Taxes, Waste, and Liberty
Stefan Karlsson recently wrote an interesting piece for Mises.org on the substitution and income effects of taxation. (See also the blog thread.) He denies the relevance of income effects of taxes on economic efficiency and argues instead that the substitution effects of marginal tax rates reduce economic efficiency by shifting us towards less work and more leisure at the margin. While his reasoning is sound, it ignores a tried solution to this problem of taxing labor without affecting labor supply.
Supply Side Economists emphasize these issues in arguing for lower marginal tax rates, and refer to John F Kennedy as one who put this into action. However, it is the case that Supply Side economics was implemented by none other than Josef Stalin in the Soviet Union- Yes, Ronald Reagan and Joseph Stalin were both avowed Supply Siders.
Stalin set high infra-marginal tax rates on labor (Olson 2000 P120). This means that Stalin set effective tax rates on the standard work week for soviet labor at very high levels. Stalin set effective tax rates on marginal income at very low levels, so that workers kept nearly all of their ‘overtime pay’ (Olson 2000 p123). What does this look like?
Stalin set taxes to try to collect the value of the area above the supply of labor curve, up to the point where people would work less at the margin. This made the income from a normal work week (infra-marginal income) too low for workers to live on. Not only did workers refrain from reducing their labor supply at the margin, they seem to have increased this supply, if possible. Stalin explicitly paid incentive pay to make workers produce more. This increased supply, as Karlsson pointed out, reduces leisure- so there is a real cost to workers. But his argument that substitution effects matter to taxation is rendered ineffective by this approach where taxes are paid mostly off the margin.
There are other costs involved here. First of all, taxes off the margin affect the returns on developing labor skills. Taxing taxed people according to their ability, but for his needs. This meant that he could reap great revenues given the existing abilities of workers, but discouraged any future efforts at developing such abilities in the future.
Olson (2000) also points out that the bureaucracy of Stalinist Russia evolved into a set of narrow special interest groups that reduced the productive efficiency of the Stalinist system, even in terms of serving political elites. Tax and spend redistribution states spur competition over money income. This is fundamentally different from normal entrepreneurial behavior. Competition over customers in capitalism means producing goods that actually serve to satisfy consumer demand. Competition over distribution burns up resources that could be used to produce goods, but are instead used to produce transfers (Tullock 1967).
Society can operate according to the principles of voluntary trade and respect for property rights or through coercive transfers and the violation of property rights. Western welfare states do in fact cause problems with the allocation of resources by taxing labor at the margin, but this is a special case where politicians ignore the logic of marginal value theory. Even when politicians recognize the importance of the margin and set tax rates in a way that serves their interests better, waste and economic inefficiency will follow. This is the nature of political competition.
Of course, Stalin’s tax system was a part of a brutal tyranny that deprived millions of freedom, and even their lives, so the avoidance of marginal losses in labor markets is no justification for such a system anyway. But the fact of the matter is that Western Democratic Welfare states could adopt Stalinist infra-marginal tax rates to eliminate the substitution effects that Karlsson worries about. Substitution effects are indeed something to worry about. So are the wastes of political competition and the erosion of individual liberty.
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Olson, Mancur (2000) Power and Prosperity
Tullock, Gordon (1967) The Welfare Effects of Tariffs, Monopoly, and Theft
Comments (4)
I don´t know much about the Soviet tax system apart from what you wrote, but if I interpret it correctly, Stalin had different tax levels for different persons depending on what profession they belonged to. This , as you acknowledge will create a substitution effect for people to develop labor skills. Moreover, that kind of approach wouldn´t eliminate substitution effects even for existing workers in a non-communist society where people are free to choose jobs because for one thing they often change their profession and clearly then there will be substitution effects. And there would also be a substitution effect for reducing working hours below the normal and even quiting your job,especially given the existence of welfare and unemployment insurance.
But actually there is one way to tax without creating substitution effects, that is to have a "poll tax", where everyone pay a equal dollar amount regardless of income or wealth. This was what Margaret Thatcher tried to implement for local governments in Britain and which actually exists partially in Sweden, where everyone who owns a TV have to pay a tax of 1872 kronor (roughly $250)per year regardless of income or the kind of TV one owns. If as under a poll tax system the amount you pay in taxes are not in anyway effected by how much you work, save and invest, then no substitution effects.
But of course, with that kind of tax system the poor will end up paying a much higher proportion of their income than the rich, and the redistributive justification for the welfare state will no longer exist.
Published: July 28, 2004 6:50 AM
Stefan,
I think the poll tax system (ie 0% marginal tax whatever the income) is in fact similar to the "tax off the margin" (0% or low marginal tax tax beyond a certain threshold) described by MacKenzie, it only pushes the approach a little further.
As Rothbard pointed out, the beauty of the poll tax is that it forces government to set it at a fairly low level in order for the tax to be "bearable" for the masses of low earners, thereby reducing overall tax revenues.
Thatcher's failure to understand this point (as she attempted to switch to a poll tax system while keeping local tax revenues constant) led to her demise further to violent protest.
A state's objective is not to maximize efficiency or reduce subsitution effects. It is to raise the maximum amount of tax revenue (in the short term) with the minimum amount of protest. Hence the progressive tax rates typically encountered in social democraties.
Published: July 28, 2004 10:08 AM
Stalin did have different taxes for people with different abilities. He also set marginal tax rates at zero. For instance, say that a 'normal' work week is about 37 hours, and people generally think about working overtime at around this point. A Stalinist tax system would tax the first 35 hours at a very high rate, and 36+ hours at zero or very little. The taxes on inframarginal hours has an income effect that pushes workers to spend more time working. The zero tax rate at the margin eliminates static dead weight losses. These are the general features of the Stalinist system. Supply Siders stress the importance of marginal tax rates and Stalin understood this back in the 1930's. Modern legislators could adopt this kind of a system to limit the negative effects of taxes on labor supply at the margin. This does not prevent waste, as tax revenue frequently gets spent badly, and political competition over income transfers expends real resources in an unproductive process.
Published: July 29, 2004 10:42 AM
I am looking for a simple explanation of the effect of increased tax to the free market economy. The relationship between spendable income and the effect of lowering spendable income through increased taxation.
I sit on the City Council of Billings Montana and I am having a difficult time convincing other council members, the mayor and staff that excess taxation is harmful to the economic vitality of our community.
Thank you
Dave Brown
Published: September 8, 2004 7:12 AM