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Tuesday, April 12, 2005

Op-Ed: Principles of Taxation

This Op-Ed I wrote appeared today. It describes principles of taxation and distributional equity generally (in 800 words or less), so it may cover familiar ground for many of you. [There are quite a few copyedits I wasn'€™t thrilled with, including the way it ends]:

www.registerguard.com | © The Register-Guard, Eugene, Oregon

April 12, 2005

Guest Viewpoint: Some taxation principles, to get debate started

By Mark Thoma    

Fairness seems simple enough at first, and something we should strive for. But defining what's fair is not easy.

When food is scarce, should everyone get the same amount, or should bigger people get more? Should those who toil at manual labor all day get more than those who sit at desks? Should warriors get more than workers? Should the rich get more than the poor? What is fair? What is best for society?

The fancy economics term for this is distributional equity. Principles of distributional equity are based upon value judgments, not economic theory. In the example above, economists cannot comment one way or the other on whether society should take an apple from one person and give it to another. We can tell you the consequences - one person is better off, the other is worse off - and give some evaluation of the effect on each person. But we cannot judge whether one person's loss is worth another person's gain.

How should taxes be distributed? A shift from an income tax to a consumption tax and other proposals to revamp the federal tax codes are currently in the news, and April 15 is drawing near. So it is a good time to review some of the principles of distributive equity supporting various forms of taxation.

The first is absolute equity. Under this principle of fairness, everyone pays an equal share, which is determined by dividing the value of government expenditures by the number of people.

The second equity principle is ability to pay. This principle is based on the idea that the pain of paying taxes, which is distinct from the dollar amount, should be the same for everyone.

The most popular variant of the ability-to-pay principle is called the equal marginal sacrifice principle. It is often used to justify progressive taxation. The idea is to examine what a person gives up when the last dollar of taxes is paid. To pay the last $50 in taxes, a low-income person might have to give up something essential, such as a pair of shoes. A high-income person might give up a luxury of little practical value or necessity. Accordingly, taxes should be increased on the high-income person and reduced on the low-income person until both sacrifice equally when the last dollar of taxes is paid.

The third principle of distributive equity is called the benefit principle. Here, all people pay for the government-provided goods and services that they individually consume. All government services are privatized and the purchase of government goods and services is voluntary. Since the goods are purchased in the private market, payments are in accordance with the benefits each individual receives.

In practice, the voluntary approach is restricted in its application because many government goods cannot be privatized due to the free rider problem. The free rider problem exists when people enjoy the benefits of government provided goods independent of whether they pay for them.

The classic example is national defense; I am protected whether or not I pay, so there's no reason for me to pay unless forced to do so. In such cases, the government must provide the good itself and force individuals to pay for it with taxes.

If higher-income people are willing to pay more for the same amount of government services than lower-income people are willing to pay, then the benefit principle can be used to support a progressive tax structure.

In addition, if those with higher incomes also consume more government-provided resources - such as airports, police protection of businesses and homes, museums, performing arts centers and so on - then the benefit principle justifies a progressive tax structure. But if lower income groups consume more government goods and services than higher income groups, then this could also support a regressive structure. The quantity of government services consumed by each group is ultimately an empirical question.

Pick your favorite principle of distributive equity and argue for progressive, flat, regressive or equal taxes as you see fit. Argue loudly and passionately with others who hold different views about what is fair.

But in the end, the solution must come in the political arena. Economic theory can only assess the consequences of the choice society makes and who the likely winners and losers will be. It cannot guide the choice.

Mark Thoma (mthoma@uoregon.edu) is a macroeconomist and a member of the economics department at the University of Oregon. The views expressed are his own.

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