Series on tax: Part 2b – let’s experiment with explanations

By Matt Nolan 21/05/2013

In the second part of my series on taxation I wrote about distortion and burden.  But I’m not sure whether my description about wedges and how people respond to prices was necessarily clear enough for a non-economist audience.  So I’m going to experiment with some other ways of articulating what I mean – ways that are equivalent, but for different people may be clearer.

Note:  I apologise in advance if this is a bit scattered – if you have questions or comments note them down in the comments, you’ll be doing me a favour :)

Paying our labour and capital

Remember that I stated in part 1 that we want to think about taxation, and spending, in terms of changing the allocation of goods and services.  This is not saying that goods and services are “fixed” and we are moving them around – no no no no.  It is saying that we are instituting policies that change the mix of goods and services, giving up some and increasing the amount of others.  We are thinking about how to use our scarce inputs to create outputs.

Now I have a strong preference towards private provision, given that voluntary prices are truly democratic and combine knowledge we don’t share as a society (but have internally as individuals), so let’s not get too ahead of ourselves in thinking we can “plan” the economy.

But, when looking at the issue we can say that we have a government sector, and a non-government sector. Labour and capital combine in both sectors to make goods and services … these are government goods and services and non-government goods and services.

Now if the government sector made goods and sold them to the public for a price, without raising any taxes, they would be just like any other firm.  In this case, the price paid for the government goods creates the income to pay for the labour and capital, and the labour and capital owners will purchase a mix of government and non-government goods at the relative prices :)

But government doesn’t work this way.  It pays for its goods by taxation instead of setting a price.  It uses this tax money to pay labour and pay capital when they create government products.  There is likely to be a reason for this, such as the existence of public goods, the urge to redistribute some products by providing them publicly, the desire for equal access to health and education.  That is cool.

In this context, the taxation is the government “claiming some proportion of non-government goods” to pay labour and capital with – since the labour and capital who produce government goods want to consume both government and non-government goods.  The government taxes non-government good providers, taking some of their output, and then sending over some of the produce of government production.

In this way, the tax exists in lieu of a price.

Now, while a price would see government goods and non-government goods produced with respect to their relative market value, taxation and spending is unlikely to lead to this same case for two reasons:

  1. The government goods are explicitly being produced beyond their relative market value – as we believe there are non-market benefits associated with it.  This is redistribution through tax and corresponding spending.  In of itself this isn’t necessarily inefficient – with a lump sum transfer relative prices will just adjust.  We can view this as changing the “endowment” of underlying resources for different people.
  2. Depending on the type of tax there are relative price effects, which reduce efficiency directly.  This occurs because it creates a gap between the cost of the good for the person buying it and the return for the person selling it (the “wedge”) – and so the very existence of the tax changes where people work, what they consume, and where capital ends up relative to the case where prices represent underlying value given the allocation associated with the government transfer.  This only occurs with taxes that influence relative prices – so not lump-sum taxes.

A web of prices, an ideal frontier, the fundamental welfare theorems

Now here is the way I see this idea when we think of spending, taxation, and the economy.

There is a set of resource (land, labour, capital, enterprenuers) and agents are endowed with some quantity of these resources.  Through trade, and the establishment of institutions and contracts, this leads to outcomes.  Prices in this case represent a set of relative values, and there is a frontier of outcomes (depending on initial endowments, that can be changed through lump sum government transfers) that can be seen as “pareto optimal”.  This is really just the fundamental welfare theorems which hold for perfect competition.

When we have a tax that isn’t lump sum, so it creates a wedge between the buyers and sellers price in a market, we end up in a situation “below” this frontier, which is in turn pareto inferior to a potential outcome.  This is why you will often see economists arguing for the idea of a poll tax with a progressive transfer system.  I’m not entirely sure – as I inherently see the transfers as having the same impact in terms of labour supply (unless we actually delink the benefit system from work), and believe that when equity concerns are taken into account some of these outcomes are not truly “pareto inferior”.

Now we don’t have perfect competition, it is more likely that we have monopolistic competition and the associated inefficiencies of that.  Modern policy oriented models do assumes this (eg DSGE models) and work from there.  However, even given this the tax principles are not terribly different – and as a result, I stick with useful simplifying assumptions to describe tax policy.

Furthermore, issues of information, incomplete markets, endogeniety and co-ordination failures, and oligopolistic competition do push us away from this idea, and provide scope for government interventions that are win-wins!  But at the current margin we already allow for those with policy – the “marginal” concept of taxation is very much along the area of trade-offs I’m discussing in these articles.

Trust me, these additional issues do play a significant role in how we try to discuss interventions – and many current interventions are based on it (eg monetary policy that tries to close output gaps, government intervention in markets over competition and consumer issues). Even if we “unrealistically” assumed perfect competition and perfect knowledge, the distributional impact of tax changes are insanely hard to work out – the best we can do (and that I’m aiming to do) is to provide a flavour for the direction of the different trade-off between taxes, not the magnitude or an implication of what we should do.

When we look at a range of marginal ideas such as “shall we try to ramp up healthcare” we are facing the traditional transfer problem akin to the fundamental welfare theorems, and this sort of exercise is useful.

That is so unrealistic, man economists say such stupid thing

I have tried to be honest about assumptions.  Often when an economist does this, someone is a dork and says something like the above.  If someone appears that feels like commenting in this way, I am replying to you right here.

Excuse me for admitting that allocation is an incredibly complicated issue that requires great care and thought when setting up a policy.  Why don’t you just go back to telling the world about your “make everyone better off by magic plans” and not bother talking to me again.

Why am I bothering with this comment – because there are innumerable people out there who simultaneously believe:

  1. There are really obvious and easy solutions to economic problems.
  2. Economists make really dumb assumptions and are stupid.
  3. Economists massively overcomplicate issues with maths and terminology.

I find those assumptions mutually inconsistent, and whenever I meet a person like that (which is far too often) I can’t help but feel that there is really something wrong in their life that they are trying to make up for.  If I had any empathy I’d be sympathetic – instead I’m going to write this part of my post to insult them.

To everyone who has avoided their snark and has constructive things to say – thank you, I want to give you a hug.


Hopefully these examples helped to clear up the idea of burden and distortion – it is an interesting issue, and one that requires careful analysis when we actually go to investigate policy!  Next week I will have an article up with some “ideal taxes” (poll taxes, land taxes, ability taxes), and I will touch on ideas of horizontal and vertical equity!  With all that we will be ready to hit factor taxes and consumption taxes the following week, inflation taxes the week after, and externality taxes the week after that.

Where I have gone in parts of this post is beyond where I’m heading on the Rates Blog posts – quantitatively I am talking about the same results, but the description involved is more involved.  It wouldn’t be fair to burden that on the larger public on Rates Blog who are less likely to be as nerdy as anyone over here ;) … unless they are interested in the ideas, in which case I hope they see it!

By the end of it, we should all have an idea about the framework we view tax within.  Given that, we can make our own judgments about what is fair, and interpret the evidence about burden to try to figure out whether that makes much sense.  To be honest, all of that is far beyond me ;)