Recently economists got very excited by a book on wealth inequality (Piketty, 2014), which reminded me of how economics is still mostly an ideological debate and how far it is from being the queen of social sciences.
We see again the old left wing anti-capitalism rhetoric and its denial by the traditional adulation of the rich by the usual ass-kissing right wing. Economics can claim to be the science of many things, but apparently it is unable to be a science of common sense.
If economists relied more on common sense, they would immediately realize that the rise in inequality is hardly news. There has been plenty of studies showing that. Meanwhile, the focus on the share of the top 0.1%, apart from creating an “identifiable” common enemy, tried to create a stereotype equivalent to the XIX century top hat capitalist depicted by Marxists.
Remember that the later began by focusing on the 1%, but probably this group was too large to provide the necessary stereotype. Note also that the debate relies largely on the Gini coefficient and ignored the different weightings that society may put on inter-group income transfers using the metric suggested long ago by Atkinson.
Yet the greatest failure is on understanding why inequality is rising, and the reason may be quite plainly related to the failure to correct a well-known feature of capitalism.
Capitalism is the most efficient economic system ever devised by humankind that replaced a largely hereditary class system (nobility, clergy and serfs) based on predatory (conquest) economics by a system mostly based on social mobility through free enterprise and trade.
Yet, its central feature, the free accumulation of private property has two limitations. On one hand some ventures require large amounts of capital which are beyond individual means and require institutions (such as governments and institutional investors), and on the other hand the law of compound interest would allow such long-living institutions to ultimately own the entire capital stock and self-destroy capitalism itself. As we have shown in this post, the solution to this feature is easily achievable through reasonable levels of progressive taxes and the taxation of inheritances.
We add here that the survival of capitalism should not rely on artificially curbing the return on capital (Piketty’s r/g) or opportunistically expropriate the rich from time to time as some on the left advocate. There may be some reasonable curbing of executive compensation in listed companies where shareholders are basically powerless, but that is a different governance matter.
Let us exemplify with one of the richest man in the world. Would it make sense to have limited Warren Buffett’s wealth? If we had done so, he would not have created so many jobs and profits through his smart investments and society would be poorer without his $300 billion company. However, he is a very wise man and has decided on his wisdom to donate most of his fortune to charity.
Some will dispute whether that is the best use of his wealth. Some would prefer that he had given his money for research, environment, sports, culture or whatever, while others may say that the government should decide, not him.
How the inheritance money should be spent is an interesting question to debate but not relevant to decide whether to like or dislike capitalism or to bring back through the backdoor a destructive class warfare as advocated by Marx.
In conclusion, common sense suggests that governments should exercise moderation on taxing inheritances and give the taxpayers enough say on where governments will spend their wealth. We do not need to go back to the old divide.
Showing posts with label taxation. Show all posts
Showing posts with label taxation. Show all posts
Friday, 30 May 2014
Monday, 13 May 2013
Is the informal economy part of market capitalism?
Expressions like informal sector or informal economy and many similar expressions (e.g. underground, black market, shadow economy, under the table, "off the books", "working for cash" or moonlighting) are used to describe all activities that typically are undeclared for one (or all) of the following intents: payment of taxes, law and regulation or statistical reporting. Such activities are often paid in cash and are estimated to represent about 20 to 40% of GDP in developed economies and less developed economies, respectively (the percentages in terms of employment are higher).
Since they involve mostly self-employed, small businesses and part-timers one would imagine that they are part of the competitive market sector. Indeed, some even think of them as the best entrepreneurial antidote to the entry barriers often found in the formal sector. However, this would extend its rationale too far, because the informal economy includes activities that in terms of amounts and moral values are substantially different. We can appreciate that by classifying some of those activities in six groups defined on the basis of the amounts transacted and the legality of the activities as shown in the following table.
The colouring used highlights the degree to which the various activities are similar to formal and open competitive markets. Potentially only the yellow and orange activities may be included in the market capitalism sector, because free and competitive markets demand equal opportunities in the face of the law. There is obviously scope to transfer through legislation some activities from the red coloured areas into less serious offense categories. For instance, some governments may legalise and regulate the sex and soft drugs trade. Indeed, in some countries the tax authorities sometimes advocate such policies to raise tax revenue.
