One of the sadnesses of the political economy is that we simply never will have a perfect tax system. We do know what a perfect system would look like -- or at least the most efficient that could be crafted. We also know that if we actually had such a tax system then there would be a revolt -- fortunately, at the ballot box these days. The problem is simply that we humans are, well, human. And what we think is fair is not always what is efficient. As we desire to have a tax system that is both fair and also efficient then this poses something of a problem for us all.
This is the problem that faces us as we consider the proposals from Rapid (Research and Policy Integration for Development). They tell us that the Bangladeshi tax system raises some 65% of total revenue from indirect taxation and only 35% from direct. Other countries in much the same situation, or most of the more developed ones, do this rather the other way around -- something like 70% from direct taxes.
So, we should change the Bangladeshi system to be more like those of other countries. Which is one of these “well, yes, sort of” type demands. It would definitely make the tax system fairer. It would also almost certainly make it less efficient. Which might not be quite what we want to happen.
Direct taxes are things like income tax, capital gains, profits, and so on. We know who is making the money, we can charge the richer a higher rate and we can collect it directly from them; indirect taxes are all the other things: Tariffs, land taxes, VAT, prices for spectrum, and so on. The thing about indirect taxes is that they are efficient in the economic sense. Direct taxes -- however much fairer it is to say that the rich should not just pay more but be seen to -- are less efficient.
Our problem here is that all taxes have “deadweight costs” which are economic activities that don't happen because of the existence of the tax. We're poorer because we've imposed a tax that is. You're quite right, some of the things we buy with tax are worth more than these deadweights. Other things we can argue about of course. But we're going to have at least some things that the government just has to buy and we need to tax ourselves to pay for them.
The next stage is to note that different taxes have different deadweight costs. We even know the ranking of them. Resource taxes -- land value taxation (and there are entire libraries discussing Henry George's views on this) and mining taxes and the selling of spectrum for mobile phones and so on -- have the lowest deadweights. Then come the so-called “sin” taxes, on tobacco, alcohol, pollution, and so on. We actually want to reduce the amount of those things that happen so the deadweight -- the activity that doesn't happen because of the tax -- is part of the point.
Then, higher deadweights with each form of taxation come consumption taxes, then income, then capital, corporate, and -- right at the top -- transaction taxes.
The problem with this efficiency and fairness trade off is that we humans actually subject to a tax system see capital and corporate taxes as fairer than income and all three much fairer than a consumption tax like VAT. Usually, we're all fine with the really low deadweight taxes, but in that middle range we think the more efficient are the less fair and vice versa.
Which is a problem in the design of a tax system. Because yes, obviously, we want to be efficient in collecting taxes. Let's make ourselves the least poor as we can be in the process of raising money for the government to then make us richer. But also it's all got to be fair enough that the population will sit still to be taxed.
The ultimately efficient tax system would have no taxes on companies or capital (which really means rich people) at all and we know that's not going to survive an election campaign.
What Rapid is really demanding here -- and they're quite open about it -- is that we should have a fairer tax system. But this comes at a cost: It would be a less efficient one. There is no solution to this. We can only trade off one against the other to come to some least bad balance. Or, as is the basic lesson of economics itself: There are no solutions, only trade offs.
Well, there's no solution here to a degree. It is possible to at least suggest that we could have a tax system that only taxed those resources (land, rent, spectrum, minerals) and sin (tobacco, alcohol, and so on) and then didn't touch anything else at all. That would mean entirely fair taxation and also deadweights of almost zero except where we really wanted less economic activity: Those sins.
Which would be nice. The problem is that this would raise in between 5% to 10% of the GDP level in tax and that's the absolute maximum it would as well. I would like that world, but then again I'm a neoliberal and in today's world that means I'm evil. The real problem with such a system is that the politicians would never wear it.
Who wants to go to all the trouble of getting elected only to be restricted to spending 10% of everybody else's money? Even though that is twice what the American federal government had for the first 150 years of its existence.
Tim Worstall is a senior fellow at the Adam Smith Institute in London.
