This is disturbingly awkward as I’m about to claim that a politician has the right idea and do so for the second time in a month. But it is so, Finance Minister AMA Muhith is correct in his insistence that the VAT should be brought in. I do not claim that his specific plans are perfect but the general idea is indeed thought to be very good economics. And for very much the same reason, I praised the earlier insistence that property should be properly registered and taxed.
VAT is one of the lesser bad forms of taxation out there. None of us like paying taxes, even if we think that what the government does with it is absolutely alright -- a delusion shared by very few -- we do still understand that the tax is the cost of us getting the benefits of government spending.
And there’s no doubt at all that we need to have at least some form of government, however modest, and that also means that we must have tax revenue, again, however modest.
At which point, economists insist that tax is a bad idea. Yes, true, we could buy wondrous things with the money paid in tax. If you tax something you will get less of it, so, whatever it is that we tax we’re going to get less of. That’s why land taxation is so effective -- we’re not going to make Bangladesh smaller by taxing the land, but other than that, whatever we do tax we’ll get less of.
If we tax profits, then people will make less effort to make profits. If we tax income, then people will work less hard. If we tax people buying things, then people will buy fewer things. This is just how it works. Taxing any economic activity means less of that economic activity going on.
We call that loss of economic activity the “dead-weight cost” of the tax. Just things that don’t happen because of the very existence of the tax. If apples cost Tk5, I will buy one. If a tax makes apples cost Tk7, then I won’t buy one. The dead-weight cost of the Tk2 tax is one less apple sold. This applies to just about every tax.
However, we also know that different taxes have different dead-weight costs. There’s a spectrum in fact -- from that land tax which has almost no such losses, through consumption taxes, to income, to capital and corporate, and at the very top something like a transactions tax. We want to do as much of our taxation as we can at the lower cost end of that spectrum than the higher.
Think it through for a moment. The dead-weight is the economic activity that just doesn’t happen because of the existence of the tax. Yet, we like economic activity, it what makes us richer over time. But we also need tax revenue because we want a government. So, we should get our tax revenue from the tax which eliminates the least-in-demand economic activity.
These are not the correct numbers, but just to show the logic of the example. Imagine, if we get Tk1,000 from taxing profits, that then cuts off Tk300 of economic activity. If we get Tk1,000 from taxing income, that takes away Tk200; and if we get the same tax revenue from taxing consumption then only Tk100 is the cost.
We would obviously like to get more of our tax revenue from the consumption tax, wouldn’t we? Because that translates to the most economic activity while we also fund the government.
And a VAT is indeed a consumption tax. The people who really pay it are those who buy things to consume. We consume a shirt by wearing it, we consume a bed by sleeping on it -- but that is also where our problem is of course because this means that we’re now taxing the people rather than just the rich.
That is, a VAT is a regressive tax, it falls on all rather than only those with the big wallets. There is a partial solution to this, which is to leave some things not subject to the tax. It’s not unusual, for example, to not to pay VAT for food -- although places like Sweden do charge for it. But there isn’t really any perfect solution.
For here, we’ve got our great economic trade off again. We’d like to be efficient, because that is what makes us all richer over time. But we’d also like to be fair and that’s a very different calculation. Fair would be if only the rich had to pay for all of the government -- even Adam Smith said that the rich should be paying a greater portion of their income in tax. But that wouldn’t be efficient, the rich gets much of their money from profits which we know has high dead-weight costs. Thus, being fair now makes us poorer in the future than we would be otherwise.
As far as economics is concerned, there is no right answer to this. For economics can tell us what is efficient but it cannot tell us what is fair, that’s about morality. The best we can do is some sort of vague balancing act.
Yes, we should be getting some to much of our tax revenue from VAT and such consumption taxes just because that makes all richer, eventually. Whether it’s fair or not just has to be offset against that overriding goal, which is, after all, the very point of having an economy in the first place -- that we all do get richer over time.
Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.