A couple of weeks ago, I suggested that the large, rich Western democracies ran out of room some time ago to raise income tax revenues to any significant extent, and therefore the ability to fund large programmatic change by governments was similarly constrained. I promised to come back and discuss some alternative solutions to those who advocate such change. On the left, those advocates call, for example, for much increased welfare provision or otherwise significant redistribution to reduce inequality. On the right, such advocates argue for large scale debt reduction of the kind last achieved (and then only to a modest extent) by Clinton in the US or Blair in the UK. Anyone of the left or right who foresees the need for significant increases in military expenditure to protect ourselves in our new multipolar world should also be concerned about our ability to fund large programmes when we have run out of tax rope.
This problem is not new. The American Revolution was set off by a British government that had fought an extremely successful, but very expensive, war against the French. The so-called Seven Years War was really the first global world war, and briefly brought the British world domination at the expense of a large increase in British government debt, regarded at the time as unsustainable. (Today we would simply laugh at their worries. Our debts are much, much bigger.) Attempts to fund the costs of running newly secured North America by taxing its residents met with a predictable response, and the United States was born. Much, I would add, to all of our long-term benefit.
Between the mid-eighteenth century and the early twentieth century, the major change in the nature of government was the expansion of the franchise from a narrow elite to include all adult citizens. With such an enormous increase in legitimacy, governments found themselves able to raise far higher sums in tax as a share of GDP, and the state expanded three-to-five-fold. They also started to spend their new income on different stuff, and so the welfare state was born. I argued that a similar expansion is no longer possible, and so governments now have to make harder choices. Defence, or welfare, or debt reduction, but surely not all three at once. How can we square the circle?
Perhaps the simplest answer is that we can’t, and so we must choose. That was the answer of the eighteenth-century Whigs, but they lost America. Modern politicians don’t like this answer either, because it tends to cost them elections. Can we do better?
Another answer is that we shouldn’t, because governments mostly spend money on the wrong things, either defence, or welfare, or more generally shovelling money towards their own clients in a wasteful exercise in order to secure re-election. Almost everyone I know deplores at least one of these three categories of additional government spending. However, in a democracy we don’t get to veto the spending priorities of election winners, and so, unless we can re-educate the vast majority of voters to be more of our own point of view, this kind of sentiment will get us nowhere.
The first step is to understand that both tax and welfare transfers (negative tax) are highly distortionary in the sense that they alter incentives and change what agents choose to do, as opposed to what they would do, in the absence of such taxes or transfers. At the higher-earning end, agents reduce their effort in response to higher taxes. At the other end, agents also reduce their effort in response to such transfers. Everyone can surely think of examples of both the high-earning freelance who simply can’t be bothered to take on an additional assignment because the after-tax payoff is too low, which costs the government lost revenue. Most of us can also think of other struggling friends who lose a crucial state benefit because they get a pay-rise at work, resulting in a marginal effective tax rate of way over 100%. The latter have, in my experience, caused real hardship to hard-working families I respect and have ended up helping, causing me to curse the inefficient bureaucratic state which decrees such things.
At the rich end an obvious improvement would be to recognize that most very rich people want to create wealth, not income. Someone who strives to build a billion-dollar business is probably, though not always or ever entirely, motivated by a desire to become rich and to bequeath their wealth to their offspring. Most of them often do without large incomes on the way up, investing most of the profits of their growing businesses back into the business. These are the people who built our economy and will continue to build it. If we tax them on their wealth rather than their income, and so long as we aren’t too greedy, we can surely increase the tax revenue from them while avoiding demotivating them.
Tax havens live on this insight. By offering very rich people a deal based on a small tax of their wealth while promising to leave their income alone, countries like Luxembourg and Switzerland, but also many other small well-off countries, have prospered. Why not steal their methods and offer a similar internal deal to the very few, but very successful, wealth creators without inducing them to leave their countries of birth or success? For example, imagine if any American who achieves wealth of over $1 billion can opt to pay a wealth tax of 1% (yielding $10 million to the Treasury every year) and no other tax at all?
Such a low wealth tax rate hardly effects the motivations of such a wealth-creator, ensuring the wealth is created, while furnishing far more in tax revenue than a 40% tax on an investment banker who works every minute of every day to earn $10 million per year (yielding the Treasury $4 million). Both jobs are more or less equally difficult, the banker’s job is more stressful (probably), and the latter tax is much more demotivating. If you also have an aesthetic preference for more wealth creators and fewer investment bankers, you will get your desire. Finally, the hypothetical investment banker will probably spend a lot of money and effort on tax boondoggles, while the wealth creator simply can’t be bothered.
We have little idea how such wealth taxes would succeed because we have no data on personal wealth in large countries, and the small tax havens like to keep such things secret. A wealth tax would reveal the distribution of wealth at the top, and likely reduce the incentive to move countries. Lovely as it is, Switzerland is probably not where most super-successful Americans, British and French really want to live. There’s no one to talk to.
For such a tax to work, which could double the tax take from the super-rich, where it matters, it would have to be accompanied by a pledge not to raise it much. (Such a pledge was indeed made, and broken, when income tax was first introduced in the UK.) Equally important, governments would have to pledge not to raise it again on the next generation by taxing inherited wealth much harder. What often motivates such wealth creators, like everyone else, is the desire to bequeath wealth. Such inheritance taxes would be almost as demotivating as high wealth taxes.
What about the other end of the income spectrum? Low earners have no significant wealth and often face very high marginal tax rates, as mentioned, owing to benefits with arbitrary thresholds and often just incompetently designed tax thresholds too. Middle income earners are even more the victims of poorly designed tax thresholds. (George Osborne introduced the gradual abolition, depending on income, of the untaxed income band in the UK, making earners in the income range between about £50,000 and £150,000 subject to marginal tax rates of 60%, sufficient to demotivate any middle-aged, middle-class income earner on, say, £70,000. These people are the backbone of any tax system, almost always overtaxed.)
Redesigning welfare benefits to eliminate marginal tax rates over 100% has proven to be beyond the ability, even the interest, of most Western governments. (There are honourable exceptions: Bill Clinton tried hard to fix the problem. The British Tories have not done so well despite also trying quite hard.) Yet this has the potential to transform the net fiscal calculus because there are so many people on such benefits, just as the few high wealth earners have such high wealth.
After 15 years of messing with a well-designed tax system post 2008, but one always based on income tax, and a welfare system that requires Nobel Laureates to fix its distortions, it’s surely time for a bigger, cooler look at the whole problem. Especially if it could prevent the decline of the West.