidence, feasibilty of collection (including transaction costs), and the inevitable distortion of incentives.

Some thinkers who favour a progressive tax
The man who first propounded a view on justice, Plato wrote: ‘When there is an income tax, the just man will pay more and the unjust less on the same amount of income.’ (in The Republic).

Jean Baptiste Say, the great classical liberal: "Say, in his work on political economy written in I803, argues that "if it be desired to tax individual income, in such manner as to press lighter in proportion as that income approaches to the confines of bare necessity, taxation must not only be equitably apportioned, but must press on revenue with progressive gravity.""

Adam Smith: "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more in proportion".

Ronald Green: "to subject a poor individual to the same tax as a millionaire … [is] the height of absurdity" ("Ethics and Taxation: A Theoretical Framework", The Journal of Religious Ethics, Vol. 12, No. 2 (Fall, 1984), p. 152)
 

Mill seems to have a mix of progressive and minimum tax: "Whatever sacrifices it [a government] requires from them," he said, "should be made to bear as nearly as possible with the same pressure upon all, which, it must be observed, is the mode by which least sacrifice is occasioned on the whole.' [pressure, it can be argued, is the same as perceived disutility]

Public goods charges must price discriminate (and this is efficient as well)
Not many (indeed none that I can find) philosophers have connected the dotted line on first principles between (a) demand for life and liberty, (b) a specific form of social contract, and (c) a specific public finance system. The state is a monopoly. This concept of the monopoly state has nothing to do with its form, ie. whether it is democratic or autocratic, local or state or federal. It simply says that if there is one and only one defence force in a country, then the monopoly kicks in.

This is what I've written in Breaking Free of Nehru (online notes): "As a constitutional monopolist, a government can, and should, price-discriminate for its services based on a citizen’s the ability to pay. The rich actually receive a disproportionately higher protection of their assets from the armed forces and police, and cost our justice and security system relatively more. During war, the army tends to protects large factories to the relative neglect of the houses of the poor. The rich also use our airports, electric supplies and roads far more, and pollute more than others. Further, the marginal utility of money declines steeply: a rich man cares far less for Rs.1000 than does a poor person. Therefore, income and wealth tax will continue to be progressive, not flat. The general taxation principle would be: the poor should pay no tax, the moderately well-to-do should pay modest levels of tax, and the rich should pay relatively higher levels of tax."

I quote Adam Smith (Richard and Peggy Musgrave, Public Finance in Theory and Practice, 5th edition (1989) footnote at p.219) "The subjects of every state ought to contribute towards the support of the government as nearly as possible in proportion to their respective abilities; that is in proportion to the revenue which they respectively enjoy under the protection of the state" (Wealth of Nations)

This converts into two basic principles that I advocate:
a) It is individuals who must pay (not artificial entitles like corporations)
b) These individuals must pay in proportion to their ability to pay (which is proxied by their net 'revenue' or stock plus flow (wealth plus income). This is nothing but prefect price discrimination under the theory of monopoly.

The view that Adam Smith (and I) are advocating is simple: "as nearly as possible in proportion to their respective abilities". This model can be read in two ways: The simplistic way will read this as a prescription for flat tax – which is what you are suggesting: everyone pays in direct proportion to their incomes. The other (and the view that a careful reading of Adam Smith will substantiate) is it should be a proportion of the ability to pay.

Now, one's "ability to pay" increases proportionately with net wealth, given (and this is VERY important to understand!) the diminishing marginal utility of money (ie. the increment of Rs.1 becomes less valuable to a person the wealthier he gets). Therefore to get the very rich (say Bill Gates) to 'feel' the same at the end of his tax payment as the poor man, the rich will have to pay proportionately higher for the same proportional effect on their ability to pay. This, Adam Smith's model, is therefore nothing but that of the price discriminating monopolist.

Given perfect monopoly and total information re: the preferences of the consumer, the monopolist is most efficient by charging different prices for each consumer. As Frank Knight notes at p.418 of the third edition of "Microeconomics and Behaviour", "In general, the more finely the monopolist can partition her market under the hurdle model, the smaller the efficiency loss will be." He then discusses "What about the fairness problem?" He gives a roundabout (and in my view a somewhat imperfect answer) to conclude: "it is by no means clear that the economic profit with natural monopoly creates distributional inequities of the sort commonly perceived." For the government, my answer, above, is clear: there is no inequity involved in the progressive tax regime since the rich can pay far more as a proportion of their income – their ability to pay therefore increases with their income.

