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Can there be tax reform without redistribution?

Many nations around the world the United States, the United Kingdom, many nations in the European Union and India are facing unsustainable budget deficits and need either to increase revenue or reduce expenses or choose a combination of the two. While there is consensus on the need for fiscal reform, the disagreement on how it is to be done has created serious controversies. As United States, tax reform is one of the controversial issues in the upcoming presidential elections and will be aired in the debates between presidential candidates. In Europe, there are riots in Mediterranean nations that are cutting public expenditure and increasing tax collection to reduce budget deficit. In India, the change in economic policy that includes changes in taxation is threatening the stability of the coalition government at the Center (Federal cabinet). What can be said about the feasibility and consequences of fiscal reform without being an advocate of one side or the other? The Institute of Fiscal Policy, an independent non-profit organization in London devoted to research on fiscal issues, published at the end of last year a two volume study of taxation in the United Kingdom. The study was authored by eminent economists headed by Nobel Laureate economist, James Mirrlees. Even though it is focused on taxation in one nation, the expertise of those who wrote it and the thoroughness of the study provide insights useful to those involved in fiscal reform world over. Taxing seen as a device for collecting revenue for the state is game: for each action by one party, there is a reaction by the other. The two parties are the government wanting to maximize revenue (subject to the law) and the taxpayer who wanting to minimize paying it.1 One reason why tax laws are complicated is that the state has to make rules to collect the needed revenue considering the strategies tax payers will adopt to circumvent them. Every year, at time of filing for taxes, there is widespread demand that tax forms should be simplified. It is like hoping that the strategy in a football game can be reduced to two: throw or run! In a competitive economy, a buyer and seller of a product balances the cost and benefits to each from the transaction and enters into an exchange if both feel that he or she is better off from the exchange. This is possible if the seller can restrict the sale to those who pay and the buyer exclusively enjoys the benefit for the product or service purchased. There are services, like national defense or clean environment that are public goods and benefits many in so far they are offered whether they pay for it or not. Provision of such services is financially feasible only if there is an authority able to collect the cost of production through taxes. 2 Modern states provide some services that like the poor, the old and the sick in which the benefits are restricted to the groups alone. Because their economic condition, the taxes to finance these services are collected from others and this is form of redistribution. It is in the nature of taxes and public expenditure that some benefit more than the others. Tax reform necessitated by deficits changes the distribution of benefits among the various segments

2 of the society and in that sense, involves redistribution. In democracy the public can choose the tax reform they want but whatever the choice, the burden of taxes on different groups will change. Since redistribution in unavoidable, the challenge is to choose a tax schedule that meets public approval. Any tax system must satisfy three criteria: (1) tax system must be socially acceptable; (2) it should be efficient in the sense discussed below: and (3) it should be viewed as equitable. England used to tax houses based on the number of windows; no wonder some of the old houses looked like dungeons. In earlier centuries, many countries had state religion and additional taxes were levied on those residents who did not belong to it. Such taxes are no more socially acceptable. Efficiency requires that the tax system must have least distort the economy. Taxation of labor income will induce employees who would have entered the market to drop out, may make those already working work less. It may change their investment in education and careers they choose. High earners like managerial employees will have less incentive to work long hours. In addition, individuals in high-tax economies have greater incentive to tax avoidance (gaming the tax rules for minimizing taxes) and tax evasion (which is illegal). Because of the disincentive effects, a tax increase to raise $1, based on current income of an individual, will raise less than $1 as she cuts back on her effort and reduces her income. The elasticity of tax revenue, the percentage change in reported income for a percentage change in tax rate, measures this response. In the debate over Laffer curve, the claim was that it is negative at high rates of taxation and a reduction of taxes will increase tax revenue. Today tax economists including the Mirrlees report assume it to be 0.46. Even more difficult is determining a fair distribution of burden among groups with different levels of income. Most of the discussion in economics follows the utilitarian tradition of maximizing the benefits for the whole society and this may require, under assumptions of utilitarianism, to tax the upper income individuals for services whose beneficiaries are those less well off.3 One measure for calculating the tax rate is based on a measure of the upper trail of the income distribution and, for the United Kingdom, Mirrlees Report takes a value of 1.67. Combining the two measures, they calculate the maximum tax rate must be set at 56.6 per cent. Even as economists accept the magnificent work done by the group of economists, they are unwilling to accept it as the final word on progressive taxation. First of all, recent research in economics questions the assumption that rational individuals maximizing their utility in making decisions. Then the literature pulls in opposite directions. Some use non-utilitarian considerations to make a case for lesser inequality of income if necessary through taxation. Studies of individual behavior, including those done by experimental economists indicate that people are altruist and enjoy giving to those less fortunate; some of it is in the form of voluntary payments but they are willing to be taxed if they know whom and how

3 much they benefit. Other economists following the English philosopher John Lock and German philosopher Immanuel Kant claim that any taxation by depriving the workers of the income they earned, infringes on their property rights (see footnote 4). But as one of the leading experts on taxation warns us about undue precision in calculations like the one in previous two paragraphs: One conclusion that I draw is that we need to highlight the limits of our knowledge . . .4. If this is true for economist, it is all the more true for politicians and that is something to remember in this election season.
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Myron Scholes et al, Taxes and Business Policy: A Planning Approach (Prentice-Hall, various editions). What are public goods that have to be tax financed is debated. Here the relevant point is that some exists.

For a short discussion of utilitarian tradition and its critics, Opportunities and choices: Understanding our economic decisions, pp.13-15.
4

Anthony B. Atkinson, The Mirrlees Review and the State of Public Economics, Journal of Economic Literature, September 2012. P.774.

Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2012 Rama V. Ramachandran