Dick Thaler, writing in the New York Times, says so many wrong things about the estate tax that I don’t know where to begin. But let’s begin here:
First, it is incorrect to say the estate tax amounts to double taxation. The wealth in many large estates has never been taxed because it is largely in the form of unrealized — therefore untaxed — capital gains.
This is just not true. Virtually all of the wealth in every large estate has already been taxed at least once. Namely, it was taxed when it was earned. You do not understand this issue unless you understand the following simple example: Scrooge McDuck earns a dollar, makes some fortunate investments, and leaves a hundred million dollars in unrealized capital gains to his ne’er-do-well nephews. If Scrooge has to pay 50 cents income tax on that dollar, then he invests half as much, earns half as much, and leaves his nephews half as much. Scrooge’s fifty cent tax bill has already cost his nephews fifty million dollars.
In fact, there’s a good chance Scrooge (or his ancestors) earned a lot of that money back in the bad old pre-Kennedy days when marginal tax rates hovered around 93%. If so, 93% of the estate is already lost to taxes. That’s pretty far from nothing.
A more accurate statement might be this:
First, it is incorrect to say the estate tax amounts to triple taxation. The wealth in many large estates has been taxed only once because it is largely in the form of unrealized capital gains. Therefore the estate tax amounts to double taxation, not triple.
Of course, when you say it the more accurate way, it stops looking like an argument for estate taxation.
(Edited to Add: I am unsurprised to learn that Don Boudreaux beat me to the punch on this. I am, however, surprised to learn from Don’s post that the point about double taxation — a point I’ve been harping on lately — was made by John Stuart Mill. I am, however, unsurprised to be reminded that Don Boudreaux is better educated than I.)
Then there’s this:
There are lots of ways to spend $250 billion. Trim the deficit, improve education, support the troops, or make sure heiresses like Paris Hilton have the proper attire for trips to St.-Tropez. At this time in our history, which of them seem prudent?
What seems prudent is to discourage Paris Hilton from buying a $100 million diamond-studded gown, so that she’ll leave her money in the bank where it can fund mortgages, business expansions, and, yes, government projects. One way to do that is to remind her that she’s spending her future kids’ inheritance. (Actually, I expect that even Paris Hilton can figure this out on her own.) Except that doesn’t work so well when the inheritance is taxed. So by all means, let’s be prudent and not tax it.
What if you borrow $1,000, invest it, grow it to $1,200, then repay the $1,000 and keep the $200? Then that $200 has never been taxed.
(Well I suppose that even in that case, you could argue that a lender’s willingness to lend to you, is proportional to your ability to repay the loan, which is in turn roughly proportional to your after-tax income — so if you hadn’t been paying that 50% income tax, the lender would have been willing to lend you $2,000 instead of $1,000, and you could have made $400 instead of $200, so in a way your capital gains were taxed already…)
Bennet Haselton: I don’t buy your argument that the interest has already been taxed. However your investment must out-perform the interest charged to you.
So if your investments out-perform the interest charged, the “excess” interest is tax free?
I actually thought Thaler was making an argument about the stepped-up basis law. Stepping up the basis doesn’t make sense if you get rid of the estate tax, right? Or to say it in a more sensible SL-like manner, the stepped-up basis law ensures that the money gets double-taxed instead of single-taxed, which is consistent with way the law would work if the money had been spent pre-death.
Steve, this is my first reply to your interesting blog,
although I’m reading for quite a while.
I’d like to hear your opinion to the following argument on
capitol gains tax/inheritance tax.
I’m not argueing by basic fairness:
Person A started with nothing, and has only his labor to offer
to make a living. Person B inherited a huge estate, and can
comfortably live on his capitcal gains/interest. If that’s not
unfair enough, wouldn’t it be unfair if person A pays with his income taxes for police, school, national defense,
but person B does not contribute?
Maybe I would agree with abolish capital gains tax if we set
the inheritance tax to 100%, so that everybody has the same
starting point…
Typo on the previous post:
I AM argueing with basic fairness.
Bennet,
say in the world without a tax the lender requires you to pay 4% interest. You would make your $200 dollars then would have to pay the lender 1040 and would be left with 160.
Now say there is a 50% income tax. The lender would raise his interest rate to somewhere between 4-6%, let’s say 5%. so now you make your 200 and must pay back 1050, leaving you with 150, of which you must pay 75 in tax. The lender must also pay taxes and is only left with a return of 25.
So now you are less likely to take a loan given the higher interest rate caused by the tax and then compounded by the lower return.
awp – without the income tax, is it the case that Bennet’s $160 is tax free? Or is the tax hidden somewhere? I think in earlier blogs it was argued that IF Bennet manages to increase the value above interest rates, he must have worked to achieve this, so the income should be classed as wages.
