Tax Rates and Coercion

[Tim Lee]

Will Wilkinson has a question:

Libertarians and many conservatives often talk about lower taxes as a matter of liberty. But a higher tax isn’t more coercive than a lower one. You’re either being coerced or you’re not. A guy who mugs five people with thin wallets is no less guilty of coercion than a guy who mugs five people with thick wallets. The harm from coercion might be greater if more is taken, but there is no more or less coercion. But if you don’t think that the size of the opportunity set is a matter of liberty, then you should not think of lower taxes as a gain in liberty, but just as a reduction in harm. Yet libertarians and conservatives don’t tend to talk this way. Why not?

I think the way to think about this is to remember that taxes have two effects, which economists would dub the income effect and the substitution effect. The income effect is the one most people think of when they complain about taxes: when taxes go up, people are able to consumer less of stuff than they were before. Under the substitution effect, in contrast, consumers react to rising taxes by shifting their consumption to something that's untaxed. For example, if you raise taxes on income, people shift to consuming more leisure.

The income effect dominates for low tax rates. The substitution effect dominates for high tax rates. As tax rates approach 100 percent, the tax system increasingly comes to resemble a prohibition on whatever is being taxed. And that has two important consequences: first, the definition of what's taxed becomes all-important. And second, tax evasion becomes a more and more serious problem.

For example, in an economy with a 99 percent tax rate, barter would be extremely common. Rather than paying the mechanic to fix my car, I'd ask him to fix my car in exchange for mowing his lawn for a month. Rather than giving me a raise, my boss would let me have a company car. If there's still a deduction for health care, health care plans would suddenly get obscenely generous, as all sorts of perks only tangentially related to health care would suddenly come with health care plans. And of course businesses would live and die by the tax status of various transactions. When "income" is taxed at a higher rate, people do less of things that lead to "income," as that's defined by the government.

And that, in turn, would mean that the IRS would have to get increasingly involved in policing every aspect of peoples' lives to make sure that no tax-evading bartering was going on. Has your daughter been volunteering to watch your lawyer friend's kids because she provided some free legal advice to you a few months ago? Did the contractors who re-did your deck really do it for $1000, or did you give them some money under the table? Should your company have to report the fair market value of the meals they provide you at work as income for you? To achieve the same compliance rate, the IRS would have to hire more agents, conduct more audits and investigations, and bring more people to court over alleged tax evasion.

Moreover, tax loopholes would become an increasingly potent mechanism for social control. You'd see a huge increase in lobbying over the tax code, which gives Congress and IRS officials much stronger positions of authority. A lot of people think we've inflated home ownership rates with the home mortagage deduction. Imagine how potent such incentives would be if the tax rate were 90 percent.

Finally, you'd see a large increase in the black market, as more and more people did business under the table rather than report income that would be largely confiscated anyway. Forcing people into the black market undermines liberty in a variety of ways, including weaker property and contract enforcement, a need for secrecy, and being vulnerable to extortion from government officials. A world in which almost everyone earned money on the black market is a world in which tax officials have the power to harass anyone they wanted.

The effect is easiest to see at the top end of the tax scale, but the effect exists all along it. As a recently self-employed individual, I'm newly conscious of all the ways that the tax code shapes my behavior. I can deduct computer purchases as business expenses, so I am, on the margin, more likely to buy computer hardware. Hiring a plumber means that both he and I have to pay income taxes on the transaction, so on the margin I'm more likely to fix the plumbing myself to avoid that tax wedge. At a lower tax rate, I'd be more likely to hire the plumber.

In all of these cases, the effect of higher taxes isn't just that I'm able to buy less stuff, it's that the incentives of the tax code more strongly distort my behavior. One way to look at the tax code is as a series of rewards and punishments for doing certain things. The tax rate is a scaling factor for all of these rewards and punishments. If we think a $1000 fine is more coercive than a $100 fine, which I think it is, then a 95 percent tax rate is less coercive than a 50 percent tax rate.

Photo courtesy Beatrice Murch