Your Money or Your Life

by Sheldon Richman

  Taxation, the late economist Murray Rothbard wrote, separates production from distribution. In the free market, production and “distribution” are two aspects of a single phenomenon. To be precise, in the market income wealth is not distributed; it is produced and exchanged. But as soon as taxation is introduced, there is a new factor: the allocation of the wealth extracted.3 Taxation creates two classes that do not exist without it: tax producers (payers) and tax consumers. Taxpayers are the creators of wealth. Tax consumers are those who receive some or all of their income from tax revenues. Rothbard, drawing on the Southern statesman John C. Calhoun, emphasized the implications that this class division has for society, particularly how it undermines social harmony by creating a conflict of interest among the two groups.

  Most discussion of taxation assumes that the people at large benefit from government spending and that the benefits outweigh the costs of taxation. One of the few political economists to question that assumption was the Frenchman J.-B. Say in the early nineteenth century. In his classic work, A Treatise on Political Economy, Say discussed taxation in the chapter titled “On Consumption.” Taxation is not usually thought of as a consumption activity. But for Say, taxation and government spending are not investments by the state. They are, indeed, acts of consumption. He said a tax is imposed “by the ruling power … for the purpose of supplying the consumption it may think proper.”4 And in Say’s view, “It makes a vast difference to the public prosperity, whether the individual or the state be the consumer.”5 He called the claim that taxes are payments for services “a gross fallacy [because] the value paid to government by the tax-payer is given without equivalent or return.”6

  According to Rothbard, calling government spending “consumption” is entirely justified because through taxation government officials substitute their preferences for the preferences of those who produced the wealth. Government “investment” is not driven, as market investment is, by the choices of consumers, but by those of politicians, bureaucrats, and their clients. “Once let the tax be eliminated, and the producers are free to earn and consume. The new investments called forth by the demands of the specially privileged will turn out to be malinvestments.”7 Say would have agreed. He pointed out that the diversion of capital from private to government purposes reduces the well-being of society, “for industry may be presumed to have chosen the most profitable channel.”8 In other words, entrepreneurs seeking profit are better at satisfying the needs of people than bureaucrats. They have a stronger incentive to be so, and they have the best reality check known: the profit and loss system. Businessmen who fail to satisfy consumers lose access to capital; those who succeed earn profits. Government programs tend to work in the reverse. Bureaucrats have no incentive to serve the people at large (special interests dominate), although all are made to pay. Moreover, a government program is likely to receive more money if it fails to accomplish its goals.

  Say insisted that taxation depresses production. “The subtraction of a product must needs diminish, instead of augmenting, productive power,” he wrote. “It is a glaring absurdity to pretend that taxation contributes to national wealth by engrossing part of the national produce, and enriches the nation by consuming part of its wealth.”9 Implicit in Say’s discussion is the view that anything worthwhile the government now does could be accomplished more efficiently without taxation.10

  To appreciate how income taxation reduces prosperity from what it could be, imagine a 100 percent tax on incomes. We wouldn’t expect much prosperity in such a society. People would have no incentive to earn money. They would devote resources to hiding the little they did earn. No investments would be made. No savings would exist to increase living standards. People’s activities would be grossly influenced by the tax.

  If we lower the rate from 100 percent, the principle does not change. The reduction merely lessens the effects of the tax. Other things being equal, the degree of prosperity in a society laboring under an income tax must be less than in a society without an income tax. If you want less of something, tax it.

  We saw in chapter 2 the results of that principle. In the discussion of fairness, it was noted that when the top marginal tax rate is lowered, the top filers produce more wealth and then pay a greater portion of revenues than previously. The top marginal rates are indeed a disincentive for the people in the best position to invest. The principle is also illustrated by the fact that the share collected from the top 1 percent shrank after President Clinton raised the highest rate from 31 percent (where President Bush had pushed it) to 39.6 percent.11 When the disincentive to produce is increased, those with resources turn to leisure. They lose out, but so does the rest of society. Lost production through taxation harms everyone.

  An income tax must lower living standards. The tax reduces the compensation from work and investment and tampers with the natural incentives of the marketplace. That could have different effects on different people, but either way, their standards of living will be diminished. The tax on work could make leisure appear more attractive. If so, fewer tradable goods would be produced, making everyone poorer. But the loss of income might prompt some people to work more hours and give up leisure. The choice will depend on the subjective preferences of individuals. What matters is that the allocation of time between work and leisure has been upset by the government’s forced extraction of wealth. Whatever a given person chooses, he is worse off than if the tax had not been imposed. The person who gives up work for leisure because of the tax will miss out on consumption and savings (for future consumption) that he would have engaged in. The person who gives up leisure for work will miss out on the satisfaction his leisure would have brought. In each case, the person’s first choice has to be shelved for a less-preferred option.