Thomas: I think this is the point. Tax on capital may be argued for in order to reduce inequality. Steve’s point is that it should not be argued for on the basis of all income being taxed equally. Person B inherited a smaller estate than he would have done due to the tax paid by his ancestor.
Another problem identified in earlier blogs was wages (earned income) disguised as capital income. This allows the wealthy (those with some assets) to reduce the initial tax that has supposedly been paid on the income. Steve refered to this as skulldugery, but I think many consider it normal practice.
It’s great to see you and Donald Boudreaux linking to each other’s articles. The two of you are both very good and very different economists, in terms of “style.” It’s nice to see professional respect reaching across what can be a wide divide (especially in economics).
Needless to say, I’m a faithful reader of both of your blogs. :)
“First, it is incorrect to say the estate tax amounts to triple taxation. The wealth in many large estates has been taxed only once because it is largely in the form of unrealized capital gains. Therefore the estate tax amounts to double taxation, not triple.”
Your response to this version of his statement could be even stronger- since capital gains will be taxed when they are realized, and they must be realized before reaping the benefit from those gains, the estate tax does cause triple-taxation, albeit as the middle layer of the tax Oreo. Without the estate tax, it would just be the 2 wafers.
Thomas, what if we didn’t tax anything besides consumption? That would seem to solve your objection. Also, keep in mind that if I inherit unrealized wealth, it will be taxed at the time it is realized.
Furthermore I would like to point out that it is not easy maintaining a portfolio or a business. If one inherits wealth and is not willing to work hard to manage it, they will bleed money to poor investments, poor managers, or will pay a fortune to have others do the work for them.
Thomas,
Re your post on fairness, here are some things that I think you should consider:
1) It appears that you believe that Person A will prefer a system where capital gains, and not just income, are taxed, because that would make life less “unfair” relative to Person B. Why? Person A quite possibly works not only to make a living, but also to make a better life for his descendants (ie, so that they too don’t start “with nothing”). In that case, he may very well prefer that capital gains not be taxed, so that he and his descendants can benefit from the fruits of his (and, btw, their) labor in the same manner as Person B (and his descendants) are benefitting from their parents’ labor (and, of course, their own labor as well).
Shouldn’t fairness be evaluated across time, and not just across the same generation?
2) If we should be concerned about the fairness of inheritance, why stop at inherited financial wealth? Many children inherit more attractive features, superior athletic or musical skills, healthier anatomies, etc. than their peers. All of these are valuable to the children who possess them (and I don’t mean financially valuable).
Is that “fair”? By your reasoning, shouldn’t the government do something about it? If not (and for the record, I do not believe that it should), then why should it direct all of its inheritance-redistribution efforts towards financial wealth alone? Non-financial assets are likely harder to tax in our current system, but that doesn’t mean the government can’t take other measures to address the supposed “unfairness” that they cause.
Wait … but lets say Scrooge has a choice
a. Earn $1 and pay .50 in taxes and then invest and reap 10 million in say 10 years down the road if he works at building value and reinvesting in the endeavor.
His total tax in this would be .50$ (assuming capital gain is not taxed and a flat 50% tax on all income)
b.
Earn 1 million per year for 10 years
His total tax is 5 million (same assumptions)
—–
Do I have this wrong, or can people structure their activities to avoid income tax?
A further problem with the last quote is that Thaler equates a tax cut with a spending increase. As you have so aptly demonstrated on this blog before, it is hardly appropriate to say that a change in tax law that leads to a $250 billion dollar reduction in tax revenue is equivalent to the government spending $250 billion.
@Clifford: “Do I have this wrong, or can people structure their activities to avoid income tax?”
In your example, the person technically lowers tax bill by about $5,000,000, but both scenarios are essentially identical in spendable income at death. The latter is what really counts. A similar, and real world, example is that people can largely avoid income taxes by investing most of their income in municipal bonds, and the interest from such bonds is tax free. But because of this, the bonds are bid up in price so that the tax free rate of return is about the same as as a taxable bond minus the income taxes paid on that income. Thus the owners of municipal bonds do not technically pay taxes on them, but they earn about the same on them as if they did pay taxes, so the loss is the same, which is what counts.
Clifford:
If Scrooge had not had to turn over $0.50 in taxes to begin with, he could have invested the full dollar, and, in principle, reaped $20 million in 10 years, right? So, from his perspective, he gave up $10 million additional earnings because of the taxes, didn’t he? In your scenario, Scrooge’s $1 is worth $20 million to him.
Keep in mind that the government officials can use their ‘share’ of Scrooge’s dollar just as effectively as he does. If they do, then they can turn it into $10 million too. But if they don’t, and they come back to him for another share of his gain, then they are taxing him twice.
