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The tax code classifies people as "rich" by looking at their income and their wealth, and subjects them to higher taxes.  The tax code does not distinguish between those who don't spend on anything that would identify them to the outside world as "rich": mansions, art, fashion, jewelry or yachts, say a Warren Buffet, and those indulging themselves in such conspicuous consumption.

The former are workaholics, entrepreneurs, who pour back most of their income into their business, start-ups, venture capital and keep a fraction in savings. Outsiders will not perceive much conspicuous consumption - except, perhaps, having an apartment in Manhattan or Silicon Valley close to workplaces. Is this person "rich'?  Yes. Does he behave as "rich," becoming an eyesore for the envious and those who covet? No.

What happens if you tax away a large fraction of such people’s income? They will have less to invest and save, matching talents they select with their capital.Instead the government will do the matching – drawing on politicians and bureaucracies far more limited experience in carrying out such matching in an accountable manner.

If a rich person according to the tax code classification spends money on mansions, vacation homes, cars, private planes, jewellery, art, high-fashion and fancy vacations, society would be better off taxing such consumption, rather than taxing too high the savings and investments of workaholic entrepreneurs and innovators. This argument suggests that a significant part of the tax burden should thus take the shape and form of sales taxes.  Yet that's not quite the practical implication of the above arguments, because I left out two main points.

One is that when sales taxes are high, people can avoid paying them by not declaring transactions. This is one reason that even France realized that it better tax home repair at 5.5% rather than at the roughly 18% tax rate it once imposed (still imposed on most consumption items).At 18% percent, much home repair and construction were done under the table. Italy, Spain, Greece have not yet come to such realization that high and complex taxes lead to much evasion and avoidance, though their governments and central banks do occasionally admit that their official statistics are unreliable because of their large and fluctuating black markets.    

As long as neighbouring countries or states have significantly lower sales taxes, a large underground economy would result - as happened for years with cigarettes both within the US and on the US-Canadian border too as sales taxes in the US are much lower on cigarettes than in Canada, and they also vary among US states. The differences in taxes (and prohibitions too, of course) bring about spending more on police, prisons and border patrols, and a weakening respect for laws. In Europe now, people also avoid high taxes by moving to a lower tax jurisdiction within the European community, evading the “exit tax” – a move Gerard Depardieu, the great French actors popularized when moving from high taxed France to neighbouring lower taxed Belgium (as such move is not subject to exit tax, whereas move to outside of the EU is). Janet Yellen’s chances of agreeing on similar taxes across some countries are slim to non-existent.

Briefly, just as too high taxes on income and capital have severe detrimental effects, so do "too high" sales taxes or VATs have their own significant negative impacts. There are no absolutes in domestic taxation: When people consider taxes too high for what governments deliver, they would evade and avoid it domestically, and also avoid it by voting with their feet and move to friendlier jurisdictions – see the migration to Florida and Texas from California and New York. 

In addition to such moves to avoid and evade taxes, taxes should take into account the impact of that incalculable element called "luck." 

There are the genetic accidents of spectacular good looks, eye-hand-feet coordination, memorable voices. Fortunes can be built on them in sports, fashion and the media, often with relatively little effort and at young age. Taxing some of the rents received on these "natural resources" - genetic accidents - would not deter its owners from changing careers and stop doing the catwalks, do their best in sports, movies, performing in stadiums or on the Net. Their second best career alternatives are so inferior in terms of incomes (become a sport trainer? A secretary?), that perhaps it is not so surprising that Hollywood and very successful artists and sportsmen are often prominent favouring higher taxes on incomes of the "rich."  

They extrapolate superficially from their own experience justly believing that even if paid $2 million for a movie, rather than $20 million, would not affect their performance – so wouldn’t that be the case for people in the $100-$200K range too (never mind if these people may be already in their 50s)?   

Similar arguments apply to successful innovators and entrepreneurs. Google founders solved search algorithms doing their PhDs at Stanford. Mark Zuckerberg was at Harvard, and solved the problem of rating young women. Mike Bloomberg was in his 40s, when was fired and started his company, and Henry Kravis often mentioned that if Bear Stearns agreed to compromise about compensations, he would not have started his company, and would have become much less wealthy. 

