A few of my favorite things.
James Hines, University of Michigan
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Paying taxes is not the same as bearing tax
burdens.
Capital taxes are the most distortionary of all.
Efficient tax policies make everyone better
off.
Markets work; the economy is in general
equilibrium.
Broad-based, low-rate tax systems are not
optimal.
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1. Paying taxes is not the
same as bearing tax burdens.
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Why the difference? Because taxes affect prices, and
price movements impose burdens.
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Hence, for example, sellers bear part of the burden of a
sales tax increase if it forces them to reduce their prices.
The extent to which tax burdens are shifted depends on
supply and demand throughout the economy.
Example: Social Security taxes – are they really paid
half by employers and half by employees? Well, no.
And the burden on employees would be completely
unaffected if the employer instead paid 75 percent or
100 percent of the Social Security taxes (with
compensating adjustment in the benefit schedule).
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Implications.
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The distributional effects of taxes may look
very different than how they are commonly
conceived and measured. The actual tax
burden is not a function of who remits money
to the government.
For example, the burden of a source-based
capital income tax in an open economy falls
entirely on fixed factors (primarily labor).
This effect is quite real, even though it is
invisible to any single individual or company.
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2. Capital taxes are the most
distortionary of all.
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The effects of capital taxes compound over
time, making these taxes extremely costly.
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Even a low rate of capital tax imposes a huge
wedge between consumption now and
consumption 30 years from now.
No other tax has this compounding feature. There
is something deceptive about the real burden in a
setting with compounding.
The cost is greatest in an open economy,
since the supply of capital is so elastic.
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Implications.
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If the goal is to impose greater tax burdens on the
rich than on other income groups, then capital
income taxation is a terribly inefficient way to achieve
this goal.
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Much better would be to adopt sharply progressive
consumption taxes, for example.
If the goal is to impose greater tax burdens on
foreigners, then capital income taxes will not achieve
that goal. Instead, capital income taxes significantly
reduce local incomes by distorting the economy and
thereby reducing the productivity of local labor and
other productive factors.
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3. Efficient tax policies make
everyone better off.
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Efficient tax policies minimize distortions to resource
allocation.
Often there are apparent conflicts between efficiency
objectives and distributional objectives.
These conflicts can be real, but may be misplaced in
evaluating particular taxes, since there is more than
one way to redistribute income.
Generally speaking, governments should redistribute
income in the most efficient manner, and not by any
possible means and with every available tax.
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Implications.
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For example, taxes that might be attractive because
they help to protect the environment or correct other
problems may be undesirable on distributional
grounds.
The distributional consequences of environmental
taxes can be remedied in other ways, notably,
through changes in income tax schedules.
An efficient system is one that pursues every goal
efficiently, which then offers more for everyone,
including more effective pursuit of efficiency and
distributional objectives.
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4. Markets work; the economy
is in general equilibrium.
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All markets clear in general equilibrium,
which implies that everything affects
everything else.
There is evidence that not all markets
work perfectly all of the time, but these
deviations from market efficiency –
which are of great interest to academics
– tend to be very small.
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Implications.
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Economic adjustments, including bankruptcies and
plant closings, can be signs of economic health.
When some firms close, others open using the freed
resources.
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This is progress; this is why we are not all still farmers.
Practical applications of general equilibrium:
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Imposing a much higher tax on gasoline reduces consumer
purchases in Detroit, and thereby reduces state sales tax
collections in Michigan.
The principle that markets work – the “law of one price” implies that VAT border adjustments do not stimulate
greater exports.
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5. Broad-based, low-rate tax
systems are not optimal.
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Many bad tax systems share the attribute of having
narrow bases and high rates.
It does not, however, follow that broad-based, lowrate systems are optimal. (Though they may be
better than various bad alternatives.)
Economic theory indicates that price-insensitive
activities should be taxed at higher rates than pricesensitive activities. And economic theory calls for low
capital tax rates. There is no theoretical case for
broad-based low-rate tax systems.
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Implications.
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The idea that all income should be taxed at
the same rate may have political or other
practical appeal, but such policies are costly
in economic terms.
One might want to distinguish:
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Capital and labor income.
Domestic and foreign income.
Capital gains and ordinary income.
Other forms of income that differ in their price
sensitivities.
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