However, in itself this does not guarantee that they may be added to the market capitalism sector because many cannot be carried out in an open and competitive manner. In fact, this problem also affects many of the activities in the orange group because of problems of information asymmetry. For example, if someone discovers a loophole in the tax code he or she cannot advertise it otherwise the tax authorities will move to close it.
To simplify, we will assume that only activities that fit in the yellow group are part of market capitalism. And, because there are so many activities in this category we assume that they will add up to a substantial part of the market economy. So, let´s examine what drives the growth of this sector.
The economic rationale for those involved in these activities is basically two-fold: economies of scale and abnormal profits. Economies of scale usually derive from two situations – either the participants are too poor to pay the minimum “overhead” imposed by the formal sector or their demand is insufficient to cover such costs. In most advanced economies the “overhead” costs typically include sales taxes, personal and corporate income taxes, compulsory employee insurance, accounting and administrative requirements that easily cost as much as the net salary of those employed in the formal sector.
For example, those on low income often are forced into inefficient household production of junk food at a cost of $4 because they cannot afford the $5 price of a burger at the local McDonald. However, they would be better off by paying $2.5 at the street corner from someone working in the informal economy. Likewise, imagine a middle class neighbourhood where every resident has a small garden that only requires 4 hours of work per month. So, a full-time gardener would need to sign in 40 residents. What if there are only 20 residents? Well, he could still live as a part-time gardener in the informal economy with a net income equal to what he would earn net in the formal economy working for 40 residents.
Without exception, governments fail to appreciate the relevance of an adequate balance between activities carried out in the household sector, the informal sector and the formal sector using two contradictory arguments – the need to promote a level playing field (the informal sector is a source of unfair competition for the formal economy) and the need for social policies to protect the weak working in the informal sector and the low paid sectors in the formal economy. The policies used to squeeze the informal sector include both a stick (persecution, fines and taxes) and a carrot (fixing a minimum wage or granting a minimum income for the unemployed on condition that they do not carry out any paid activity).
Such policies are often ineffective, contradictory and very costly. Yet, a common sense policy would simply aim at reducing the formal economy “overhead” on both sides. That is, creating a semi-formal sector with a small overhead (e.g. 25%) and reducing the current overhead costs of the formal sector by another 25%.
Unfortunately, the current level of sales taxation is high and rising creating a strong incentive for those seeking abnormal profits in the informal sector to risk a lose-lose war with the tax authorities. Nevertheless, there is much to gain from a quasi-formal sector by empowering the poor to rely on their own initiative and entrepreneurship rather than on government hand-outs. Therefore, creating such sector is also part of the fight to promote market capitalism as a pillar of human well-being.
Since they involve mostly self-employed, small businesses and part-timers one would imagine that they are part of the competitive market sector. Indeed, some even think of them as the best entrepreneurial antidote to the entry barriers often found in the formal sector. However, this would extend its rationale too far, because the informal economy includes activities that in terms of amounts and moral values are substantially different. We can appreciate that by classifying some of those activities in six groups defined on the basis of the amounts transacted and the legality of the activities as shown in the following table.
The colouring used highlights the degree to which the various activities are similar to formal and open competitive markets. Potentially only the yellow and orange activities may be included in the market capitalism sector, because free and competitive markets demand equal opportunities in the face of the law. There is obviously scope to transfer through legislation some activities from the red coloured areas into less serious offense categories. For instance, some governments may legalise and regulate the sex and soft drugs trade. Indeed, in some countries the tax authorities sometimes advocate such policies to raise tax revenue.
However, in itself this does not guarantee that they may be added to the market capitalism sector because many cannot be carried out in an open and competitive manner. In fact, this problem also affects many of the activities in the orange group because of problems of information asymmetry. For example, if someone discovers a loophole in the tax code he or she cannot advertise it otherwise the tax authorities will move to close it.
To simplify, we will assume that only activities that fit in the yellow group are part of market capitalism. And, because there are so many activities in this category we assume that they will add up to a substantial part of the market economy. So, let´s examine what drives the growth of this sector.