Hence ideally there would be an infinity of 'slabs'. The reality is that no monopolist (government) can ever have perfect information, and imposing slabs under an imperfect information regime increases the deadweight loss of unnecessary transaction costs to discriminate, and calculate. Hence most governments have adopted 3 to 4 slabs, and coupled it with a range of wealth taxes.

The price discriminating model (first order price discrimination) of a monopoly leads to the 'perfect' price (MC=P) for every individual (Hal Varian's Microeconomic Analysis 3rd edition, p. 243). Also, "the monopolist in this market produces the same level of output as would a competitive industry". In other words, you get the benefit of maximum output even as you get the maximum revenue, and the price (that the individual is willing to pay) equals the marginal cost to the monopolist.

Of two people who want a particular good (say defence), but want it in different quantities (the rich one R wants it more than the poor one P), the good will not get provided because P will free ride. The optimal solution is through "Lindahl prices" where the each individual pays (a different price) equal to what the good is worth to him, at the margin (see The Economics of Collective Choice by Joe Stevens, 1993, p. 106). That is a price discrimination solution as well.

A precise model of taxation for public goods is shown in Microeconomics and Behaviour in Robert Frank (3rd ed. p. 622-23). That is the closest anyone has got (in all my readings so far) to a precise theoretical model of taxation – even though Frank has not yet gone into the linkages with the social contract and the broader theory of equal freedom.

Frank uses a very similar model to the Joe Stevens model I've cited above (two different 'willingness to pay' demand curves for the same public good), and concludes that "a tax structure that levies the same tax on all citizens cannot in general be Pareto efficient". (note that in economic theory 'willingness to pay curves' are the same as 'abilty to pay' – both being related to consumer surplus. In plain English, at the margin, willingness to pay and abilty to pay become the same).

Thus we note that a progressive tax model (which tries to proxy people's ability to pay) is Pareto efficient as well (noting that the only efficiency relevant to an economist is Pareto efficiency).

I now need to know if there has been any thinker in human history who has linked the Hobbsean monopoly social contract to a monopoly's perfect price discrimination model that I have linked together, along with the demand side links as well with marginal utiltity. That is the only missing link in my research so far. Someone is likely to have said exactly what I'm saying (that's what I always find, much to my chagrin!) if only I keep searching.

Equal disutility Equal disutility from tax is the only harmonious way for free society. The flat tax creates a very large disutlity on the poor and middle classes but a much lower disutlity on the rich. Theoretically, the poor will then be forced to remain poor for ever (paying, say, a 25% tax rate on Rs. 1 lakh, thus losing out all potential chance of capital formation, while the rich will pay the same rate on an income of Rs. 10,000 crores, of the balnce Rs.7,500 crores they will consume, say, Rs. 10 lakhs, leaving them with a massive amount to keep reinvesting and growing hugely rich.

The richer one gets, one consumes less and invests more. Thus the rich man’s income works for him even when he is not working. The rich man also cares much less for that last Rs. 25,000 if he earns Rs.10,000 crores each year. The rich must therefore pay an amount equal to their marginal disutility.

Every citizen must be 'given' equal disutility from taxes. That is the essence of the theory of taxation. This is also the completely mirror image of Adam Smith's 'ability to pay' argument. Note that this is perfectly "fair" as well. Everyone gets to feel equally bad about taxes. Note that equal feeling is easily modelled through the utility theory and the theory of consumer surplus; the point being that everyone's share of consumer surplus is equally captured by the government in a 'fair' system (though I don't like using the word 'fair' for it is most subjective and thus problematic). This is a general principle that treats everyone in society perfectly equally.

Joining up the two arguments
We can now join up two things from both sides:
– a) the monopoly is most efficient when it price discriminates
– b) the citizen must pay based on ability to pay

IF we choose a single state (one government for India, not ten), then it is fully justified for the government to price discriminate and establish a progressive income tax (but more correctly a progressive 'net present value of net wealth' regime).

Progression must be on net worth
If we agree that individuals create a state through a social contract and that they must pay based on their ability to pay for the services they demand of their government, then the question is: what does the ability to pay mean? Is the individual to pay only from the 'flow', or the income, or from the changes in stock, as well? I argue that the ability to pay of the individual is a function of net present value of the individual's net worth.

