What is a fair tax?

An election year takes us back to a debate that goes back to 18 th century.

States, ancient and modern, have to balance their expenses and revenues. The problem was acute for medieval rulers who effectively governed only a small portion of their kingdoms. Over the rest he had only nominal authority as they were the fiefdoms of local barons. The king obligates the barons to make payment in kind and in money and provide soldiers in times of war. The barons in turn extracted even more from the local population forcing them to a state of destitution. There were no national norms relating the dues to the status, wealth or income of the payee. 1 Beginning of the sixteenth century, political and economic changes required maintaining standing armies to defend the state and navies to protect international trade along the newly discovered routes to Asia and the American continents. These changes presaged centralization of power and rise of absolute monarchies. Taxes were imposed on production and sales of goods within the nation and on imports from foreign countries. These taxes added to the prices of goods and the increase in price was the source of revenue for the state; since consumers were not paying directly to the treasury, such taxes are classified as indirect taxes. Direct taxes on income and wealth became widespread only in the twentieth century. Average citizens resented the dictates of the autocratic monarchs. During eighteenth century a number of philosophers provided the rationale for a democratic political order that respected the right of individuals. John Locke (1632 -1704) considered the father of liberalism argued that an individual has right to the fruit of his labor and the taxes should be levied only to provide protection to individuals and their properties. In a strict interpretation of this argument, no one should be taxed to promote other social objectives that benefit many without the consent of the individual paying the tax. Robert Nozick, a twentieth century political philosopher, is known for his arguments in favor of such an interpretation of property rights. In contrast the utilitarians following Jeremy Bentham (1748 832) argue that state should strive to maximize the collective welfare the society. Over and above law and order, public preferences may require actions to minimize poverty levels, improve education and clean up the environment. The taxes needed to provide these services can be levied if they are approved through a democratic process. Such ideological differences underlie the current debate on taxation in the United States.

For a short description of the debate see, Opportunities and choices, pp.13-15.

Adam Smith (1723 -1790) in his book, An Inquiry into the Nature and Causes of the Wealth of Nations (widely referred to as the Wealth of Nations), sets out four principles for designing a efficient and fair tax system. The first one states: The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state. In a primitive economy that John Locke visualized in his argument, the product of ones labor in hunting and farming is easily identified. In modern economy the output is from the cooperative effort of many individuals. How much of the success of a corporation depends on the floor workers, how much on the middle management and how much on the chief executive officer? What does it owe to the society for the law and order, the social infrastructure in education and transportation, and for a legal system that clearly defines property rights and enforces it efficiently? If the income of the upper strata owes their affluence to social environment, it is fair that they contribute more to the revenue of the state. This principle do not explicitly state whether the tax rate should be flat or progressive; it depends on whether the goal is protect property rights or to maximize social welfare. The second principle of taxation states: The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person. In the first sentence is a rejection of the arbitrary levies charged under feudalism. He then goes to argue that the tax liability should be plain to the contributor and to every other person. While the tax schedule is publically available, many individuals can pay less than the tax based on the schedule by taking deductions like interest on mortgage and lower rates for capital gains. The net loss in revenue from such reductions is estimated at $1 trillion and 67 percent of it is from deductions made by the top fifth of the population income wise. 2 While possible deductions are published in the tax code, the richer individuals have flexibility in making decisions to use the tax deductions that the less fortunate do not have. Deriving most of their incomes from bonuses or investments, they can legally minimize their taxes by adjusting the timing and sources of income. His tax liability is not explicit to others. Those using tax breaks can be compensated for the change by government programs for their benefit. Today deduction of mortgage interest is encouraging those buyers to shift to larger houses. Those with lower incomes cannot afford even a small house. The government, in providing assistance to low-income Americans to meet rental costs, is incurring expenses. Consider a hypothetical situation where the government removes mortgage-interest deductions but expends the amount on providing housing assistance to those who lost the deductions. There is no net loss either to the government or to the homeowners. In this sense, the loss in revenue
2

Eduardo Porter, A Nation of Too Many Tax Breaks, The New York Times (March 15, 2012) p.B7.

from tax breaks can be viewed as tax expenditures. The term has created controversy and I prefer to call it tax discounts. Tax breaks infringe the requirement of being clear and plain to the payer and others. As benefits goes mostly to the well-off, it might breach the criteria of welfare maximization. The third principle is: Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. Provision for salary deductions and payment of estimated taxes are in the spirit of this principle. The fourth principle demands: Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state. A tax may either take out or keep out of the pockets of the people a great deal more than it brings into the public treasury . . . First, the tax system is such that its cost of collection is very high and the net revenue the state receives is much less than what is charged to the taxpayer. Next he argues the tax can discourage individuals from productive activities and the reduction in income is in addition to the tax levied. Whether the present taxation or policies proposed by the current administration will do so is a topic of much debate in the election year. Supply-side economists argue that a tax reduction can increase tax revenue as individuals will have incentive to undertake more income generation activities. For an example, consider an individual earning $100,000 a year and paying 20% tax rate; if a reduction of tax rate to 15% induces him to undertake activities that earn $134,000, the net tax revenue for the state will increase. There is no evidence that it will happen in the United Sates while there are other countries where a reform of both property rights and tax rules can lead to spurt in national income and tax revenue. Whether the incentive effect of a tax cut will increase the rate of growth of the US economy is another topic of debate in this election year. The two and a half centuries old guidelines of Adam Smith provide a useful framework to evaluate contemporary tax debate. Rama V. Ramachandran
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