Whether or not it is ‘fair’ for the government to tax Scrooge twice is a matter of opinion. Whether or not it is correct to say Scrooge is taxed twice if they take a share of his capital gain is not.
Thaler is obviously wrong here, especially in his terrible choice of words, but to be fair to him, I think he has some sort of point.
*If*, for whatever reason, you believe capital gains should be taxed, *then* you should believe that one shouldn’t be able to avoid this tax by dying. Just forgetting the words “double taxation”, is this argument valid?
John Faben: If you want to tax capital gains, you can do it by taxing capital gains (using the original purchase price as a basis). There’s no need for an inheritance tax — unless, I suppose, you worry that when the original owner dies, records of the original purchase price are likely to be lost, in which case maybe there’s a case here.
John Faben and Steve Landsburg: If you wanted a capital gains tax instead of an inheritance tax and were worried about keeping track of the original purchase price, you could force the recognition of a capital gain at the time of death. I think that is the law in the U.S., for this year only.
What’s the big thing with double taxation?
You pay sales tax, property tax (for the owner/occupier, especially), gas tax, etc. out of taxed income. Why not inheritance taxes, too?
Property tax is a tax on wealth, but few complain about that.
But taxing inherited wealth has everybody (on the right) up in arms.
I don’t get it.
Timk:
One relevant difference is that piling a consumption tax on top of a wage tax is equivalent to raising the wage tax. Whereas piling a capital gains tax or an inheritance tax on top of a wage tax is *not* equivalent to raising the wage tax, since it introduces a disincentive to save. (You might say that the sales tax introduces a disincentive to consume, but that’s not correct, because the alternative to consumption is saving, the reward to saving is future consumption, and that future consumption is also taxed.)
But the other relevant difference — the one I had in mind here — is that everyone seems to recognize that a sales tax is double taxation but many fail to notice that a capital gains tax is double taxation. Note Thaler’s allegation that if your interest earnings are not subject to taxation, then those earnings have never been taxed. That’s a misstatement, and my goal was to correct it.
Your disincentive to save argument carries little weight in a world awash with savings – just the opposite, in fact. We should raise capital gains and inheritance taxes if that would indeed encourage spending now, shouldn’t we?
I’ve reread Thaler’s piece but can’t find where he talks about interest earnings; he says much of the wealth being passed down is in the form of capital gains – untaxed as such. And he’s right – capital gains taxes usually haven’t been paid.
And without inheritance taxes, no taxes would have been paid on those gains.
Timk:
And without inheritance taxes, no taxes would have been paid on those gains.
This is exactly what’s incorrect. A 50% tax on earnings is a 50% tax on the gains that flow from those earnings. If the earnings were taxed, then the gains were taxed.
Let’s take a practical example, Mark Zuckerberg for instance. How much did he invest out of his taxed income? Probably in the low to mid 5 figures at most, wouldn’t you agree? How much tax did he pay on that – 5 maybe 10,000 – again at most?
If I understand you correctly, you’re saying that if Zuckerberg died tomorrow and left his billions to his girlfriend, she shouldn’t have to pay inheritance taxes because he already paid a couple of thousand on the original income.
And are you saying that the next Bill Gates/Mark Zuckerberg or the next Warren Buffett, now sitting in their dorm rooms, will throw up their hands and say “What’s the use? My heirs are just going to have to pay so much inheritance tax; there’s no sense in starting Microsoft, etc.”
And what about my argument that you as an economist should be arguing for inheritance taxes and higher capital gains taxes to discourage the excess savings we now have?
I greatly appreciate your bantering with me like this because I really don’t understand where you are coming from. I’m having difficulty getting a grasp on your reasoning.
Timk:
1) If I understand you correctly, you’re saying that if Zuckerberg died tomorrow and left his billions to his girlfriend, she shouldn’t have to pay inheritance taxes because he already paid a couple of thousand on the original income.
You are (I think) failing to grasp that a “couple of thousand” paid many years ago is the equivalent of far more than a couple of thousand today. If Mark has a machine that converts a thousand 1999 dollars into a million 2010 dollars, then taxing him a thousand dollars in 1999 is the equivalent of taxing him a million dollars in 2010. So it’s quite misleading to say he’s only paid a thousand in taxes.
2) And are you saying that the next Bill Gates/Mark Zuckerberg or the next Warren Buffett, now sitting in their dorm rooms, will throw up their hands and say “What’s the use? My heirs are just going to have to pay so much inheritance tax; there’s no sense in starting Microsoft, etc.”
I am saying that there are savers/investors who will be deterred by inheritance taxes. That’s not the same thing as saying they’ll *all* be deterred. If you raise the price of carrots, almost everyone will go on buying carrots — but *some* people will stop. (In the case of investment, you probably won’t deter Bill Gates, but you might just deter some of the investors he needs.)
