Next month is the presidential election, which means it is the time of year when everyone starts to have extremely strong opinions about taxes. Depending on who you talk to, taxes might be the backbone that keeps our country functioning or the heaviest weight preventing us from achieving our true potential as a society.
From an economics perspective, taxes are a uniquely interesting way to move money from one household to another. When conducting a cost-benefit analysis, we are agnostic about transfers of money from one place to another. While there has been a recent push to pay more attention to the distributional effects of transferring money around, classical economic theory tells us there is no net economic benefit to moving money from one person to another.
If you give your neighbor $20, the economy hasn’t grown or shrunk, a small part of it has just changed hands. In terms of the value those $20 create, it is unlikely that your neighbor will use it in a dramatically more efficient way than you. $20 in your hands is equal value to $20 in anyone else’s hands.
This logic changes when we talk about transferring money to the government (i.e. taxes). There are two main reasons why:
People change their behavior in response to changes in their taxes.
The government can spend its money on providing public goods.
Say the government wants to fund an expanded Child Tax Credit and plans on raising income taxes to finance it. Individuals can see that their labor is relatively less valuable to them since more of the income will be paid in taxes. This gives them good reason to work fewer hours, instead spending time on other activities that have become relatively more valuable.
This results in a distortion of the economy that economists call the “marginal excess burden of taxation.” When we do a cost-benefit analysis, this marginal excess tax burden is what we estimate as the social cost of raising taxes. Again, we are agnostic about transfers because a dollar in one person’s hands is no better than the dollar anywhere else. What we care about is how this policy change impacts the way people spend their time, which then changes the size of the economy. This distortion is also the justification for the “all taxes are bad” crowd.
However, taxes don’t just sit in a vault somewhere, they often get used to fund important public programs. Public infrastructure, our social safety net, public schools, all of these need money to function. Additionally, because these are public goods they suffer from the free rider problem. Essentially they can’t be funded privately, because there are no incentives for people to pay for these goods.
So, how can we tell if a tax policy change is worth it or not? We should figure out whether the dollars brought in by that tax are going to fund something that creates more economic value than the marginal excess burden of taxation we are incurring.
There is another key tradeoff of public policy: equity vs. efficiency. Yes, in a vacuum taxes are an inefficient way to collect money because they create a drag on the economy. However, not collecting any taxes would lead to massive gaps in equity as people with fewer resources would not be able to access all sorts of things that are publicly provided by the government.
We still have a month to go before the election is over, so we should expect the rhetoric about taxes to stay extremely polarized for the time being. Hopefully, once we know who the next president is we can begin to have more productive conversations about tax policy and its implications on the economy.