Tax Systems

Conflicts over taxes appear to be nearly as old as government. In the twenty-fourth century BC in the ancient Sumerian city of Lagash, the citizens overthrew their government due to high taxes and selected a new ruler who restored the freedom of its citizens in the first recorded instance of social reform (Kramer 1956).

· Correct: audits can determine that taxes were paid properly

· Encourage legitimate investment

· Equal: people of the same economic situation should pay equally

· Fair: the wealthy should pay at least the same proportion as the poor

· Low cost: collection costs are small in relation to the amount collected

· Neutral: taxes should not favor one business or individual over another

· Stable: revenue should not fluctuate significantly with economic cycles

· Transparent: people should know what is and is not taxed

· Unavoidable: people should not find it easy to escape paying taxes

· Understandable: taxes and calculating amounts due should be simple

Each of the common forms of taxation—excise, income, property, sales, tariff, value added and so on—has different strengths and weaknesses when compared to these criteria. Thus, governments devise complex systems comprised of different types of taxes.

Thanks to complications such as deductions and exemptions, tax rates and tax revenues are not the same. The point is found in John Maynard Keynes (twentieth century), Frederic Bastiat (nineteenth century.), and Alexander Hamilton (eighteenth century). Even earlier, Ibn Khaldun (fourteenth century) in a section of his Muqaddamah (Introduction to History) on “Taxation and the reason for high and low revenues” wrote:

It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments.

Tax rates of 0% and 100% produce no revenue for the government—the latter because taxpayers will stop working, avoid taxes, revolt, establish an underground economy invisible to government, move to another jurisdiction, or some combination of the five, all of which occur as rates increase. Assuming initially that a parabola (Figure 11.1) describes this phenomenon best, two tax rates, one high, one low, produce the same total revenue—the lowest being more desirable based on the criteria above. In the United States, the concept became known as the Laffer Curve and directly inspired the Kemp-Roth tax cuts of 1981. Subsequently, both government revenue and government deficits increased substantially. Liberals pointed to the deficits to justify their opposition. Conservatives responded that the deficits had nothing to do with income and credited both the increase in tax revenues and GNP to the tax cuts. With experience, it became apparent that the Laffer Curve was not symmetrical but positively skewed and that the federal tax rate producing the highest income was substantially below 50%, in part because everyone was also paying state, local and other federal taxes as well. Actual results also justified the insights of early writers. The Laffer Curve meets all of the requirements of good theory. It is usable in that it suggests policy, empirical in that actual results of different tax rates can be tested, and is logical, falsifiable, parsimonious, and generalizable.

David Kamerschen described how it works in a parable of ten men, each representing one income decile in the United States. Every day, they went out together for dinner after work and decided to share the $100 bill the way we pay our taxes:

The first four men (the poorest) paid nothing The fifth paid $1, the sixth $3, the seventh $7, the eighth $12 The ninth paid $18 The tenth and richest paid $59

One day, the owner offered them a good customer discount of $20.

The first five men paid nothing The sixth now paid $2 (33% less) The seventh now paid $5 (28% less) The eighth now paid $9 (25% less) The ninth now paid $14 (22% less) The tenth now paid $49 (16% less)

Once outside the restaurant, one man complained that he only got $1 out of the $20. Another asked why the tenth man should get $10 off when he only got $2. Wait a minute, the first four men yelled, “We didn’t get anything. The system exploits the poor” (ignoring all past and continuing free meals they had had).⁵ The first nine men surrounded the tenth and beat him up. The next night the tenth man didn't show up. When it came time to pay the bill, they discovered they didn't have enough money among them for even half of the bill! The people who pay the highest taxes get the most benefit from a tax reduction. Attack them for being wealthy and they will eat elsewhere. Figure 11.2 gives the latest numbers on 137,982,203 individual US income tax returns, for comparison against the three definitions of “fairness” (Chapter 2):

We see this for real in wealthy individuals with overseas bank accounts and multinational corporations moving overseas. We see it at the state level, as high tax states drive businesses and individuals to those that are keeping their taxes competitive. People who live and work near the borders of states that charge sales tax, such as Washington and California, often make major purchases in states that do not, such as Oregon. Ever since 2000, each time California has raised its tax rate to reduce its deficit, more businesses and wealthy individuals move, California’s tax revenue goes down, and the state tries the same solution again with the same result. The tax increases imposed by President Hollande of France are leading many of its wealthy citizens to move across the border to Belgium although the French courts are intervening and the outcome is not clear as of this writing. In England, increased taxes on million pound incomes mysteriously reduced their number in a single year from 16,000 to only 6,000.