If we don't agree with the above principle, we’ll create strong incentives for the rich to purchase assets on which capital gains taxes are not imposed, and we’ll create a feudal society. Let's say I am as rich as Bill Gates. In my society there are only income taxes, no capital gains taxes nor property taxes (note that wealth tax is called by many names, not necessarily 'wealth tax'). This particular society would tax dividend from shares and rental income from landed property (being income) but not the capital gains on my shares and land (being change in value of 'stock').

To circumvent paying taxes, I will then immediately:

a) buy up billions of dollars worth of gold and diamonds and sell these in small lots – thus paying a small income tax – to feed myself and family for 1000 generations, without working – ie. we get the feudal outcome.

b) buy a lot of land – say half of Uttar Pradesh, and sell it in small lots – thus paying a small income tax – for my next 1000 generations to live (again, a feudal outcome).

c) buy companies with only one condition – that they NEVER pay dividends, and sell my shares in small lots – thus paying a small income tax – for the next 1000 generations to live (again, a feudal model).

Without wealth tax we will end up at once with feudalism. We will create an English aristocracy, or the great Zamindars or Princes of India, who, despite their huge wealth, were never taxed appropriately. The serfs paid their share of taxes.

The case against indirect taxes
Indirect taxes are regressive and impact the poorest the most, even those who should be receiving a negative income tax. I oppose all forms of sales and indirect taxes. In brief, these hurts the poorest of the poor the hardest. That is not an acceptable position for us to take.

Corporation tax only acceptable with dividend imputation
Corporate taxation is acceptable if dividend imputation (franking) is included, which means that ultimately the individuals pay the taxes through the income tax system.

The progressive tax sits squarely in the classical liberal traditon
There can be essentially three 'freedom' based parties: (a) Nozickians – the libertarians; (b) classical liberals like us based on Smith, Mill, and Hayek; and (c) social democrats based on Rawls. FTI is firmly classical liberal. Green primarily cites Nozick, Smith (and utilitarians), and Rawls as representing three different views on taxation. Unfortunately, I Rawls or Nozick did not have a consistent theory of tax. If we have the Nozickian feudal state with (perfectly) competitive protection associations, we would then perhaps have a flat tax model since it would be allocatively more efficient [I've changed my mind on that as well; it would be a poll tax instead].

Conclusion
These theoretical arguments have led the entire West (and East) to follow progressive taxation. Except for one or two countries, no one has the flat tax system; and none that is purely a flat tax. All existing flat tax systems are digressive. This model (progressive tax only on individuals, and on their net worth) is far simpler model than the one currently used in most countries with a myriad of taxes. It will reduce the complexity of taxes significantly even as it broadens the base by forcing everyone to lodge their accurate tax return (which must be accurate else they would be committing perjury and go to jail) every year.

OTHER REQUIREMENTS OF FREE SOCIETY TAX SYSTEM
The other basic requirement of a tax system is that taxes collected should be sufficient to operate an efficient government. The government should NOT go into deficit (and thus place the bill on future generations) unless absolutely essential (for investment in education, for instance).

Corollaries:
a) The social insurance scheme must be paid through the tax system and while its premiums will be transparently (and separately) accounted for, based on a publicly disclosure of the calculations, the actuarially fair premium in this case will be subject to the same monopoly price discrimination outlined above.

b) Since there is a negative income tax for people below the social minimum, there is simply no point in setting indirect taxes. What that does is to force the people below the social minimum even further below the minimum (while creating transaction costs for government to collect indirect taxes) merely to somehow re-assess their income and bring them back to the social minimum through the social insurance scheme. However, it may well be that in the transition to the 'perfect' model, indirect taxes will continue given they are very easy to collect, even though iniquitous (indirect taxes are highly regressive).

A progressive tax is based on the theory of the diminishing marginal utility of money. Same thing applies to wealth tax. It is ridiculous for someone sitting on a property worth Rs. 30 crores in the middle of Mumbai to pay no tax because of a taxable income of Rs.3 lakhs, say. A small tax on wealth is legitimate in this case.

An argument I don't invoke but which makes sense in the strategic setting of the social contract:

Reciprocal altruism

‘we can view the progressive tax as a form of  reciprocal altruism: we help the less fortunate by paying more tax when we have surplus income, anticipating that they will do the same if the situation is reversed. … Because the tax is based on my ability to pay, I never sacrifice, I never even greatly inconvenience myself, when I pay taxes to help meet his or her needs. Yet to the extent the tax is redistributive, I recognize and meet my connection to the other’[1]


[1] Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.518.