These and many other founders often admit that they neither anticipated the riches, nor did the riches come as consequence of the initial problems they solved. Google founders did not think about advertising, and neither did Zuckerberg, suggesting that parts of their wealth could be taxed – without impacting their own behaviour. Same about innovators and entrepreneurs during earlier times: Charles Goodyear accidentally spilled some rubber with sulphur on a work stove - and stumbled on "vulcanization." Percy Spence at Raytheon, the military contractor, walked by a magnetron, the chocolate bar melts in his pocket - and there came the microwave oven. And when communism suddenly went up in a puff, the "peace dividends" came in variety of unanticipated ways and forms.

At first sight the above suggests that if you tax away part of the effect of luck - no investment pattern in the society would change. Inventors and entrepreneurs would not make less efforts. But now recall the old adage that “luck favours the prepared mind," implying that by taxing away the chances to be lucky (even from genetic accidents) – you may lose the prepared minds – the talents whom these successful entrepreneurs spot, groom, matching them with their capital.  The more these entrepreneurs’ and innovators’ wealth was taxed the lesser would be their ability to match “prepared minds” with capital, and grooming the starts ups and ventures.

What about inheritance?  Do the above arguments apply there too? The answers here are more complex. Rich parents know that unless they educate their children to be disciplined they risk the kids leading a dissolute lifestyle. Religious education may prevent that – though the “three-generation-shirtsleeves-to-shirtsleeves” pattern across countries and time suggests that parents have not always successful to prevent such generational declines in family businesses. Few such businesses survive over generations in open societies – that is, societies with deeper financial markets.

If parents do not give their offspring such education – there will be downward social mobility for them, and upward social mobility to whoever gets paid from such inherited money. However, if the parents and their offspring are prudent, not pursuing “conspicuous consumption” (not provoking envy and coveting and “wrath of Gods”), taxing inheritance (“family businesses” in principle, if not by name) "too high” has similar impact to taxing entrepreneurs too high. The high taxes transfer the solutions from matching talent and capital from private hands to politicians and bureaucracies with more questionable accountability, resulting thus in more mismatching, and thus reduced prosperity.      

Briefly: if "too much" is taxed away, there would not be enough money left to bring "vulcanization," "microwaves," and plenty of innovations and entrepreneurship to fruition, matching more “prepared minds” with private capital, whatever its source. In order to sustain a society where "luck needs the prepared mind" - better err on the side of having enough savings and capital in the hands of those financing the options of such minds more accountably. By doing the opposite, there are more chances of creating a "luckless," hopeless society – a recipe for instability or tragic stagnation. 

So what's the solution concerning taxes for a society that wants to stumble into a stable society whose members and offspring have hopes of “pursuing their luck”?

Jean-Baptiste Colbert, Louis IV's finance minister said that "The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing." This statement is incomplete: Pay too much attention to the hissing of the increased number of people who get benefits from the government, but hardly pay taxes, and you'll quickly get a "luckless," unhappy society by mismatching people and capital.

Though I started this piece with discussion about the form of taxes - and these are important - the conclusion suggests to first have a debate about the total taxes that society can pay without killing the geese that lay the golden eggs. This is the inflection point societies find themselves at from time to time. Myopia and political rhetoric can gradually bring democracies to kill the geese for the simple factual observation made above: Every society must match its people with capital.  Very few managed to have the institutions to hold people, capital and matchmakers reasonably accountable. Except in one country, democracy does not solve this problem.  

Only Switzerland managed to find a solution how with the expansion of government it could hold bureaucracies and politicians accountable. Their unique “direct democracy” achieves such accountability. Politicians have little power passing “stimulus bills,” “baskets of spending,” and there isn’t much distinction between the major parties since each and every major spending idea is subject to referenda and initiative, and all spending the government plans, can be voted down.

About a century ago, the US was trending toward such a system of governance. A range of crises – the Great Depression, WWII, the Cold War, then the 1973, 2000, 9/11, 2008 and now Covid – prevented a discussion on how the US can emulate features of this unique and successful Swiss experiment, and restore accountability at all levels of governments.  Who, knows, perhaps this Covid crisis – and risk of if not default, then falling significantly behind other countries - would lead the US to re-examine the fundamentals of accountability in government, of which taxes are just one component.        

Reuven Brenner is governor at IEDM, and on the Editorial Board of American Affairs. The article draws on his books, Labyrinths of Prosperity, Force of Finance, A World of Chance.      

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