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Understanding how taxes really work

  • Published at 07:12 pm October 12th, 2019
It’s not always complicated

Any competition is good competition

Contrary to a lot of the political arguments floating around, tax competition is actually a beneficial process. This is something that needs to be understood when people like Miroslav Palansky argue against such competition.

The crucial point to understand is that competition makes producers more efficient and more productive. We know that this is true of businesses. It’s one of the major arguments in favour of international trade -- that people get exposed to that competition which makes them more productive. There’s nothing at all, in either theory or practice, which says that this same influence isn’t true of governments. Being exposed to competition means that government must become better.

The same is true of tax systems. 

We also need to recognize that there are bad taxes and good taxes. For sure, there are some things that must be done and which can only be done by the government. Therefore, we need to have it and also the taxes to pay for that institution. 

But some taxes cost more than others to collect. The technical term here is “deadweight.” Taxing something means we have less of it. But the effect of taxation will be different and is dependent upon what it is that we tax. 

We also know the spectrum here. Taxes upon land -- land value taxation -- have the least effect, then in rising impact upon consumption, then incomes, then at the top is corporate and capital taxation. Transaction taxes have such a stupidly high effect that we tend not to use them at all. 

So, we need to have some money in tax. We also know that the effects of different taxes vary, so we’d like to get the tax revenue we need from those which have the least effect. Land and consumption, perhaps incomes, but we really don’t want to be taxing companies.

There’s another point here too, that companies are just collections of people. There’s reason not to tax the company, but instead to tax the people who get the money from it. So, tax dividends but not corporate profits. That shifts us to a lower cost form of tax.

The political contention is that we’ve got to change the method of taxing international companies so as to increase the tax revenue from them. And more than that, we’ve got to limit this competition between tax systems so that we can do so. Yet we have that other influence, that competition makes tax systems more productive, more efficient -- just as competition does with anything else.

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It is the second argument that should win here, whatever the politics. Corporate taxation is inefficient and we destroy more economic activity that way than we do by raising the same revenue with fewer deadweights elsewhere. So, if international competition means that we lower corporate taxes and collect our money some other way, then that’s a good result, not a bad one we need to protect against.

There is another angle of attack here too. There’s an assumption that it is the company paying the tax. But this is obviously wrong: Any tax means that the pocket of some human being is lighter. With corporate taxes, we know that it’s some combination of the shareholders in the company and the workers in the economy levying the tax. The mechanism is that more capital is what increases worker productivity and thus wages. So, if we tax capital, then there will be less capital employed, and so productivity and wages will be lower.

We also know what influences that split. The larger the economy, the more it is the shareholders paying the tax. So, when we come to foreign investment in a small economy like Bangladesh, we find that the majority of that corporate tax is actually paid by the workers. Not the foreign capitalists at all, but local Bangladeshis. This probably isn’t a good idea. It’s certainly not what we’re told in the politics of the issue now, is it? 

A high corporate tax in Bangladesh is inefficient and the people really paying that tax are the workers. Joe Stiglitz -- rather left wing and also a Nobel Laureate in economics -- even pointed out in 1980 that the loss to the workers can be more than 100% of the tax raised.

So, if international tax competition stops us from using this bad form of tax raising and pushes us into using a better one, then we should welcome that competition. Not change the system to abolish it and thereby insist that we use a worse taxation system. 

Market competition makes the world a better place as it’s the main method by which productivity increases. We thereby get more for whatever effort we put in -- that’s what increased productivity means. The same is true of government and taxation. Competition improves these things -- why would we want to stop the government getting better? Which is why we don’t want to stop tax competition. We want to insist that our rulers are exposed to as much of it as possible.

For really, no one at all is going to claim that any current or extant government is perfect and cannot be improved. Nor tax system, eh?

Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.