The economic rationale for those involved in these activities is basically two-fold: economies of scale and abnormal profits. Economies of scale usually derive from two situations – either the participants are too poor to pay the minimum “overhead” imposed by the formal sector or their demand is insufficient to cover such costs. In most advanced economies the “overhead” costs typically include sales taxes, personal and corporate income taxes, compulsory employee insurance, accounting and administrative requirements that easily cost as much as the net salary of those employed in the formal sector.
For example, those on low income often are forced into inefficient household production of junk food at a cost of $4 because they cannot afford the $5 price of a burger at the local McDonald. However, they would be better off by paying $2.5 at the street corner from someone working in the informal economy. Likewise, imagine a middle class neighbourhood where every resident has a small garden that only requires 4 hours of work per month. So, a full-time gardener would need to sign in 40 residents. What if there are only 20 residents? Well, he could still live as a part-time gardener in the informal economy with a net income equal to what he would earn net in the formal economy working for 40 residents.
Without exception, governments fail to appreciate the relevance of an adequate balance between activities carried out in the household sector, the informal sector and the formal sector using two contradictory arguments – the need to promote a level playing field (the informal sector is a source of unfair competition for the formal economy) and the need for social policies to protect the weak working in the informal sector and the low paid sectors in the formal economy. The policies used to squeeze the informal sector include both a stick (persecution, fines and taxes) and a carrot (fixing a minimum wage or granting a minimum income for the unemployed on condition that they do not carry out any paid activity).
Such policies are often ineffective, contradictory and very costly. Yet, a common sense policy would simply aim at reducing the formal economy “overhead” on both sides. That is, creating a semi-formal sector with a small overhead (e.g. 25%) and reducing the current overhead costs of the formal sector by another 25%.
Unfortunately, the current level of sales taxation is high and rising creating a strong incentive for those seeking abnormal profits in the informal sector to risk a lose-lose war with the tax authorities. Nevertheless, there is much to gain from a quasi-formal sector by empowering the poor to rely on their own initiative and entrepreneurship rather than on government hand-outs. Therefore, creating such sector is also part of the fight to promote market capitalism as a pillar of human well-being.
Thursday, 21 July 2011
Taxation and Moral Values – the Case of Conspicuous Consumption
Everywhere, politicians advocate public policies to foster virtues (e.g. philanthropy) and discourage vices (e.g. smoking) through both the revenue and the spending side of the budget. However, they frequently treat them differently by failing to measure separately the costs of tax breaks and surcharges applied to achieve such policies.
Free markets do not require neutrality in the rates of taxation on property, income and consumption. Indeed, they should not be neutral in relation to the taxation of consumption for the satisfaction of basic needs (food, healthcare, etc.) and the taxation of luxuries and conspicuous consumption. Fiscal neutrality is often defined as in the FT Lexicon: “when the impact of taxes and of government spending cancel each other out, with demand neither boosted nor curbed”. Others add the requisite that it does not cause distortions. Besides, to some extent, the use of taxation for policy purposes goes against the principle of budget unity, and the repudiation of earmarking specific revenues for given expenditures.
However, in general, when it comes to differentiating between different classes of conspicuous consumption there is a strong case to advocate the rule of fiscal neutrality. We will exemplify with a choice between spending on impressionist masters and trophy wives, because the first may have some cultural value while the second may be morally degrading.
Imagine for example an ostentatious billionaire who is considering spending 50 million on a master’s painting or in marriage to a super-model under a pre-nuptial agreement that grants her the same amount if the marriage lasts three years. Since he is neither an art lover nor is he in love with his trophy wife both types of investment are morally questionable.
Yet, most countries will treat differently the two investments when he decides to file for divorce or sell the painting. Assuming that he cannot earn transfer fees on his wife and makes a capital gain in the painting, some tax codes will give him a tax credit on his divorce settlement and charge capital gains in the sale of the painting. As a result, he will be rewarded in the most degrading investment and will be punished in the cultural investment. This is exactly the opposite of the proclaimed objective of encouraging virtue and discouraging vice.
Not only is the taxation of virtues and vices difficult on practical grounds. For instance, it is impossible to distinguish between a genuine and a convenience marriage. But it is also impossible to make a distinction between capital gains and losses on ethical grounds. Therefore, taxation should be kept away from policies based on moral judgments. Its concerns should be based mostly in a fair sharing of the funding and the minimization of the government revenue collection costs.