3) And what about my argument that you as an economist should be arguing for inheritance taxes and higher capital gains taxes to discourage the excess savings we now have?
What makes you think we have excess savings? Given the incentives built into the tax system, there is every reason to think we save too little.
1. $1000 taxes in 1999 just isn’t the same as $1m taxes in 2010. I can’t follow your reasoning.
2. But how many savers/investors would be encouraged by a balanced federal budget brought about (partly) by inheritance taxes? How do you want to measure the trade-off?
3. I’m talking about the world, not just the US. Low interest rates is one indication. As are the trillions that central banks of exporting nations are stuffing away. Insurance companies and pension funds having trouble finding safe places to put their investments.
Wasn’t it Bernake who coined the term “savings glut” in 2005? (It was. I cheated and looked it up.)
Have I got this right?- Scrooge McDuck earns a dollar and pays tax on it of 50 cents. His nephew inherits 50 cents and has to pay estate tax or death duty. The State is getting a double bite of the cherry. Had Scrooge simply given the money away a sufficient number of years before his death then there’d be no second bite of the cherry.
That’s why estate lawyers encourage you to start giving stuff away some years before your expected demise. I guess this ‘double tax’ speeds up the rate at which nephews come into their inheritance while, perhaps, increasing the anxiety of the elderly who will worry that they have given too much away and won’t be able to cover their expenses if they live longer than expected.
The problem with this argument is it is bad Economics. Why? Well, standard theory says the Govt. should tax all economic goods and services at the same rate (on the usual assumptions).
The fact is Scrooge’s death has created an economic good which did not previously exist- viz. it has eliminated uncertainty about his date of death (something he would pay money to hedge against) and the need to maintain a precautionary balance in case he had lived longer than he expected.
Thus actually, from the Economist’s point of view, what is being taxed is the gain from a reduction in uncertainty which did not previously exist- so this is not a double tax on one and the same thing. It is a tax on a new state of the world.
Tax planning on the basis of actuarial advice would, if Scrooge were a rational agent, ensure that only the cash value of the reduction in uncertainty was being taxed- i.e. no excess burden or inequity should arise.
This is from http://socioproctology.blogspot.com/
Granny Sweetums is a widow who earned $1 by scrubbing the floor of Tax Inspector Nasty. He promptly taxed her income at 50% leaving her with 50 cents. Granny Sweetums did not spend the 50 cents because she planned to buy her grand-daughter Goldilocks a nice new pair of titties for her 21st birthday. However, instead of giving the money to Goldilocks, or pre-paying the plastic surgeon, Granny Sweetums hid the 50 cents in her panties (where not even Tax Inspector Nasty would look for it). Goldilocks would often say to Granny Sweetums, ‘Kindly hand over the cash you dumb broad. Don’t you know that Death Duty is levied at 50%?”
Granny Sweetums replied ‘I would if I could be sure I’d be dead by the time you are 21 (at which age you are legally entitled to work as a porn star). But what if I live beyond that time whereas you are run over by a bus? That’s why I’m hanging on to the 50 cents.’
Sadly, just before Goldilocks 21st birthday, Granny Sweetums keeled over and died. The undertaker found the 50 cents in her panties and Tax Inspector Nasty immediately took 25 cents in inheritance tax leaving Goldilocks with money for only one boob enlargement- thus confining her to the unprofitable early Victorian silhouette end of the Porn industry where she met Steve Landsburg. Being a chivalrous sort of chap he challenged Tax Inspector Nasty to an internet debate.
“You are guilty of double taxation!” he thundered angrily.
“Not so.” said Nasty, “I am taxing an economic good or service which did not previously exist, Granny Sweetum’s death created a hedge against the uncertainty and need to maintain a precautionary balance which her previously unknown date of death was responsible for. In other words, something- namely a hedge- has been created for the Estate and it is that which is being taxed. Had Granny bought a hedge in the market that would have been taxed. It is the implicit hedge which has fructified which I now lay claim to. The situation is the same as that of a unrealized and previously un-monetized capital gain on an asset which becomes so when it comes under probate. The moment something enters the market, or is exchanged, an economic activity occurs. The canon of neutrality requires it be taxed at the same rate as any other economic activity. This is different from a simple transfer. Had Granny Sweetums pre-paid the plastic surgeon for the boob-job no tax would have arisen other than the one she paid as Income Tax. By keeping the 50 cents in her knickers Granny was using the money to buy something for herself- viz. a hedge against the uncertainty arising from her unknown date of death. Her death relieved her Estate of that cost which we are taxing as though it had been paid through the market because under the law of probate this money now comes to Goldilocks not as a voluntary gift or transfer but as something on which she has a legal and enforceable claim upon.