A note on why the inheritance tax violates freedom

Inheritance tax violates the first principle of taxation: it is a double taxation of net worth. A flat inheritance tax will fall unequally on people depending on their relative longevity. Imagine two families A and B, each with a total land of 1000 hectares initially, members of one with a long-lived gene (A) and the other with a particularly short-lived gene (B). It is obvious on the slightest reflection that members of family A will soon become wealthier than members of family B, particularly if there is a flat tax on inheritance, i.e. unrelated to the size of wealth. If, however, inheritance tax is progressive, then members of family A will generally pay a higher inheritance tax each time it is applied on one of their members, than members of family B with smaller land holdings. That would at least make the incidence of inheritance tax equal.

An argument I don’t agree with but which has some merit (benefits principle)

What is it? ‘The tax should equal the price of the benefit (governmental goods and/or services) that the taxpayer willingly would pay.’[1] ‘Clearly, those with property to protect receive greater benefit from property protection than those with less (or no) property.’[2]

‘While I cannot discover and prove the exact schedule of progressive rates, there is evidence that benefits rise geometrically with income. If this lack of definiteness makes the case for progressive taxation based on a benefit theory uneasy, it is still less uneasy than the case for a flat tax which ignores the basic curve altogether’[3]

Some people have argued that taxes must be charged based on the benefits received. This, indeed, underpins the user-pays principle, and to an extent it is valid for small services such a toll road where the charge must be fixed regardless of one’s total wealth, else we will find it virtually impossible to administer the road. But more broadly speaking, ‘[i]t is difficult … to show that greater benefits are received from government by people having greater incomes.’[4] He most obvious problem is that this argument flies in the face of the principle of economies of scale. ‘If attention is directed to the costs of protecting property, it would be preposterous to assume that such costs increase more rapidly than the value of the property being protected.’[5]Clearly is cheaper at the margin to protect larger property than smaller property. This chain of thought would clearly lead us, instead, to a highly regressive taxation principle.


[1] Cited in Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.491.

[2] Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.492.

[3] Kornhauser, Marjorie E., ‘The Rhetoric of the Anti-Progressive Income Tax Movement: A Typical Male Reaction’, Michigan Law Review, Vol. 86: 3 (Dec., 1987), p.497.

[4] Blum, Walter J., and Harry Kalven, Jr., The Uneasy Case for Progressive Taxation, The University of Chicago Law Review, Vol. 19:3, 1952, p. 454.

[5] Blum, Walter J., and Harry Kalven, Jr., The Uneasy Case for Progressive Taxation, The University of Chicago Law Review, Vol. 19:3, 1952, p. 454.

Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[9] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[10] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[11] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

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The case against the flat tax

 

I advocate a slightly graded but clearly progressive tax, based on first principles.

However, to get this argument accepted, it is also perhaps necessary to demolish the imposter that has emerged in the last few decades and threatens to swamp liberalism. Regrettably, Hayek himself has added to the confusion on an inappropriate ground, even as he acknowledged the need for at least two levels of progression (one, because of the social minimum; the second, to offset the regression of consumption taxes). Hayek makes one very good point against progressive tax, though. That must be taken into account, and that is why I argue for a very slightly graded progressive tax.

I argue the case for progressivity  separately. This blog is tries to argue the case against flat tax.

This is work in progress and so the stuff provided here will change. The arguments are listed in no particular order. The only reason why liberals can reach two views on any issue is if their assumptions are different or one persons’ logic wrong. In the case of flat tax, it is clear that assumptions of flat-taxers are questionable.

No link of flat tax with the theory of the social contract
The argument for the flat tax has no relationship to a social contract designed to defend life and liberty. One needs to make the necessary link between the state as monopoly, the social contract and the tax system. I’ve yet to see the linkage drawn by any thinker between the inevitable necessity of a progressive tax once we have a monopoly government (Leviathan). A social contract will need to be strategic and just; balancing out responsibilities of participants in their ability to bear these responsibilities. Anything else will ultimately fail as the society slowly but surely converts into a feudal society

Flat tax violates Economics 101
It violates Economics 101, basically violates the diminishing marginal utility of income. This validity of the diminishing marginal utility curve is demonstrated by the simple fact that the solution to the incentive problem in firms has been to increase salaries disproportionately with seniority. That is why CEOs are paid 100 times more than a business analyst. Without paying disproportionately more, sufficient incentives aren’t created for harder work, as the value of money keeps declining. Even the most basic experimental economics proves the existence of the diminishing marginal utility curve.