You do not need to agree with James Buchanan and other libertarians that a moral order is preferable to moral anarchy and moral communities because it only requires a minimal intervention of the Government. Simple common sense tells us that governments are not apt to judge on the basis of moral merits, without becoming an easy prey of vocal interest groups.
Free markets do not require neutrality in the rates of taxation on property, income and consumption. Indeed, they should not be neutral in relation to the taxation of consumption for the satisfaction of basic needs (food, healthcare, etc.) and the taxation of luxuries and conspicuous consumption. Fiscal neutrality is often defined as in the FT Lexicon: “when the impact of taxes and of government spending cancel each other out, with demand neither boosted nor curbed”. Others add the requisite that it does not cause distortions. Besides, to some extent, the use of taxation for policy purposes goes against the principle of budget unity, and the repudiation of earmarking specific revenues for given expenditures.
However, in general, when it comes to differentiating between different classes of conspicuous consumption there is a strong case to advocate the rule of fiscal neutrality. We will exemplify with a choice between spending on impressionist masters and trophy wives, because the first may have some cultural value while the second may be morally degrading.
Imagine for example an ostentatious billionaire who is considering spending 50 million on a master’s painting or in marriage to a super-model under a pre-nuptial agreement that grants her the same amount if the marriage lasts three years. Since he is neither an art lover nor is he in love with his trophy wife both types of investment are morally questionable.
Yet, most countries will treat differently the two investments when he decides to file for divorce or sell the painting. Assuming that he cannot earn transfer fees on his wife and makes a capital gain in the painting, some tax codes will give him a tax credit on his divorce settlement and charge capital gains in the sale of the painting. As a result, he will be rewarded in the most degrading investment and will be punished in the cultural investment. This is exactly the opposite of the proclaimed objective of encouraging virtue and discouraging vice.
Not only is the taxation of virtues and vices difficult on practical grounds. For instance, it is impossible to distinguish between a genuine and a convenience marriage. But it is also impossible to make a distinction between capital gains and losses on ethical grounds. Therefore, taxation should be kept away from policies based on moral judgments. Its concerns should be based mostly in a fair sharing of the funding and the minimization of the government revenue collection costs.
You do not need to agree with James Buchanan and other libertarians that a moral order is preferable to moral anarchy and moral communities because it only requires a minimal intervention of the Government. Simple common sense tells us that governments are not apt to judge on the basis of moral merits, without becoming an easy prey of vocal interest groups.
Saturday, 28 May 2011
Sharing the burden of government
The old fear that democracy would allow the poor to expropriate the property of the rich has never materialized. If anything, the opposite may be happening in America.
Explaining this fact is one of the greatest puzzles of American politics. An interesting attempt to solve the puzzle can be found on this post by Christopher Jencks.
However, in our view, the author misses two of the most important reasons, namely the decreasing returns to scale in the field of taxation and the policy of “bribing of the poorer among the poor”.
The first relates to the well known fact that the rich can afford to buy more tax planning/avoidance protection, and that when faced with higher taxes they have a greater incentive to take their income and wealth away from the taxman.
The second is largely unknown or considered something that happens only in less developed economies. For instance, Chavez and other populist dictators often secure their political power base by providing some income distribution among the poorest members of society to provide them with a base of popular support. This technique is also used by criminals when setting up their own system of social security in the neighborhoods they control.
What is not recognized is that the American situation, where the bottom 50% of the population hardly pays any income tax, corresponds to a similar policy. This policy has been at the expense of the remaining 45% of the non-rich population (mostly middle and upper middle classes).
This raises two interesting questions that we will revisit later. First, why representative democracy did protect the rich but failed to develop a better tax system based on expenditure and wealth rather than income? Second, are the bottom earners really benefiting from income tax exemptions?
Explaining this fact is one of the greatest puzzles of American politics. An interesting attempt to solve the puzzle can be found on this post by Christopher Jencks.
However, in our view, the author misses two of the most important reasons, namely the decreasing returns to scale in the field of taxation and the policy of “bribing of the poorer among the poor”.
