Principles of Taxation II

In our first discussion on the principles of taxation I elaborated on the importance of the government’s ability to tax its citizens in order to finance the functions necessary to support the social contract. I also argued that greater clarity and transparency in the tax system would increase the public’s trust in the tax system that has been undermined by the current complexity and opaqueness of the tax code. In this second essay on the principles of taxation I want to discuss why I think it is impossible to create a “fair” tax system.

On Fairness

Dr. Daniel Kahneman in his book Thinking Fast and Slow (based on his research along with his long time partner Amos Tversky) asserts that the human brain consists of two systems but I could never keep them straight. I call System One (which is quick thinking and intuitive) our instinctual brain while I call System Two our rational and scientific brain that is controlled by reason (and justifies our species being called homo sapiens or wise man). The instinctual brain is more related to the survival instincts of our hominid and great ape ancestors. Kahneman further asserts that while the rational brain is what makes us human it is also lazy and is only called to action when necessary. The rest of time the instinctual brain is in charge.

The instinctual brain is the fast part of thinking fast and slow. For primitive man, hesitation on the savannah or the tundra could be the difference between life and death. If it were not for our instinctual brain we would not have survived as a species long enough to become rational. But many of our biases and prejudices lie in the instinctual brain because they were necessary for survival in the primitive world but are an impediment in our current more civilized world.

I believe that the concept of fairness lies deep within the instinctual brain. A pack animal that does not get its fair share of the hunt does not survive. This relation to survival also explains the visceral reaction to perceived unfairness. We have all seen the pack or pride consuming the fresh meat from the hunt, snarling and snapping at others in the pack (and any other interlopers like vultures or hyenas) to make sure they get their “fair’ share.

Humans do not initially learn about fairness in the pew or classroom. We learn it on the playground long before we become self-aware. Not a lot of snarling or snapping but a lot of crying and running to mommy to complain about perceived unfairness.

I have been told that the sense of fairness is part of our innate goodness as human beings and that it underlies many of our religious principles and perceptions of civilized behavior. That may be, but that does not alter its savage origins.

Whether it is innate or instinctual, fairness is subjective. There is no such thing as universal fairness. Fairness is personal. A sense of fairness can be shared by many people if it matches their specific circumstances or shared belief systems. But when their circumstances change or when there is a different belief system this shared sense of fairness can evaporate. A ref’s call can be fair or unfair depending on if you are a Packers’ or a Cowboys’ fan no matter if you share the same religious or educational background.

Tax Fairness

Drs. Kahneman and Tversky had many insightful revelations about how humans react to various situations that they elaborated into the Prospect Theory for which Kahneman won the Nobel Prize in Economics (having passed away Tversky did not receive a prize because these prizes are not awarded posthumously – hey! That’s not fair!). A critical aspect of Prospect Theory is the concept of loss aversion. Kahneman and Tversky asserted that people feel losses more than gains. Gains are pleasing but losses hurt – a lot.

Taxation is a taking of one’s personal property through the use of coercive force by government. It is inherently unfair from the perspective of the taxpayer. It takes a force of will to summon the rational brain to realize that this payment is for the greater good of society and that, as an individual, you benefit from a smooth running society. It is even a benefit in a not so smoothly running society because it is better than the Hobbesian chaos of being outside of society.

But even if you realize that taxes are a necessary evil that you willingly (if sullenly) submit to in order to be a part of a greater society, your subjective sense of fairness antennas are up to make sure that others in the society are paying their taxes fairly. But how you define fair depends on your specific circumstances. If you are a rich person you might think a highly progressive income tax is very unfair but a poor person would have the opposite view. Likewise the rich person might think a flat tax would be fair but the poor person would be very upset with such a tax.

Because of the subjective nature of fairness, fairness is not a good standard to use in establishing tax policy. The standard I prefer is the “not too unfair” standard. We might not be able to agree on what’s fair but we should be able to come up with a tax policy that everyone can say (somewhat grudgingly) is not too unfair (although their objections might be for different reasons depending on a person’s specific circumstances). The process of judging if a policy is not too unfair engages the rational brain and let’s us control the instinctual brain that is screaming “not fair, not fair!”

