The Case Against
“Progressive” Taxation
Reykjavik, Iceland
November 16, 2012
What Is Economic Growth?
More labor
More capital
Better efficiency of labor
Better allocation of capital
Labor and capital are the ingredients
The chef mixes the ingredients
Years Needed to Double Economic Output
7 percent growth
6 percent growth
5 percent growth
1
4 percent growth
3 percent growth
2 percent growth
1 percent growth
0
10
20
30
40
50
60
70
80
Two Fundamental Fiscal Issues
What’s the appropriate – or growthmaximizing – size of the public sector?
Classical liberal vision?
Welfare state?
What’s the best (or least worst) way of
extracting revenue?
Low rate and broad based?
Punitive and redistributive?
Not All Gov’t Spending Is Equal
Core public goods such as rule of law and
protection of property rights associated with
growth.
Physical and human capital spending can be
helpful to prosperity…or it can be wasteful
and inefficient.
Transfer and consumption spending are
unambiguously linked to weaker economic
performance.
Size of Government Matters…a Lot
There is a “Rahn
Curve” relationship
between
government
spending and
economic growth
similar to the “Laffer
Curve” relationship
between tax rates
and tax revenue.
Burden of Government Used to be Small
50
Expenditures as a percent of GDP
45
Sweden
40
UK
35
US
30
Japan
25
Germany
France
20
15
10
5
0
1870
1913
1920
1937
Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"
1960
Burden of Gov’t Today Is Large
Average burden of spending in advanced
nations is more than 40 percent of GDP.
Most of that spending is for transfer and
consumption outlays.
This leads to misallocation of labor and
capital, reducing prosperity.
It also means ever-higher tax burdens that
penalize productive behavior.
What is Good Tax Policy?
Tax economic activity at a low rate.
Define the tax base correctly, taxing
economic activity only one time.
Tax all economic activity alike, since neutrality
ensures economic criteria rather than tax
provisions determine resource allocation.
Tax only economic activity inside national
borders, the common-sense notion of
territorial taxation.
Why Have a Low Tax Rate?
The marginal tax rate – the burden on the
next increment of income – must be kept low.
A low marginal tax rate rewards productive
behavior. People will work more, save more,
and invest more.
Incentives to hide, shelter, under-report
income are lower when the marginal tax rate
is reasonable.
Research indicates that the marginal tax rate
should be no higher than 20 percent.
Why Tax Income Only One Time?
Many nations impose multiple layers of tax
on income that is saved and invested.
This is the wrong definition of the tax base.
Taxes on interest, dividends, capital gains,
and inheritances are examples of the
discriminatory treatment of capital.
This is a self-destructive policy since it harms
the activity – capital formation – that all
economic theories agree is necessary for
economic growth and rising living standards.
Why Neutrality?
Government should not pick winners and
losers.
Special preferences and penalties distort the
allocation of capital and undermine efficiency,
leading to lower incomes.
Special preferences and penalties also
encourage taxpayers to squander time and
energy in search of political advantage
instead of concentrating on productive
behavior.
So Why Have One Tax Rate?
As a matter of economic theory, it doesn’t
matter.
Iceland’s former flat tax system was not as
good as the “progressive” system in
Singapore.
The single rate in Iceland was almost twice as
high as the top progressive rate in Singapore.
The goal is to have low marginal tax rates.
The Moral Argument for One Rate
The rule of law should apply equally to
everyone.
If you apply for a license to run a business,
the rules shouldn’t vary based on your
income.
If you commit a crime, the rules shouldn’t
vary based on your income.
If you file a property deed, the rules shouldn’t
vary based on your income.
The Taxpayer Unity Argument
A so-called progressive system allows
politicians to play divide and conquer.
They can target one group of taxpayers in a
certain year.
Then they can target another group the next
year.
Because only a small group of taxpayers each
year are affected, politicians can more easily
raise taxes.
The Massachusetts example.
The Administrative Argument
Having one low rate, broadly applied,
minimizes the compliance burden for both
taxpayers and the state.
But the broad and neutral tax base is very
important.
A single rate, however, is important if you
want to tax capital income at the source.
That also enables considerable simplicity.
Protecting the Poor Argument
This is not about the existence of a “zerobracket” amount.
Instead, it is the notion that keeping tax rates
low on the “rich” is the best way to keep tax
rates low on the poor.
In western nations, tax increases follow a
pattern – class warfare provisions followed by
tax increases on the less fortunate.
Look at history in the U.S. and U.K.
The Laffer Curve
Higher tax rates discourage people from
earning and reporting income.
To determine the impact of a tax policy change
on tax revenue, which effect dominates: The
rate change or the change in taxable income?
Answer can vary over time since even small
changes in long-run growth rates can have a
large effect over time because of
compounding.
Tax Rates, the Rich, and Revenue
In 1980, there were
116,800 rich people.
Those rich people
reported $36.2
billion of income to
the IRS.
They paid $19.0
billion of income tax
to the federal
government.
Tax Rates, the Rich, and Revenue
In 1980, there were
116,800 rich people.
Those rich people
reported $36.2
billion of income to
the IRS.
They paid $19.0
billion of income tax
to the federal
government.
By 1988, there were
723,700 rich people.
Those rich people
reported $353.0
billion of income to
the IRS.
They paid $99.7
billion of income tax
to the federal
government.
Conclusion
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Twitter: @danieljmitchell
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