‘Goldilocks could not have sued Granny for the 50 cents since she had no legal claim to it. However, under the law of probate, Goldi does now have a claim to the residue of the Estate after tax. This is an exchange, not a transfer, and since it is an economic exchange based on a new state of the world- viz. the reduction in uncertainty concerning Granny’s date of death- a good or service has been produced, is measurable, and can be easily taxed-ergo it should be taxed.”
But Steve Landsburg wasn’t listening. He just repeated the argument all over again on his blog a couple of weeks later.
Goldilocks is doing well as a shadow puppet in Thailand.
Tax Inspector Nasty was fired for racially abusing a typist of Indian origin and sexually harassing a Japanese photocopier. He now writes children’s books under the pseudonym Arianna Huffington Bear.
Kev: I cannot tell whether you are making a fairness argument or an efficiency argument.
If the former, your argument boils down to this: Granny and her family just had a wonderful thing happen to them — namely a reduction in uncertainty — and it’s only fair to tax their good fortune. This rather overlooks the fact that this wonderful reduction in uncertainty was packaged with the rather less wonderful demise of Granny. So if you’re saying “People should pay more taxes when good things happen to them”, I don’t think that’s a very convincing argument for taxing people who have just lost a loved one.
If you are making an efficiency argument, then I am quite unable to follow it. Efficiency demands (more or less) that all consumption goods be taxed equally — not by assumption, but as the conclusion of a careful argument. Uncertainty-reduction is not a consumption good, so it’s not clear that the usual argument applies.
This is just the canon of neutrality i.e. the notion that different sorts of economic activity should be treated equally. If I scrub floors to earn money then I am providing an economic service. If I lend money to a Bank or invest it in a Company and receive money from that then I am performing a different sort of service. Now if we taxed one type of activity at a higher rate than another then (unless there is some source of market failure) we lose allocative efficiency.
Now consider Granny’s estate as if it were managed by a soul-less machine. While she lives- there is a future contingent which, in practice- for a large enough Estate- you purchase various sorts of hedges for. But not buying the hedge is still a hedge. A rational agent’s Death duty would exactly equal the sum of hedges not bought to leave the Estate indifferent. Now, in the same way as unrealized and unmeasured capital gains are (under some jurisdictions) measured and taxed during probate so too with the value of such assets left in the Estate (the only reason there are any assets there is because of uncertainty as to date of death and life span of heirs and other contingencies)which represent an economic activity- viz. it functions as a hedge.
As far as fairness goes, legacy hunting- since ancient times- has been a widespread economic activity. Why should it be treated differently and escape taxation when people who do Equity release financed Retirement homes, or write annuities etc are taxed?
Love regulates transfers. If I give you money because I love you or I think you deserve it or because I want to salve my conscience- there is no economic activity passing as ‘consideration’. But people can simply pass money to their heirs in their lifetime. The fact that they don’t shows they are involved in hedging against uncertainty. The assets they are using for that purpose thus serve a different function, they give rise to an economic activity and so- to observe neutrality- they can be treated the same as unrealized capital games which become measurable during probate.
Sorry. should have clarified- I don’t think there are any consumption goods- there is just economic activity and states of the world. Otherwise one gets trapped in essentialist, Aristotelian, nonsense supported by a Theophrastian world of stereotypes- the worthy widow and orphan, the horny handed labourer, the capitalist in his top hat, the nobleman in his castle and so on.
Just today on Channel 4 in the U.K we had a really silly programme called ‘Britain’s trillion pound horror story’ by Martin Durkin which tries to show that only making stuff like cars is productive and so Britain has to go back to making stuff like they did in the Nineteenth Century. Risibly, Tory dinosaurs from the Thatcher age where wheeled out to endorse this nonsense though, of course, the great charge against Thatcher was that she destroyed real jobs- i.e. manufacturing jobs- and gave the City of London its head.
You may recall Harold McMillan railing against Thatcher for Privatization calling it ‘selling the family silver’.
No question dealing with Uncertainty is difficult but it is very much an Economic activity and, in consequence, stuff Economists need to study even if it means letting go of an essentialist world-picture.
kev:
This is just the canon of neutrality i.e. the notion that different sorts of economic activity should be treated equally. If I scrub floors to earn money then I am providing an economic service. If I lend money to a Bank or invest it in a Company and receive money from that then I am performing a different sort of service. Now if we taxed one type of activity at a higher rate than another then (unless there is some source of market failure) we lose allocative efficiency.
Kev: Calling something a “canon” doesn’t make it true, and in this case, in fact, your assertion (under any reasonable assumptions I can think of) is false. If you have a proof (as opposed to another assertion) do share it, and I’ll either find your mistake for you or thank you for teaching me something.
‘Efficiency demands (more or less) that all consumption goods be taxed equally — not by assumption, but as the conclusion of a careful argument. Uncertainty-reduction is not a consumption good, so it’s not clear that the usual argument applies.’