Note that the rich will never fight wars for their nation. They always leave the dying and bleeding to middle class soldiers and armed service officers. The progressive tax makes sure that the rich – who never pay with their lives for their country – compensate at least by paying a bit more through progressive taxes for their safety and for the upkeep of their nation. They live the cushiest lives. No dirt, no sweat, no blood. We all work hard for them. There is therefore no reason why an army officer must pay 30% tax on income and Ambani must pay 30% as well. The flat tax is purely a whim of the rich and upper middle classes to trick the poorer and lower middle classes into not only slogging for them and shedding their blood for them in war, but also paying for their upkeep! Very clever sleight of hand! Indeed, as I show elsewhere, not only will flat taxes shift the burden to the poorer sections, they will hit them with a much higher tax bill! Great way to give the future generations of Ambani a great free ride.

The flat tax debate takes us away from the key issue that we should pay as low as necessary to get the best government services we need
I’ll let Murray Rothbard speak on my behalf. ‘The flattax movement is part of a process by which the government and its allies have been able to split and deflect the tax protest movement from trying to lower the taxes of everyone, into trying to force everyone into paying some arbitrarily defined “fair share.”’[1]

‘Thus, let us compare two hypothetical tax systems. In system A, there is a progressive income tax, ranging from one to ten percent. In system B, everyone pays a flat, strictly proportional income tax, of 20%. I have a hunch that, in choosing between these systems, even the upper-income groups would opt for the far more progressive, but much lower tax burden. The central point is the lowness of each tax, rather than the distribution of the burden.’[2]

Now let C. Lowell Harriss speak: ‘Clearly, the present system, with federal plus state rates of over 50 per cent at the margin, must deserve criticism. Significant rate reduction, however, does not require a shift to a single rate’[3]

Murray Rothbard again: ‘One of my favorite economists, the 19th-century Frenchman, J. B. Say, after pointing out that taxation is a coercive transfer from individuals and groups to the government, crippling their ability to produce and consume, concluded: “The best scheme of finance is to spend as little as possible; and the best tax is always the lightest.”’[4]

There is nothing in the progressive model that says one can’t flatten and reduce tax rates overall (that is why tax revenues go up in some cases where flatter taxes are introduced, due to the Laffer curve argument – but also by slugging the poorer for greater share of taxes – not because of the flattax per se). I have nothing against a modest progression, and one that kicks in strongly after a much flatter range, with only the richest required to pay the highest marginal tax. Also, no one is saying the highest rates must be 90%. 40% is more than enough (current highest slab in Australia is ; even less is fine depending on what a government needs. But there must be progression. That principle is crucial to a free society where everyone behaves responsibly as a citizen. Everyone who can afford to must contribute as a citizen and not free ride on the poorer sections of the community who are hit hardest by flat tax which is essentially regressive.

The flat tax is essentially progressive, but the flat-taxers don’t explain why!
No one has ever proposed a genuinely flat tax. They are all degressive taxes, with at least two taxthresholds, zero up to a particular amount, and then flat thereafter. (J.S. Mill first proposed this model which calls for zero or negative taxation till a particular point, followed by flat tax).
What justifies this? The flat tax must be purely flat (assuming it has any logical sense at all!). Why is it progressive? And if it is to be ‘slightly’ progressive, why is it progressive at all? What is the justification for that? How do flat-taxers justify this abrupt progression?

Now, I’ll let Murray Rothbard speak:

“The flat tax, quite simply, proposes that every individual and every organization be subjected to the same, uniform proportional income tax. To achieve that uniformity, the flattaxers propose the ruthless suppression of all credits, deductions, exemptions, and shelters, all of which are sneered at as “loopholes” in the tax system. In the flat-taxers’ pure theory, the proportional income tax would apply to everyone regardless of income. But early in the development of the flattax movement they decided that, politically, the poor would have to be exempt from the tax. As a result, all flat taxschemes are now “degressive”: proportional above an arbitrary minimum income floor, below which line income receivers pay no taxes, The “degressivity” leaves an important element of progressivity in what has been touted as a strictly proportional plan.”[5]

To remain revenue neutral, the government would heavily slug the working classes

“Under any conceivable shift to a flat-rate system, the total tax of the highest income groups would be reduced.”[6] The only way to fix this would be by significantly raising the taxes on those who currently pay a lower rate.

