Principles of Taxation: What is a Fair tax?

Greg Mankiw on fair taxes, with comments at the end:

Fair Taxes? Depends What You Mean by 'Fair', by Greg Mankiw, Economic View, NY Times: Do the rich pay their fair share in taxes? This is likely to become a defining question during the presidential campaign.

At a recent fund-raiser for Hillary Clinton, ... Warren E. Buffett said that rich guys like him weren’t paying enough. Mr. Buffett asserted that his taxes last year equaled only 17.7 percent of his taxable income, compared with about 30 percent for his receptionist. ... These claims are enough to get populist juices flowing. The problem with them is that they don’t hold up under close examination.

The best source for objective data on the distribution of the tax burden is the Congressional Budget Office. ... The C.B.O.’s most recent calculations of federal tax rates show a highly progressive system. ... The poorest fifth of the population, with average annual income of $15,400, pays only 4.5 percent of its income in federal taxes. The middle fifth, with income of $56,200, pays 13.9 percent. And the top fifth, with income of $207,200, pays 25.1 percent.

At the very top of the income distribution, the C.B.O. reports even higher tax rates. The richest 1 percent has average income of $1,259,700 and forks over 31.1 percent of its income to the federal government.

One might wonder how Mr. Buffett gets away with a tax rate of only 17.7 percent, while a typical millionaire is paying so much more. Most likely, part of the answer is that Mr. Buffett’s income is made up largely of dividends and capital gains, which are taxed at only 15 percent. By contrast, many other top earners pay the maximum ordinary income tax rate of 35 percent on their salaries, bonuses and business income.

The distinction is crucial for understanding how much the rich pay. Indeed, the share of top incomes coming from capital is much lower now than it has been historically. ... If your image of the typical rich person is someone who collects interest and dividend checks and spends long afternoons relaxing on his yacht, you are decades out of date. The leisure class has been replaced by the working rich. ...

None of these calculations, however, say whether the rich are paying their fair share. Fairness is not an economic concept. If you want to talk fairness, you have to leave the department of economics and head over to philosophy.

The quintessential political philosopher of modern liberalism is John Rawls, the author of the 1971 classic “A Theory of Justice.” Professor Rawls concluded that the primary goal of public policy should be to redistribute resources to help those at the very bottom of the economic ladder. If Professor Rawls were alive today, he would most likely want to raise the top income tax rate of 35 percent in order to finance a more generous safety net. And for much the same reason, he would probably raise taxes on the middle class as well.

Professor Rawls would get a vigorous debate from his Harvard colleague, the libertarian philosopher Robert Nozick. In his 1974 book, “Anarchy, State, and Utopia,” Professor Nozick wrote: “We are not in the position of children who have been given portions of pie by someone who now makes last-minute adjustments to rectify careless cutting. There is no central distribution, no person or group entitled to control all the resources, jointly deciding how they are to be doled out. What each person gets, he gets from others who give to him in exchange for something, or as a gift. In a free society, diverse persons control different resources, and new holdings arise out of the voluntary exchanges and actions of persons.”

To libertarians like Professor Nozick, requiring the rich to pay more just because they are rich is little more than officially sanctioned theft.

There is no easy way to bridge this philosophical divide, but the political process will, inevitably, try to forge a practical compromise among those with wildly divergent views. At the 2000 Republican National Convention, ... George W. Bush made clear where he stood: “On principle, no one in America should have to pay more than a third of their income to the federal government.” As judged by the C.B.O. data, he has accomplished his goal.

A question for any political candidate today is whether he or she agrees with the Bush tax ceiling. If not, how high above a third is he or she willing to go?

Greg's use of the word "only" in the sentence "The poorest fifth of the population, with average annual income of $15,400, pays only 4.5 percent" makes it seem as though he does not consider that amount to be much of a burden to the poor, not like a rich taxpayer who "forks-over" 31.1 percent of their income which seems to imply much more hardship. But remember, "Fairness is not an economic concept."

---

Here's something I wrote awhile back on the same topic (edited slightly):

Guest Viewpoint: Some taxation principles, to get debate started, by Mark Thoma, Register Guard, April 12, 2005: 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 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 determine which choice to make.