As you know models incorporating uncertainty- especially pricing catastrophic contingencies- generate results re. allocative efficiency in a far less satisfying manner than the standard sort of models. However, uncertainty exists in the real world. If there is a non-zero death duty and dates of demise were known in advance then it would be an exercise for one of your students to show that the tax paid on any estate would equal the value of the hedge which the Estate has written for the deceased. The Estate is being taxed because it is in the money- dead people don’t pay taxes.
Sorry, maybe I need to add this- start off with non zero death duty and death date known in advance. Tax equals zero equals the Estate’s profit on the hedge. Now introduce uncertainty of plus minus a week to date of death, run the numbers and show tax equals the Estate’s ‘profit’ on the hedge (assuming a 50% tax). Then add more and more slivers of uncertainty to get the result.
The reason this may seem counter-intuitive is because we don’t call a person’s dealing with himself an economic activity until it comes to market or goes through probate or becomes measurable in some other way- in which we case we may deal with it as a new state of the world.
However when bargaining with your Estate you are dealing with an entity different from yourself- true it comes into existence at the moment you cease to do so- but there is a gap, a discontinuity.
I am puzzled as to why you deny the notion that efficiency, absent market failures, arises when all economic activity is taxed at the same marginal rate. Any argument that succeeds here will be equally powerful against your own stated view that all consumption goods should be taxed at the same rate.
‘Uncertainty-reduction is not a consumption good’- all a matter of interpretation. I think every consumption decision is an uncertainty reduction mechanism. I’m eating this burger to reduce my uncertainty re. whether I’ll get hungry a bit later when I’m tucked up in bed.
I personally could never see any point in saying oh! if the firm buys biscuits that’s bad and if they buy a photocopier that’s good. The biscuits will get eaten but the photocopier is an asset we can hand down to future generations. Sheer nonsense- it costs money to have the photocopier carted away whereas the biscuits boosted productivity, boosted economies of scope for the organization and didn’t get me fired for a sexual indiscretion after the Christmas party- not to say I was in any way to blame, that photocopier was just asking for it, the slut.
Kev:
I’m eating this burger to reduce my uncertainty re. whether I’ll get hungry a bit later when I’m tucked up in bed.
You are a very unusual person. Most of us eat to reduce the expected value of our hunger, not its variance.
‘Most of us eat to reduce the expected value of our hunger, not its variance.’ We do both when we make consumption decisions because there are hysteresis effects in things like digestion which means we don’t know what probability distribution we should be looking at.
To clarify, the tummy knows more than the mind can calculate. Consumption decisions can affect not just the expected value of utility but all its moments. I had a burger rather than Chinese coz my tummy reckons burgers have smaller variance. And yes, before you ask, I could afford to loose a few pounds.
Seriously though, since uncertainty arises even in a one period economy- and the underlying probability distribution known to God actually doesn’t exist because of hysteresis effects- why make a distinction between consumer and capital goods in the first place? More generally, why not speak of economic activity and states of the world rather than consumption and savings and other Nineteenth Century stuff embedded in National Income Accounts? Do you accept that. under the usual assumptions, if all consumer goods should be taxed at the same rate then so should all economic activity?
If not why not?
Kev:
Do you accept that. under the usual assumptions, if all consumer goods should be taxed at the same rate then so should all economic activity?
No.
If not why not?
Because:
a) I know a proof that under the usual assumptions, for efficiency’s sake, all consumer goods should be taxed at the same rate.
b) That proof does not apply to all economic activity.
c) For all your bluster, you haven’t given even the remotest hint of any alternative proof that might in fact apply to the activities you keep wanting to apply it to.
Play fair- give me a link to the proof you know and let me show it is either meaningless or implies what I say.
Kev: Take two consumption goods, say apples and oranges. If you tax the goods at different rates, you get a new budget line with a different slope than the old one. Call the optimum point P. If you tax the goods at the same rate and hold govt revenue fixed, you get a new budget line with the same slope as the original, also going through point P. To avoid the crossing of indifference curves, the optimum along this new budget line must lie on a higher indifference curve than P (draw the picture!). Thus consumers are better off under the equal-taxation policy.
Note that this argument (which is perfectly standard and available in any intermediate theory text) relies on indifference curves and hence applies only to consumption goods.
Incidentally, a proof that ‘does not apply to all economic activities’ (i.e. fails to take account of economic activities occurring in the real world) arises out of a model that is not concrete and therefore has no business being used to support real world arguments.
I personally think there must be a Godel type result showing how the element of impredicativity that arises in free economic activity (where both mechanism design and bargaining are going on simultaneously)will transfer efficiency proofs to some backroom of Complexity theory and cease to trouble public discourse.
