If the Government Is Taxing You, It's Doing It the Wrong Way

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Economists believe that the best taxes are those that do not change people's decision. These taxes are deemed efficient. Taxes which change decisions are generally not efficient because they distort markets away from the equilibrium of supply and demand. As you start collecting all your tax-related documents for the past year, think about how many of the items represented in that stack of paper involve decisions influenced by taxes. Each item on that mental list you just composed is a sign that the relevant government tax policy is a bad one.

Normal free markets are efficient in the sense that they equate the marginal value of a product with the marginal cost of producing it. In the aggregate, this maximizes society's welfare. When government policy, whether regulations or taxes, causes a different market outcome, society's total welfare is reduced. This welfare loss is called a deadweight loss by economists.

There are a few cases in which the free market outcome is not efficient to begin with, generally due to what economists call an externality-some feature that is not accounted for in the price of a product. For example, when production of a good involves pollution which damages the environment, a free market does not automatically incorporate the cost to society of that pollution unless the producer is charged for the damage. Consumers will purchase too much of the product because the price is artificially low. In such a case, a tax on the product equal to the cost of the environmental damage will actually move the market toward the efficient outcome and increase national welfare. Taxes on gasoline and cigarettes are examples of such situations.

However, such examples are fairly rare within the set of all the taxes our government levies. In particular, the most common taxes on income from both jobs and investments are distortionary in ways that make no sense and create perverse incentives that lower efficiency and encourage tax avoiding behaviors.

When the government places a tax on something, the tax raises its price and causes consumers to buy less of it. Income taxes essentially raise the price of labor and so society ends up with fewer workers. Minimum wages work similarly; by raising the price of low-skill workers they lead us to an economy with fewer employed low-skill workers. But these well known impacts are just the beginning.

Before investors buy or sell investments they might consult with their investment advisor, accountant, or tax lawyer about the tax consequences of their financial decisions. When these investors do not sell an investment because of tax implications, capital is not allocated efficiently. Too much money gets stuck in some industries while other sectors are left with too little capital. This tax-induced inefficient resource allocation means lower economic output, slower growth, and lower incomes. This is quite a sacrifice in exchange for some tax revenue which could easily be collected in a less distortionary fashion.

When income taxes treat various forms of income differently, it creates an incentive to receive income in the form that faces the lowest tax rate. Thus, long-term capital gains and dividends are preferable to wage and salary income. Most of us have limited ability to change the form of income we receive, but those that do waste resources (such as accountants and lawyers) in order to benefit from this feature of the tax code. Worse, the particularly favorable treatment of money management fees (the famous "carried interest"), creates a large incentive for smart people to become money managers, to start and run hedge funds.

While the financial sector certainly has its benefits and uses, we are almost surely overinvested in the financial sector relative to an efficient allocation of society's resources. However, as long as that type of earning is encouraged by our tax law, do not expect it to change.

To remove the incentives to collect income in the most tax-favorable manner, we should equalize taxes on various forms of income, particularly wages, capital gains, dividends, and interest. At the same time that we do this, we should remove the double taxation on dividends by making dividends a tax deduction for businesses. This would mean that subjecting them to potentially higher levels of personal income taxes would still actually be a tax cut in the aggregate because they will not be subject to corporate taxes first.

Removing the double taxation of dividends would also provide an incentive for corporations to return their profits to shareholders rather than retain them. Removing or greatly reducing the tax on repatriated foreign profits would also help to improve the efficiency of capital allocation. The current policy has trapped billions of dollars overseas which American corporations might prefer to deploy here if not for the tax burden involved. Think of Apple and it enormous cash assets, which certainly appear to be at least partially a tax related distortion.

To remove the incentive people have to hold onto assets that have risen in value in order to avoid capital gains taxes (and to sell those that have fallen), we could investigate perhaps marking assets to market each year for taxation purposes. This would be complicated and would need careful study. Assets such as real estate and businesses are likely ill-suited for such treatment as that could involve costly appraisals that serve no true productive purpose. However, for traded assets such as stocks, bonds, and the like, such a change in tax treatment would not be particularly difficult to implement.

When we make decisions on the basis of the tax implications, we are much more likely to make a poor decision, especially from the point of view of economic efficiency. Given the extreme need for economic growth right now, anything that will increase economic efficiency should be seriously considered. If Congress does indeed make an effort at tax reform, they should consider changes to make our tax system less distortionary.

Collect the needed revenue, but do not use the tax code to nudge, bump, drag, or force people into decisions that would never be made if not for the desire to minimize taxes. People are much smarter than the government, so we can never close all tax loopholes or have a perfect tax system. However, we can do a lot better than the tax code we have now. Making it less intrusive in our economic decision making would be a good place to start.

Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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