  A flat-rate, proportional income tax generally diminishes ability to produce, save, and invest simply by reducing the pay-off from work and by siphoning off capital. The more you earn, the more you pay, although the percentage remains the same. A progressive income tax can magnify that malevolent effect.12 As a person earns more income, the tax rate increases. Thus, a progressive rate is a system of increasing disincentives to produce wealth. The difference between the pretax and after-tax return widens as people earn more money. For example, if at some level of income the tax rate jumps from 15 percent to 25 percent, an earner will have to calculate whether the extra effort required to raise his income is worth only 75 percent of the nominal return. He may decide it is not. That issue is more obvious at high levels of income when the rate structure is deeply progressive and the top rate is 70 percent to 90 percent, as it was in the United States between World War II and 1970. But the effect exists in diminished form at lower levels also.

  Taxes on capital gains and corporate profits similarly create disincentives to produce. Since they reduce the return on investment, those taxes must affect investment decisions adversely for general economic well-being. The taxation of capital gains has other effects. By lowering the return on the sale of stock and other assets, the tax encourages people who own those things to hold on to them longer than they would have. Such tax-driven decisions reduce investment in new enterprises that would benefit millions of people. Taxation of capital gains thus makes the market process rigid and undermines it. Moreover, in times of inflation, investors pay on illusory gains because the tax is not indexed. Actual losses may be taxed because inflation makes them appear to be gains. It is no accident that (other things being equal) nations that have lower capital gains taxes, or none at all, have a greater rate of savings and domestic investment and more robust economic growth.13

  Incidentally, defenders of the capital gains tax portray it as a tax on the rich. Even if that were so, it would not be a good reason to keep the tax. The rich have rights too. But in fact, it is not correct. The Tax Foundation has revealed that from 1942 to 1992, about a third of the capital gains tax was paid by people making less than $100,000.14

  Another way that the income tax does harm is t
hrough the double taxation on savings. Money saved is taxed the same as money put toward consumption; so is the resulting interest income. That would seem on the surface to be even-handed treatment of all income. But actually it is not. The paradox is resolved by realizing that savings and consumption have an important difference: the time dimension. People save in order to consume more (thanks to interest) in the future, and that fact has important tax implications.

  Imagine that someone is deciding what to with $1,000 just earned. That person will compare the satisfaction he can obtain from direct consumption, say, buying a big-screen television, with the future income that could be generated by investing the money in a CD at the bank. The $1,000 is taxed at the relevant rate whether the money is consumed or saved. Our earner will have to buy a smaller television or save less than would be possible if the tax didn’t exist. But the tax will reduce the investment a second time, because the interest on the CD will also be taxed. In other words, the returns on consumption, being nonmaterial, are not taxed. But the returns on savings are. In that way, the income tax penalizes investment more heavily than consumption.15

  The implications for decision-making and economic progress are significant. The National Commission on Economic Growth and Taxation said that because the income tax reduces the return from investment “saving and investment must earn substantially higher returns to cover the added taxes and still be worthwhile substitutes for consumption.… The current biases in the tax treatment of capital have cost the economy several trillion dollars in savings and investment, considerably retarding the growth of productivity, wages, and employment, and retarding the growth of individual income and wealth. It is no exaggeration to suggest that the level of income in the United States could be at least 15 to 20 percent higher than it is today if these biases did not exist.”16

  A chronic complaint about America is that the savings rate is too low. It is often pointed out that nations (such as some in Asia) that do not tax savings, or that tax them at a lower rate, have higher savings rates. That is to be expected. But some comments are in order. There is no special vice in taxing savings versus consumption. Taxing either one diminishes well-being. People allocate their income between consumption and savings on the basis of their subjective preferences. Their decisions should rule. The proper aggregate savings rate is the one that emerges from the free decisions of all market participants. What is wrong with taxation is that it interferes with those decisions, not that it burdens savers. Champions of liberty and consumer sovereignty should not imply that it is better to tax consumption than savings, for that suggests that it is more virtuous to save than consume. What if a free people saves “too little”? Should there be a government program to induce people to save more? Government is best kept out of private decision-making.17

  The upshot is that the government should stop discouraging savings. But that is different from saying that it should encourage it.18

  The penalties and disincentives of the income tax obviously take their greatest toll on those who have little wealth now. The tax is inherently tougher on people trying to accumulate wealth as opposed to those who already have done so. Although in 1986 many low-income people were dropped off the tax rolls, that obstacle is not entirely gone from the system. Moreover, as already indicated, the tax on high-income savers and investors hurts low-income people, who are deprived of new opportunities and products. Consider the crazy logic of the welfare state. Government subjects people to grueling taxes, which especially impede lower-income people from climbing to a higher living standard. Then it throws them bones in the form of subsidies. If the policymakers really cared about lower-income people and understood even a smidgen of economics, they would get rid of all income taxes and subsidies. That would be the best way to help people climb the economic ladder.

