What Makes a Tax Go Bad?

taxman7A former student asked me to write up a piece on pro’s and con’s of different types of taxes. Of course all taxation is armed robbery. But whether you’re running a protection racket or voting in a democracy, it’s worth getting into why particular types of taxes are chosen, and whether one type is “less bad” than others.

Although there are as many taxes as there are bureaucrats to dream them up, broadly speaking they can be arranged into 3 categories: consumption, income, and wealth.

Consumption taxes can be on most spending (a “sales” tax or VAT). Or they can be taxes on particular things, like phone service, alcohol, or cigarettes, in which case they’re “excise” taxes. Or “sin” taxes when the government doesn’t like what you buy.

Next up: income. Taxes on income can either target all income (“income tax”), or they might treat investment income  differently, using “capital gains tax” or specific rates on interest or dividends . Rates on investment taxes are sometimes higher than income tax, sometimes lower, depending on whether voters understand that investment creates jobs, or if they think investors are idle parasites.

Finally, there are taxes on wealth. Aside from property tax, these aren’t very popular today, mainly because they cause a lot of economic trouble for very little collections. More about wealth taxes in a minute.

Which Tax to Use?

The two main considerations to choosing the right tax are economic efficiency and “fairness” (morality). Economically, whatever you tax you’ll get less of. So a consumption tax reduces consumption, an income tax reduces work, a capital gains tax reduces investment, and a wealth tax reduces wealth.

This means that a consumption tax is economically the “best” (most efficient) tax, since consumption doesn’t build the economy — it consumes. For the same reason, capital gains and wealth taxes are the “worst taxes,” since investment is the main thing that does actually build the economy.

Income taxes are somewhere in-between; in the short-run people don’t really work less if their income is taxed higher, but in the long-run they become artists and bartenders instead of engineers and surgeons. That is, they take their income in (untaxed) quality-of-life instead of (taxed) money income. You can decide whether you think the world has enough artists and enough surgeons.

On the moral side, it gets more complicated. Consumption taxes are relatively egalitarian — everybody pays in proportion to what they spend. If I spend twice what you spend, I pay twice the tax. Simple and elegant. Since rich people will in the long run spend in proportion to their income (why else bother earning income but to spend it), this means consumption taxes are functionally “flat taxes” — everybody pays the same percent.

And here’s the rub, morally. Some people don’t like egalitarian taxes; they want the rich to pay a higher rate. Politicians often cater to these anti-rich sentiments, since most voters aren’t rich. Besides, politicians can trade tax loopholes to the rich for campaign contributions.

Of course if you’re a super-egalitarian you’d go one step further: for a “per capita” or “head tax”, where everybody pays the same dollar amount. This is, of course, is how everything else works: everybody pays the same amount for a hamburger, a new car, or a driver’s license. The left tends to really hate per capita taxes, since they can’t punish the rich — of course they’d phrase it as “we can’t help the poor” which is logically identical to saying “we can’t punish the non-poor.” An economist might respond that the way to give the poor more money is to actually give the poor more money, rather than using them as an excuse to make the tax system blatently discriminatory.

Summing up, while all taxes are evil, if you’re going to have a tax then the most pro-growth tax is consumption, followed by income, with capital gains or wealth taxes being the least efficient. Meanwhile, if you’re an altruist who loves all equally, you’d actually prefer a per capita tax, then the same order — consumption, then income, with wealth taxes again being the worst.

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