Flat tax would allow a larger number to live off the labour of workers

Flat tax would definitely lead to a ‘number of families living very well indeed on inherited wealth as distinguished from income from their own industry and thrift. Desirable?’[7]

The pathetic argument of ‘fairness’
Our personal perceptions of fairness are totally irrelevant to policy discourse. We need to root our policies in a consistent theory of the free society. So if the state we create through our social contract is a monopoly, and it is best that a monopoly price discriminates, and also that marginal utility of money falls dramatically, then there must be a proof that the flat tax model is the necessary outcome of this model.

I’ll let Murray Rothbard speak on my behalf. ‘The major argument for the flat tax is not economic but moral, namely that this is the only fair way to distribute taxation. The assumption is that, given an arbitrarily determined total revenue to the government, that revenue should be distributed in a uniform, flattax manner. But the flat-taxers do not really argue their point; they simply assume it as self-evident to all people of good will. Well, sorry, but I don’t see it.’[8]

‘More specifically, I don’t see why proportional taxation is any “fairer” than many other possible patterns of distribution. Take, for example, Mr. A and Mr. B, each of whom earns a net income of, say, $50,000 a year But Mr. A is a young man, just starting in life, with virtually zero assets. He depends on personal savings to finance a future business. Mr. B, on the other hand, is an older man who has already built up or inherited millions of dollars in assets. Why is it manifestly fair for him to pay the same tax as Mr. A? Neither is it obvious to me that a sick person with heavy medical bills should pay the same tax as a healthy man with the same income. Note that I am not saying the opposite: I am not advocating a tax on health or on wealth. I’m simply saying that there seems to be no convincing argument for the fairness of one pattern of taxation over another.’ [9]

‘In fact, I will go even further, and say that fairness has little or nothing to do with the matter, that, in fact, TANSTAAFT (“there ain’t no such thing as a fair tax”). Conservative flat-taxers like to analogize to the free market, and maintain that they are trying to achieve neutrality to the market. But consider: what in the world is a “fair” price on the market?’[10]

The nonsensical ruse of simplicity
Tax system complexity NEVER arises from the 2-3 marginal rates that form part of the progressive system, but from the identification of income. The arithmetic of calculating tax is the least important part of the tax return calculation. Anyone who has passed primary school can do it. And if one can calculate a flat tax based on a standard deduction, so can one calculate a progressive tax.

The flat tax does NOT mimic the market
I’ll let Murray Rothbard start the ball rolling on this: ‘The flat-taxers have strongly implied that, in contrast to the progressive tax, the uniform proportionate tax is neutral to the market—for the market would pay in this way for the services of government. But would it really?’[11]

However, Murray Rothbard’s rhetorical answer (see his actual paper) to this question only covers a small part of the reality. Yes, the cost of a bread is the same (not proportional as flat-taxers want it to be), but the reality is that markets set a range of prices for the same good which is cosmetically different – that is called price discrimination. It is a fundamental feature of all markets. I have a Toyota Avalon with the same chasis and engine as a Lexus, but with cloth fittings instead of leather. Put in $2000 leather seat covers, a few other minor tweaks and the same car is sold for $40,000 more!

Conclusion
An FTI member wrote: “This model [flat tax] would hold taxes steady at current levels or lower them as appropriate, while making the govt expenditure more efficient and market-driven. Such a model would seek to maximise efficiency, at the least cost.”

As shown above, all claims made in this regard are wrong. But since when is efficiency the objective of freedom? And efficient for whom? Are we talking Pareto efficiency? Then the price discriminating monopoly model is most efficient. Are we talking ease of collection of taxes? Then socialism is most efficient. It can be (really!) efficient [ie. cheap; quick] to sell all of Bill Gates’s assets now that he is no longer Chairman of Microsoft and get the taxpayer $50 US billion. Thus it can be really efficient to confiscate all the wealthy. The liberal wants to maximise equal freedoms subject to accountability, not to achieve efficiency. Efficiency is one of the many minor issues to be considered, but can’t drive our fundamental theories.

[1] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[2] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[3] C. Lowell Harriss, ‘Important Issues and Serious Problems in Flat-Rate Income Taxation’, American Journal of Economics and Sociology, Vol. 43, No. 2 (Apr., 1984), p. 161.