  Manipulation via the Tax Code

  The people who write tax legislation are aware of the disincentives involved in progressive taxation, and they have tried to mitigate those effects without giving up progressivity altogether. That has resulted in the crazy-quilt system of tax deductions and credits that so many people complain about. It should be pointed out that most of these preferences benefit those who are better off. First, they more often apply to the activities of the better-off. Second, expensive tax advice, which most middle-class and working-class people can’t afford, may be needed to take advantage of them. Finally, deductions are worth more in the higher tax brackets.

  Given the objections to progressivity, the lowering of the real tax rate through deductions and credits may seem like a blessing. But they bring their own problems. The methods used to offset the system’s disincentives influence people’s behavior, undermine the efficacy of the marketplace, and increase the burden of the tax process. That is because the preferences target particular activities chosen arbitrarily through the political system.

  To the extent that economic activity is directed by the tax-bill writers and the people who influence them, the market process is less capable of serving the public than it would otherwise be. If a deduction is allowed for activity X but not activity Y, people will tend to pursue activity X. The people who write the tax code may think activity X is more worthy than activity Y, but that could be an arbitrary decision. And even if it is not strictly arbitrary, their decision is presumptuous, for it interferes with the free decision-making of market participants. Besides, if X were really more worthwhile, it would be chosen without government encouragement. In a free market, consumers determine what investment activities are undertaken in the market because serving consumers is how entrepreneurs earn profits. When the tax code distracts entrepreneurs from that task, society is worse off. The code’s jungle of technical rules regarding deductions, allowances, depreciation schedules, and the rest (all of which would be abolished along with the income tax) is a massive intrusion into the entrepreneurial process. Instead of concentrating on how best to increase people’s living standards, businessmen must be concerned with minimizing the taxes they have to pay. Taxes reduce the returns to investment, of course, and thus make some worthy projects uneconomical. Moreover, to minimize taxes, entrepreneurs may have to do wasteful things that reduce prosperity. That is most obvious with tax shelters, in which people can cut their taxes by engaging in explicitly unproductive activities. Although tax-law changes have made most tax shelters passé, that aspect of the code is not gone entirely. For example, since the interest on municipal bonds is tax-free, money that would have gone toward satisfying consumer preferences instead is dedicated to local projects.

  We should not underestimate how manipulative the government can be through the tax code. Depending on how it treats real-estate investments, the government can, and has, set off booms and busts, creating and then wiping out fortunes. The infamous S&L crisis was precipitated in part by a change in the tax rules for real estate in 1986. A seemingly small tax change can destroy someone’s business plans and profits. Or it can make someone else a millionaire. Imagine the potential for corruption.

  A perfect example of how tax preferences distort decision-making is the exemption of employer-provided medical insurance from taxation. People ordinarily would prefer cash to benefits. But since cash compensation is taxed and insurance is not, workers have an incentive to accept more of their pay in the form of insurance. As a result, people most likely use medical insurance to a far greater extent than otherwise — even for small, routine expenses. Because of the overhead, first-dollar medical coverage would probably be a bad buy. (People don’t buy such coverage for their automobiles.) But the perception that medical services paid by insurance companies are free (or close to it) encourages consumers to be complacent about price. They unwittingly bid up the price of services and in turn the price of insurance. The government then uses price inflation as a pretext for taking over the health care industry.19

  The problem is not that the government exempts medical benefits from the income tax. The problem is that it applies the tax to everything else.
Note that a leading policy response to the distortion from the medical-insurance exemption is tax-free medical savings accounts. While MSAs expand the tax exemption, they also maintain the distortion on behalf of medical spending, since the money can only be used that way. Far better to abolish the tax and the preferences, letting consumers and investors make their decisions without government manipulation.

  Because changes in the tax code can create opportunities for higher incomes, special interests spend a great deal of time lobbying the tax-writing committees for favorable changes. That is one reason the code changes so often. The process is hardly a search for the tax code that will best serve the public. Rather, it is a process in which special interests lobby their political friends for favors. And congressmen, always with an eye on the next election and in need of campaign donations, are eager to please people who can deliver money and votes.

  Who’s left out? Average taxpayers, of course. They are too busy raising their families and making a living to become informed about arcane tax-law changes, let alone to go to Washington, D.C., to lobby against them. Naturally, the changes tend to benefit small, well-organized groups and harm the vast majority of citizens.20

  For the public-choice school of political economy, this is known as the problem of “dispersed costs” and “concentrated benefits.” The cost of any particular tax change will be spread thin over the majority of citizens, making the burden on any individual small. Even if an individual understood what was happening (a big “if,” given how technical and invisible the tax-legislation process is), he would have too small a monetary incentive to fight the change. In contrast, the benefits of the change are concentrated on a small special-interest group. The value to any individual member is large. He has a strong incentive to be informed about such issues and to support lobbying activities, perhaps through a trade association in Washington. Tax-law writing tends to be done by a closed clique of congressmen, tax officials, and special interests. The average taxpayer doesn’t stand a chance under those circumstances.