When President Trump announces his new tax proposal in a few weeks he will, no doubt, assert that it is very fair. Whole bunches of people across the country will wail that it is not fair. Of course it will be unfair. But will it be too unfair? In other words, will the majority of the population concede that despite its demerits, the tax policy’s unfairness is outweighed by its benefits to society? That is the essence of the “not too unfair” standard.

But we must take care. The “not too unfair” standard requires a concession from all sectors of society. Keeping in mind that most of our recent national elections have only been won by a few percentage points, a policy that is supported by a narrow majority but violently opposed by a large minority does not meet the “not too unfair” standard. This is why it is important that we agree of the purpose of taxation. If we cannot agree on the purposes to which our taxes will be applied, it will be impossible to reach any sort of consensus on what the actual policy should accomplish.

The Obligation of Citizenship

As noted above, it is difficult to reach a consensus on fairness if the specific circumstances of citizens are very different. If large numbers of citizens pay no tax, their specific circumstances will not only be different than those that pay taxes, they will be in opposition to those citizens. Under such circumstances it will be very difficult to reach a “not too unfair” consensus.

All citizens need to pay some tax even if the other benefits received from government by the lower income sectors of society outweigh the taxes they pay. All citizens need to share the pain of loss to the takings of the government by the use of coercive power. In this way the common citizenship of all participants in society is reinforced.

Tax Manipulation

Taxes are powerful incentives that can be used to manipulate human behavior. Harken back to Prospect Theory. Psychologically, taxes are losses and losses hurt much more than gains. Humans, under the marching orders of the instinctual brain, are greatly motivated to avoid taxes even if the tax savings are minimal or not in their best interests.

The mortgage interest deduction has been pushed by realtors (most of these tax incentives are supported by one special interest group or another) as a way to increase the number of people owning homes, which is considered a good thing for most people. But home ownership in Canada, which does not have mortgage interest deduction, is 67.6% while in the United States it is only 64.5%. On the other hand, the average home size in the US is about 11% more than Canada (2164 sq. ft. to 1948 sq. ft.). So it would appear that the mortgage interest deduction does not improve the percentage of home ownership but does increase the average size of homes purchased (this may be an example of another problem with using tax incentives to manipulate people’s behavior – unintended consequences).

In order to promote plug-in electric vehicles, the government offers up to $7500 in tax credits for purchasing such vehicles (although the average credit is usually much less). This credit only partially offsets the high cost of such vehicles. The New York Times in 2012 estimated that the cost break-even between plug-in electric vehicles and standard vehicles is between 8.6 and 26.6 years, depending on the model. And, although the plug-in cars may not produce CO2, the power plants that supply the electricity do so it may also take years before the higher carbon production processes of electric vehicles are offset. So the societal gains are marginal at best but the government has determined that it wants to promote these vehicles and that a tax incentive was the best way to do it.

But I don’t mind if government wants to promote plug-in electric vehicles. Governments promote many technologies and industries and some of these promotions have been very successful. Lucrative mail carrying contracts help support the early development of airplanes. The government’s DARPA program spawned the development of the Internet.

But I do object to the government using taxes as the primary incentive for all these promotions. The government is trying to manipulate the behavior of citizens by using Prospect Theory to influence our instinctual brains. Richard Thaler and Cass Sunstein wrote a book, Nudge, about all the wonderful ways the government can manipulate our behavior for our own good. But it is not the government’s job to manipulate our behavior, but rather it is government’s obligation to follow the will of the people. This subtle manipulation has the relationship between the government and its citizens backwards.

By eliminating all these tax incentives we will not only stop all this manipulation of the people, but we will clean up the tax code so that people can actually understand what the government is doing. If the government wants to promote plug-in electric vehicles then write a check. Give it to the purchaser. Oh, and by the way, get the authorization of Congress for the appropriation and make sure the cost is included in the budget report.

In the next segment of our discussion we will look at the impact of taxes and tax cuts on economic performance. This is the Holy Grail of tax policy.