[4] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[5] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[6] C. Lowell Harriss, ‘Important Issues and Serious Problems in Flat-Rate Income Taxation’, American Journal of Economics and Sociology, Vol. 43, No. 2 (Apr., 1984), p. 160.

[7] C. Lowell Harriss, ‘Important Issues and Serious Problems in Flat-Rate Income Taxation’, American Journal of Economics and Sociology, Vol. 43, No. 2 (Apr., 1984), p. p. 161.

[8] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[9] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[10] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

[11] The Case Against the Flat Tax by Murray Rothbard [http://mises.org/rothbard/flattax.pdf]

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India needs political reforms, not a presidential system

Sanjeev Sabhlok

(Sent to Times of India in early 2008. Not Published. Hence published on internet – now published on my blog for completeness)

A question is raised periodically in India about whether a presidential system will work better for us than our current Westminster model. This is a legitimate question given that we have some of the most corrupt politicians in the world.

I propose to make a few comments regarding this debate recently revived by Mr. Shashi Tharoor. My comments are based on the experience of working with ministers within two Westminster democracies, the Indian and the Australian. I propose to show that the performance of India’s current system can be significantly improved, and therefore a presidential system should be ruled out, at least for now.

Our quality of governance is determined by the kind of representatives we elect. The mere form of democratic representation, whether Westminster or presidential, whether proportional or first-past-the-post, doesn’t seem to matter so long as good people are able to get elected. By ‘good’ I mean people who are honest, ie. do not use corrupt money in their election campaigns or lodge false accounts of election expenses, are and competent, ie. knowledgeable on policy matters.

Two democratic frameworks which look alike on the surface can lead to dramatically different outcomes based on whether they can attract good people to politics or not. A comparison of the performance of the Indian and Australian systems is a case in point. While the Australian system elects brilliant and honest representatives, the Indian system largely elects incompetent and corrupt representatives. I say this from direct observation of ministers during my working relationships with them in these two countries.

Indeed, I would suggest that the Indian system actively prevents honest candidates from contesting elections. For example, a candidate in India loses the money spent on an election campaign since there is no reimbursement on the basis of votes polled. India also pays its representatives a salary that is too low to attract talented and knowledgeable people to politics. Therefore, the numbers don’t add up, and it is primarily the morally challenged, imprudent, and incompetent Indians who participate in politics.

Our real problem, therefore, is that our Westminster system produces extremely low quality representatives, even though its Australian counterpart is able to produce outstanding results. Why is this so? I attribute this to three design features in the Australian and American systems that are not found in India. First, these countries do not have election expense limits. This allows for complete transparency in fund raising and expenditure; there is no incentive to lodge false statements of electoral expenses. Second, their governments partially reimburse election campaign expenses. The Australian system pays for each valid vote cast. Third, successful representatives are paid salaries comparable to what senior managers in the private sector get.

These design features enable thousands of good people to join politics in Australia and the USA. Citizens of these countries are spoiled for choice. By adopting similar practices, India will also be able to attract thousands of currently disenfranchised good people to politics. That will mark the dawn of a completely new era for India, an era of honesty and competence in public life that we have never experienced in sixty years.

Discussions on the presidential system should therefore be put on hold and the focus shifted to reforms of the current system. The reforms needed include the three reforms suggested above, as well as others I have outlined in a forthcoming book. These reforms should be easy to implement, at least compared with moving to a completely new system of representation.

Of course, one reason why these reforms won’t be implemented is that many current politicians will lose their seats if they allow good people to enter politics. That does not mean the presidential system will do any better. The same resistance to let good people enter politics will mean that when a presidential system is introduced, our most corrupt politician will become President.

The author, a former IAS officer, now works in an Australian state government.

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Monthly articles in Freedom First – completed, and proposed

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My articles published in FF so far

2008

2009

2010

Proposed further articles

At this stage I decided to pause writing for FF and move into the blog on a more active basis. Should I find time to do so, I'll write on the following subjects:

 

  • Leadership in politics
  • Industry policy (that there should not be a policy)
  • Arts and archeology policy [the value of social cohesion, including +ve externalities of bollywood and cricket]
  • Alcohol and drugs policy
  • Sports policy
  • Physical infrastructure policy 
  • Transportation policy (roads, rail, etc.
  • Energy policy
  • Water policy
  • Space and nuclear policy
  • Trade and commerce policy
  • Urban planning – a detailed article
  • Defence policy
  • Justice system reforms

Sanjeev Sabhlok

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