The real question you have failed to answer is why income earned from labor is different from income earned by the appreciation of an asset or the cashing out of a hedge. After all some minimal effort went into the preservation or recovery of that asset or the construction of that hedge. These aren’t simple transfers because some consideration is being received.
In an earlier post you argued against capital gains tax saying it was a double tax. Yet if I help my Dad do up a house and he pays me cash for my effort- I pay income tax. But if he gives me a share in the profits from its sale- absent a capital gains tax- I pay no tax though the effort was the same. The risk I bear is the same, because if Dad can’t sell at a profit he will stiff me on the wages anyway.
Similarly with a tax on interest income- you say it is a double tax. Yet it is a tax escapable by not putting your money in the bank. Some economic activity occurred. Money was put in the bank. How does it matter where the money came from? How is one to distinguish money that came from taxed income and money that came from an untaxed source- e.g. tax free earnings from a U.N job? But why stop there? My Dad paid for my education out of his taxed income- surely the premium on the wage I enjoy oughtn’t to be taxed because it originates entirely from his effort which was taxed? This is a very bizarre world you are letting us into where economic activities are classified according to the antecedent circumstances that gave rise to them.
You never mention one important reason for saving- viz. to escape the tax on consumption. You don’t mention the easiest way to escape Estate Duty which is to spend or give away everything before you die.
I’d like to see the proof you know of re. the efficiency of equal consumption taxes so as to look at how the income effects are treated. But, to repeat, I’m not saying a proof re. econ activity exists- or not one that is refers to a concrete model- just that it isn’t much of a jump from the one to the other. If you already believe pigs complete their reproductive cycle in air-borne mode then why not accept that pigs can fly?
I’m afraid, this argument holds only for a single person economy. Even there a small amount of uncertainty would provide counter-examples.
For two or more agents, the result becomes meaningless if the income effect swamps the substitution effect for some consumers.
In the Irish famine case, an equal tax on potatoes and meat- to yield equal revenue- would have such a devastating impact on some agents- they starve and die- that in the next period there could be less income even for the other agents- assuming the former are peasants and the latter landlords.
In an earlier post http://www.thebigquestions.com/2010/09/23/the-least-painful-tax/- you used Indifference curves to show that
assuming equal revenue to the Govt a 50% tax on income was preferable to a 40% tax on both income and savings. However, it turned out that in practice this meant a choice between
a) a 50% tax on income or
b) a 50% tax on both income and saving.
This was because of the manner in which equal revenue was to be achieved.
I’m afraid these arguments are fallacious.
Prof. Lansburg a couple of questions-
‘Note that this argument (which is perfectly standard and available in any intermediate theory text) relies on indifference curves and hence applies only to consumption goods.’
Really? Then why did you use it for your post on the-least-painful-tax which deals with savings?
One other question-
‘Now if we taxed one type of activity at a higher rate than another then (unless there is some source of market failure) we lose allocative efficiency.
Kev: Calling something a “canon” doesn’t make it true, and in this case, in fact, your assertion (under any reasonable assumptions I can think of) is false.’
What are the reasonable assumptions which you can think of which make it false to say different types of economic activity should be taxed at the same rate for allocative efficiency (assuming no market failures)?
kev:
I’m afraid, this argument holds only for a single person economy. Even there a small amount of uncertainty would provide counter-examples.
Neither of these things is true. You might try reading a textbook.
Shiela:
‘Note that this argument (which is perfectly standard and available in any intermediate theory text) relies on indifference curves and hence applies only to consumption goods.’
Really? Then why did you use it for your post on the-least-painful-tax which deals with savings?
Because savings are future consumption.
Kev: Take two consumption goods, say apples and oranges. If you tax the goods at different rates, you get a new budget line with a different slope than the old one. Call the optimum point P. If you tax the goods at the same rate and hold govt revenue fixed, you get a new budget line with the same slope as the original, also going through point P. To avoid the crossing of indifference curves, the optimum along this new budget line must lie on a higher indifference curve than P (draw the picture!). Thus consumers are better off under the equal-taxation policy.
Dear Steve- your argument is true for a one person economy with prices remaining unchanged and determined exogenously. If there is more than one agent it does not hold. There is no unique solution. One type of consumer may strategically alter their consumption mix (altering their revealed preference) and sell the less preferred item to another type of consumer so that the slope of the budget line changes for them. Indifference curves are no use here.
You say- Note that this argument (which is perfectly standard and available in any intermediate theory text) relies on indifference curves and hence applies only to consumption goods. I don’t see why. Indifference curves are used in inter-temporal choice. However, on your own argument, for a one person economy the abolition of a tax on interest income What can’t be done with indifference curves is getting an interesting result with an equi-revenue provision.