The first relates to the well known fact that the rich can afford to buy more tax planning/avoidance protection, and that when faced with higher taxes they have a greater incentive to take their income and wealth away from the taxman.
The second is largely unknown or considered something that happens only in less developed economies. For instance, Chavez and other populist dictators often secure their political power base by providing some income distribution among the poorest members of society to provide them with a base of popular support. This technique is also used by criminals when setting up their own system of social security in the neighborhoods they control.
What is not recognized is that the American situation, where the bottom 50% of the population hardly pays any income tax, corresponds to a similar policy. This policy has been at the expense of the remaining 45% of the non-rich population (mostly middle and upper middle classes).
This raises two interesting questions that we will revisit later. First, why representative democracy did protect the rich but failed to develop a better tax system based on expenditure and wealth rather than income? Second, are the bottom earners really benefiting from income tax exemptions?
Sunday, 16 May 2010
Why constitutional liberalism is consistent with progressive taxation and inheritance taxes
Constitutional liberalism does not require the state to provide exclusively pure public goods like defense, policing and justice or to act only as a neutral referee. All it requires is that the state strives to act exclusively in a subsidiary manner and to be minimalist in its activities, including those of wealth redistribution.
However, many who consider themselves liberals or libertarians often believe that the financing of such activities should be funded only by taxes, and preferably by a flat tax rate. Therefore, they tend to consider any progressive and inheritance taxes as unfair and inefficient redistribution of wealth that discourages the hard-working members of society.
But, in contrast to classical liberalism (or laissez faire), constitutional liberalism has no problems in relation to fair inheritance taxes and a progressive tax system. Indeed, both are even indispensable in a system based on constitutional liberalism for two simple reasons: to prevent an unfair free-riding redistribution of wealth in favor of the rich and to preserve market capitalism. We shall demonstrate the first in the case of progressive taxation and the second with reference to inheritance taxes.
The reason why in the absence of progressive taxation wealthy people would enjoy an unfair free ride is easily understood if we use a parallel with insurance cover. Even hard-line laissez-faire adepts accept that the state has a duty to protect people and property against domestic and foreign predators. So paying for that protection with taxes is similar to paying for an insurance premium based on the risks and amount of capital covered. Using a flat tax rate based on wealth would apparently achieve a fair result since everyone would pay proportionally to the amount of capital they have at risk. But this would be misleading.
Just as insurers charge premiums on the basis of both capital and risk (e.g. a one-million dollar house in a quake-prone area pays more insurance) so should the state tax differently citizens that add more risk to the community. Since greater wealth attracts more predators and consequently adds more risk, it follows that those with higher wealth should pay more than proportionally to their capital. On the contrary, since crime often breeds on poverty it also follows that it pays to reduce poverty to fight crime. So, without any social concerns in mind, on pure economic grounds we can see that to be fair taxation must be progressive.
The case for inheritance taxes is not so straightforward. These taxes work as a brake to the accumulation of wealth and since saving and accumulation are necessary to promote growth it seems that such brakes would be counterproductive. Moreover, while we can justify limiting the size of corporate wealth to prevent oligopolies and to preserve the competitive markets needed for market capitalism there are no similar argument to limit private wealth. So, the argument for inheritance taxes has to be found elsewhere.
Such argument can be found by considering the importance of credit in a capitalist system and the availability of quasi risk-free investment opportunities in debt financing. Unfortunately, after a sufficiently long period, if unchecked, debt financing together with the power of compound interest would lead to the concentration of all earthly wealth into a single family or institution. To check this out consider the case of a long lasting institution like a religious congregation and calculate the real rate of interest required for it to acquire all of today’s world wealth.
For instance, we can carry out such calculation for the priests at the Temple of Jerusalem who paid 30 pieces of silver (about USD 15,000 in today’s money) for Judas betrayal of Jesus. If instead they had invested that sum in risk-free debt, and ignoring the practical impossibility of lending at a risk-free rate after a certain level of capital accumulation, we can calculate that an interest rate of 1.28% per year would be enough for them to own now the entire world wealth estimated at almost 2000 trillion US Dollars.
