Wednesday, June 14, 2017

Inefficiency of High Taxes and Large Government Sectors

There are some inefficiencies that are due to the sheer size of government and the required revenue to run such a government. A government that consumes 10% of GDP is categorically different from one that consumes 40% of revenue. The latter case isn’t just the former case scaled up by a factor of 4; the latter creates problems that don’t exist at all in the former case.

Take tax avoidance. Rich people and big businesses hire teams of lawyers and tax accountants to lower their tax bill. If you can craft a legal argument that a large expense is tax-deductible, you might be able to save your company, say, $10 million. Your employer will be willing to pay up to $10 million for those savings. From the standpoint of society as a whole, resources used to argue over who gets what are a sheer waste. The loss to society isn’t the $10 million in lost government revenue. The real loss is the alternative uses of those brilliant legal and accounting minds employed to minimize tax bills. With a very low tax rate, the tax code could be very simple. There could be no tax deductions at all, so there’s no game of “thinly slicing the salami” over what is or isn’t a legal deduction. One could do away with capital taxes, which inefficiently double-tax income that has already been earned and taxed (originally as labor income). It could all be replaced with a simple income or sales tax. But the massive revenue required to run a large government sector has led to the taxation of almost all transactions, which inherently means multiple rounds of taxation on any given dollar of earned income.

In the city where I work, there are several buildings in the downtown area that have been vacant for years. (This has changed very recently, but there was a long period of perfectly usable yet unused building space.) Someone suggested to me that this is just runaway speculation: someone is sitting on a property because it could be worth a fortune some day. But I suspect this explanation doesn’t quite cut it. If the owners are able to write off depreciation, then a vacant building can be a substantial “tax asset” to a wealthy owner. That probably doesn’t make it worthwhile to buy and hold a bunch of vacant buildings, but it can certainly move the margin of “acceptable sale price” for the owner. It means that buildings remain vacant longer than they should, for inefficient tax avoidance reasons. I don’t know how big a deal this is, but surely there are other examples of this phenomenon. We have some people holding onto these crumbling "tax assets", whereas in a saner world these things would be seen as a pure loss. The owners would sell these properties to someone who places a real value on them, and society as a whole would derive some kind of use from them. With very low rates of taxation, this becomes almost a non-issue. With 30-40% rates of taxation, the write-off becomes substantial. We miss out on the apartments, restaurants, offices, and stores that those buildings might have become.

None of this is to say it's easy to simply trim our waistlines and cut government to 10% of GDP. Sure, that would create some losers along with some winners. (It's easier than you probably think, though. The big budget items, Social Security, Medicaid, and Medicare, could be mostly replaced by a forced savings policy. We would no longer have those huge liabilities requiring high tax rates.) In this post I am not arguing for a huge reduction in government. Rather I am pointing out that a large government has very high costs, which scale up much faster than 1-for-1. A public sector that consumes 50% of GDP is much more than five times as costly as a public sector that consumes 10% of GDP. The real cost probably scales up with the square or cube of the size of government, rather than a simple linear scaling. My point here is to articulate a trade-off, not to state where we should sit on the trade-off curve. There are costs here that we should face with our eyes wide open. There is the entrepreneur who fails to sell his stock portfolio to invest in a private start-up, because he doesn't want to incur a capital gain this year. There is the business that is worth starting under a zero (or at least single-digit) tax rate, but which is rendered unprofitable at a 35% tax rate. There is the bloating of home sizes, because a more expensive home leads the a larger tax asset (because of the mortgage interest deduction). There is the implicit favoring of debt financing over equity financing because of the high corporate tax rates (because interest paid on debt is now a tax asset). There are the thousands of other distortions that don't come to mind at the moment but that economists spend their lives researching.Ideally taxes are structured so as to minimize distortions.  You don't want a tax to cause someone to zig rather than zag. (Maybe you do if it's a Pigouvian pollution tax, but if the purpose is to collect revenue you want to minimize distortions.) If having a very large government sector is worth all these collateral costs, someone should be explicitly arguing that "It's worth the cost, because the benefits are so large" rather than blithely ignoring the costs or claiming they don't exist. 

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