Perhaps Graciela Chichilnisky’s approach gives some purchase to geometrical insights in this context. But they certainly aren’t going to enable you to prove anything in Public Finance.
Mr. Landsburg:
Your argument “First, it is incorrect to say the estate tax amounts to triple taxation.” seems to exclude highly paid employees who in general have their income based on their corporate profits.
Bob Cratchit works for Scrooge Inc and is so important to generating wealth for Scrooge Inc. that with his bonuses his compensation he ends up being 5% of Scrooge Inc. Profits.
Scrooge Inc. makes 20,000,000 in gross profit but needs to pay a 50% corporate tax. So Scrooge Inc. nets 10,000,000. So Bob Cratchit makes 500,000 per year. Bob Cratchit is taxed at 50% income tax so his net income is 250,000 per year.
In essence, Bob Cratchit’s income has been taxed twice already. Without the corporate tax, his income would be 500,000.
So it is incorrect it is incorrect to say the estate tax amounts to quadruple taxation of Bob Cratchit’s estate.
All you people, including Professor Landsburg, fretting over double and triple taxation are being silly. You are starting from the wrong end of the issue. The right end is America and our motto, e pluribus unum, which means from many, one — in other words, we’re all in this together. There are things we need to make life good for all of us. That’s why our forbears wrote the Constitution, which established a federal government with the power to tax us, because making life good for us isn’t free. Because we and our parents and grandparents and so on paid taxes, we have courts to settle legal disputes, we have roads to transport our goods, we have border protection to keep enemies out, and we have an educational system to prepare each generation to participate in civil and economic life. If it weren’t for the taxes we all pay, our lives would be like in Somalia, which has no government and no taxes, and live is nasty, brutish and short.
Entrepreneurs, businesspeople and employees don’t make all their money themselves. They make their money with the support and existence of civil society that created the Internet and the educational system and the roads and everything else that made this income possible. It is appropriate for economic activity to be taxed at various stages. If someone owns a profit-making business, we tax the profits as paid out every year. But if some of the profits are retained and the business grows, we tax those profits when capital gains are realized. And if the business (or corporate stock) is never sold during the lifetime of its owner, we tax the estate if it is sufficiently large, in part as an alternative to capital gains tax, and also because each dollar collected from the estate of a dead multimillionaire is a dollar that doesn’t have to be collected on the incomes of young parents struggling to feed, clothe, and house their children.
Professor Landsburg frets that money invested was already taxed when it was earned, so why should the profits on the investment be taxed? One answer is, the money wouldn’t have been earned in the first place if you lived in Somalia; the tax on the original earning is appropriate because those earnings were made possible by living in civilization. The ongoing existence and growth of the business is made possible by living in civilization, so when gains on the investment are realized, we tax that.
If we taxed money made by work and not capital gains, this would mean that ordinary working Americans would pay most of the taxes and the rich would not pay their fair share, even though they benefit the most from living in civilization. Taxes are the price of living in civilization.
Eyesay: The argument here isn’t about how much to tax, or about who should pay taxes. It is about the most efficient way to raise those taxes. Taxing labor once (at a higher rate) is more efficient than taxing it twice (at two lower rates) because the latter distorts the savings decision and encourages overconsumption.
Taxing labor once means not taxing investment income, and that means that Warren Buffet can earn hundreds of millions on his billions of investments and pay no taxes at all, while middle-class taxpayers pay 28% or more or less from their work. That’s unfair and ridiculous. And the notion that it is more “efficient” to tax labor income than to tax investment income is also ridiculous.
Let’s say a small business owner-operator owns a business that earns $100,000 per year after paying all expenses except the owner-operator’s income. The owner-operator could pay himself a salary of $100,000 and the business would earn zero, or he could pay himself nothing and the business would earn $100,000, which he could then distribute to himself as “investment income.” Economically it is the same, and it should be taxed the same. Or, someone might invest several years of their lives creating intellectual property, such as books, music, software, or patented ideas. From then on, income from that intellectual property could be regarded as investment income, or it could be regarded with equal validity as deferred labor income. Which ever way you regard it, it should be taxed the same.
These examples shows that at least in some cases, there is no meaningful distinction between labor income and investment income. They also show how ridiculous is the notion that investment income is double-taxed compared to labor income.
And the notion that people who inherit wealth should have the right to lifetime tax-free income from that wealth is also morally abhorrent. Most people work hard to earn enough money to raise their children, and pay plenty of taxes on their incomes. Those lucky enough to have inherited wealth should pay taxes on their incomes too.
Many of the world’s religions call upon their adherents to contribute 10% of their incomes to charity. None of them call upon their adherents to contribute a lower share of investment income than their labor income. The religious intuitions of fairness and justice calling for labor and investment income to be treated the same for charitable purposes are entirely apropos for thinking about taxes as well.