Taxation and Economic Self-Harm

Vikas Shah June 03rd 2010

Manchester Business School – Transforming Management - http://shah.tm.mbs.ac.uk

There is little doubt that taxation is an economically necessary and ethically valid part
of society's structure. "Taxes" stated Oliver Wendell Holmes Jr. "...are the price of
civilisation."

Many cite taxation as having four 'key' roles in society,

1. The generation of revenue for the state to provide infrastructure, education,

defence, welfare, public services and so forth

2. The re-distribution of wealth from the richer to the poorer parts of society to
aid social development and reduce economic inequality.

3. The re-pricing of goods and services to address negative externalities (such as

tobacco levies to discourage smoking)

4. The representation effect whereby a population (in theory) expects

accountability and democracy as their part of the taxation-process.

This utopian view of taxation is fundamentally an efficient system which, as Wendell

Holmes Jr. suggests above, provides the 'working capital' which is required for the
operation and development of any economies support-system (interestingly, the same
principles remain true regardless of the 'mode' of operation of society- be it
capitalism, communism, or otherwise).

Policymakers often seem to take taxation out of this ethical and efficient context, and
apply it in an economically destructive way.

Economic Engines

We often hear economic issues being cited as 'systemic' by governments. In context,

they are quite right. Economies are complex machines, with engines of production
and consumption. In general, these engines (namely private enterprise, and private
individuals) off-set the social cost of their activities with the value their activities
generate, and together they form a system which (regardless of its efficiency) creates a
market for (and of) goods and services. This market creates jobs and assets, together
with generating economic wealth for citizens and private-enterprise, which contribute
to the overall development of a state. In that sense, there is a positive economic
contribution to their actions.

Within a contemporary economy, there also exist activities which have negative
effects, outweighing their economic and social-cost. In economic theory, these are
referred to as negative-externalities. Externalities, very simply, are the non-priced
costs (or benefits) which are incurred by a party who did not agree to the action
causing the cost or benefit.
The most commonly cited negative externalities are environmental (such as pollution,
climate change, and so forth) but there is a clear case to see that certain activities
within banking-markets have contributed to our global economic conditions- creating
immense wealth for some (the principals of those firms, and trades) with a huge
negative social and economic cost for wider society who, in effect, bore the systemic-
risk for their transactions.

Taxation, in theory, should aim to not only offset the balances of economic inequality
in a social context, but also be applied in a fair and just way across the society they
are relevant to.

In most western democracies, the application of taxation seems drastically mis-

applied. Governments are keen to levy brutal taxes on the very engines that create the
market for goods and services; lowering their propensity to spend and invest by
removing the surpluses they would normally use to do so. Removal of these surpluses
also contributes to removal of psychological incentives, and we commonly see high
earning individuals and organisation re-locate to avoid such taxes. With a few
exceptions, most participants in a society (be they commercial or individual) realise
that taxes are part of their social contract, and negative views towards taxation tend to
only appear where society feels the method of application, or ultimate end-use of
these taxes are not in the public interest.

The Pigovian Solution

Arthur Cecil Pigou was an English economist who created the notion of Pigovian
Taxation whereby taxes are proportionally levied on activities which generate
negative externalities. In this sense, the Pigovian tax is thought to provide society
with additional revenue to cover the social-cost of the market activity generating the
negative externality.

Many of the world's leading economists cite a strong case for an approach based on
these principles. In recent times, we have seen the emergence of many situations
where just such an approach could have been beneficial- with industries ranging from
banking to manufacturing, transport, and farming generating numerous negative
externalities, at great private benefit to individuals and firms.

The application of such taxes has caused immense debate in academic circles- and has
been effected, in a small way, through the application of carbon-taxes, and pollution
levies (though poor policy planning means that all of these regulations can be
gamed).

Fundamentally, though, policymakers have to re-assess the basis on which society is

taxed, to create a fairer structure which encourages economic development (through
spending and investment) and positive externalities (such as increases in wealth,
education, health, and so forth) while applying heavier charges to activities which
generate severe negative externalities without providing an economic or social
benefit. The current system, as we discussed above, hampers economic growth by
taxing the very engines which would contribute to it.
Quantifying such externalities is always difficult, and some argue that such taxation
would cause massive market-distortions (though my view remains that unfair taxation
cripples economic development in a manner not dissimilar to third-world economic
corruption).

The challenges for applying a Pigovian approach are also numerous when considering
the power and influence carried by industries generating these negative externalities;
such as energy, manufacturing, tobacco, defence and more.

The solutions for this may come through technological intervention. We can now,
more accurately than ever before, view the transactions occurring within our system,
identifying the originator(s), beneficiary(ies) and intermediaries along the chain. For
policymakers, the 'trick' may be to identify activities which occur, generating negative
externalities, and apply taxation on the transaction chain itself- thereby making the
activity itself the tax-point- rather than the firms themselves. Such models have been
proposed already for speculative derivatives trading, the foreign-exchange market,
and certain modes of equity trading (increasing duties on short-term trades, for
example).

For companies engaging in such activities, a transactional levy will be a bitter pill to
swallow, as it creates (in their view) a transactional inefficiency which could (and
will) lead to them relocating to alternative markets. The need, therefore, is for co-
ordinated global action on these activities; ensuring a lack of shelter for these
activities, less restrictive taxation regimes on those who contribute as engines to
development, and policymakers who, rather than bowing to the economic might of
certain agents, realise that all participants in a society have a responsibility to it's
social contract.