Taxes are in the news these days. Both Rick Santorum and Mitt Romney recently released tax plans as part of their campaigns for president. And the Obama administration released a new budget proposal for the coming fiscal year that would alter some key tax rates.
Taxes are important for a variety of reasons. Few people enjoy paying them, but they are necessary if the government is going to, in the long run, pay for the goods and services it consumes along with the goods, services and transfer payments it provides to the public.
It is often instructive to think of the government as if it were a smaller entity like an individual or a household, but at times the comparison can be misleading. Just as households need to run balanced budgets in the long-run, governments also need to make sure they have the funds available to pay for the things they buy in the long-run. Failure to do so leads to problems like those we see in many places around the world today — Greece being one of the most prominent examples.
When governments face budgetary shortfalls, they need to either cut spending or increase revenue or some combination of both. Households face the same stark choices. Household can raise their revenue by having some family members work longer hours or having additional family members enter the work force as wage earners. They can also try to find higher earning jobs. To summarize, households usually increase their income by selling more of their available factors of production (like labor hours) or by earning more per each unit of factors provided.
Governments, on the other hand, do not really sell anything. Instead they increase revenue by raising tax rates on various kinds of assets and economic activity, or by closing legal loopholes and exemptions that previously made some types of assets and economic activity exempt from taxation. This is not the same as a household earning more income, since the government is not offering a voluntary trade of equally valued things the way a worker does when he or she works more for a higher pay.
Governments — or more precisely government policymakers — often talk of raising tax revenue as if they were behaving in exactly the same way as a worker putting in more hours on the job. What they neglect to point out — or are oblivious to — is that this revenue is extracted involuntarily from households and is not the same as a market exchange. How this tax revenue is ultimately spent as compared to how the household would have spent the money is of key importance.
As University of Rochester economist and columnist Steve Landsburg has pointed out, wasteful government spending does not magically become less wasteful simply because the government pays for it with increased tax revenues rather than borrowing the money.
Taxes are also important for the incentive effects they provide. In fact, this may be the most important effect they have on the economy. Independent of any effects on the size of the budget, taxes can incentivize or de-incentivize people in very powerful ways.
Consider the effects of taxes on capital earnings. One way to make workers more productive is to increase the size and quality of the capital goods they have available when they work. Part of a firm’s revenues are attributable to the capital it owns (roughly one-third in the U.S.) and the remainder is attributable to the workers it hires.
Labor-generated revenue is returned to households in the form of wages and salaries. Capital-generated revenue is returned in the form of interest payments on loans and bonds and in the form of stock dividends. When governments increase taxes on capital, they reduce the net return to investors who finance the purchase of new capital via their purchases of corporate bonds or stocks. Investors respond by investing less and capital stocks either fall or fail to grow as rapidly as they would have.
Taxes on capital income are often touted as a way of achieving a more even distribution of income. Since all of us have an equal endowment of time, most wealthy people do not earn the majority of their income in the form of wages. Instead, their income is primarily from investments in capital. On average, taxing capital is a way of placing a greater tax burden on the wealthy. Note however, that in the long-run this reduces the size of the capital stock and this, in turn, reduces labor productivity and wages.
In the end, heavy taxation of capital hurts both workers and investors.
Kerk Phillips is an associate professor of economics at Brigham Young University.