However, if they were charged an inheritance tax of 20% every 50 years they would need to wait another 1000 years to own the same amount of wealth. This would not eradicate the problem of wealth concentration. But, it clearly demonstrates that inheritance taxes act as a powerful restraint on wealth concentration, without the negative consequences of the usual alternatives of war and confiscation.
For today we limit our case merely under the assumption of tax neutrality, but we shall return later to discuss if the use of taxation as a social and economic tool is compatible with a system of constitutional liberalism. Note also that, regardless of the fundamental principles that interest us, in the field of taxation the disputes over the tax pie and the practicalities of the various tax options are of vital importance. That is, we should never forget the old say that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”.
However, many who consider themselves liberals or libertarians often believe that the financing of such activities should be funded only by taxes, and preferably by a flat tax rate. Therefore, they tend to consider any progressive and inheritance taxes as unfair and inefficient redistribution of wealth that discourages the hard-working members of society.
But, in contrast to classical liberalism (or laissez faire), constitutional liberalism has no problems in relation to fair inheritance taxes and a progressive tax system. Indeed, both are even indispensable in a system based on constitutional liberalism for two simple reasons: to prevent an unfair free-riding redistribution of wealth in favor of the rich and to preserve market capitalism. We shall demonstrate the first in the case of progressive taxation and the second with reference to inheritance taxes.
The reason why in the absence of progressive taxation wealthy people would enjoy an unfair free ride is easily understood if we use a parallel with insurance cover. Even hard-line laissez-faire adepts accept that the state has a duty to protect people and property against domestic and foreign predators. So paying for that protection with taxes is similar to paying for an insurance premium based on the risks and amount of capital covered. Using a flat tax rate based on wealth would apparently achieve a fair result since everyone would pay proportionally to the amount of capital they have at risk. But this would be misleading.
Just as insurers charge premiums on the basis of both capital and risk (e.g. a one-million dollar house in a quake-prone area pays more insurance) so should the state tax differently citizens that add more risk to the community. Since greater wealth attracts more predators and consequently adds more risk, it follows that those with higher wealth should pay more than proportionally to their capital. On the contrary, since crime often breeds on poverty it also follows that it pays to reduce poverty to fight crime. So, without any social concerns in mind, on pure economic grounds we can see that to be fair taxation must be progressive.
The case for inheritance taxes is not so straightforward. These taxes work as a brake to the accumulation of wealth and since saving and accumulation are necessary to promote growth it seems that such brakes would be counterproductive. Moreover, while we can justify limiting the size of corporate wealth to prevent oligopolies and to preserve the competitive markets needed for market capitalism there are no similar argument to limit private wealth. So, the argument for inheritance taxes has to be found elsewhere.
Such argument can be found by considering the importance of credit in a capitalist system and the availability of quasi risk-free investment opportunities in debt financing. Unfortunately, after a sufficiently long period, if unchecked, debt financing together with the power of compound interest would lead to the concentration of all earthly wealth into a single family or institution. To check this out consider the case of a long lasting institution like a religious congregation and calculate the real rate of interest required for it to acquire all of today’s world wealth.
For instance, we can carry out such calculation for the priests at the Temple of Jerusalem who paid 30 pieces of silver (about USD 15,000 in today’s money) for Judas betrayal of Jesus. If instead they had invested that sum in risk-free debt, and ignoring the practical impossibility of lending at a risk-free rate after a certain level of capital accumulation, we can calculate that an interest rate of 1.28% per year would be enough for them to own now the entire world wealth estimated at almost 2000 trillion US Dollars.
However, if they were charged an inheritance tax of 20% every 50 years they would need to wait another 1000 years to own the same amount of wealth. This would not eradicate the problem of wealth concentration. But, it clearly demonstrates that inheritance taxes act as a powerful restraint on wealth concentration, without the negative consequences of the usual alternatives of war and confiscation.
For today we limit our case merely under the assumption of tax neutrality, but we shall return later to discuss if the use of taxation as a social and economic tool is compatible with a system of constitutional liberalism. Note also that, regardless of the fundamental principles that interest us, in the field of taxation the disputes over the tax pie and the practicalities of the various tax options are of vital importance. That is, we should never forget the old say that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”.
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