The Economics of Taxation

Just the other day, I was invited to a party. Now, this was not your typical college party where everyone goes crazy. It was a post-graduate after-semester party where everyone went for a good chat and a bit of drinking.

Before the party, I went to grab some drinks. As a guest, I did not want to go empty-handed of course. I was browsing along the aisle of the super market, and what I noticed was that all beers with strong alcohol by volume (ABV) are relatively more expensive if compared to the ones with lower ABV. This is because drinks with higher ABV are taxed more. As a student and as a thrifty person as I am, my choice was obvious. I chose the cheaper one. Then, I went to the party, had a blast, and everyone was left more sober than they should have been (thus, safer and less likely to commit stupidities).

The moral of the story is that good taxation policy, while earning revenue, also manipulates individual incentive (thus, behavior) so that it is aligned with the desired outcome.

But, a good taxation policy is not that easy to design.

If taxation is “selective”, it can distort incentive and lead to untended consequences. For instance, imposing high tax only on the richer few can cause capital flight (businesses move oversea) and lower investment. In extreme case, it leads to the creation of an underground economy (where businesses involve in shady acts to avoid taxes). And the more tax evasion there is, the worse off everyone becomes. Government loses revenue and has to spend more on catching the bad guys. In some scenarios, an even higher tax will have to be imposed on those who pay tax (fair and square) to get to the same amount of revenue as before to cover governmental operations, and thus, it creates an even higher incentive to evade tax (and government can lose even more tax revenue).

If the tax design is too complicated, it can be difficult and expensive to collect those taxes.

As for income tax, the higher it is, the more likely it can discourage secondary income earners in the family from working. For instance, high tax on income can cause married women to stop working and become housewives instead. This is because they cannot make enough money to offset expense on childcare, for example.

In those cases, taxation can discourage productive activities that raise standard of living and thus lower tax revenue in return, a vicious cycle.

This is not an argument against taxation. An economist’s job is not to say NO to tax, but to ask and answer questions like: “What sort of tax to impose?”, “When to impose?”, “Whom to be imposed on?”, etc.

As a general guideline by Charles Wheelan, the Author of Naked Economics, and I quoted: “A good tax is simple, fair and broad”. Simple so that it is easily understood by everyone (lower mistrust by the general population) and easily collected. Fair so that only those with similar income level have to pay similar amount of tax. Broad so that everyone is taxed, and thus, a smaller tax is needed (lower incentive to evade tax).

Of course, the real thing is way more complex, but this is a stripped down version, reduced to bare essentials, so that things can be easily understood. Good economics needs to be simple too (sometimes)!

And, that’s a wrap!