All Commentary
Saturday, November 1, 1997

The Seven Deadly Sins of High Taxes

All Taxes Divert Resources from Other Useful Purposes

Dr. Lee is associate professor of economics at St. Ambrose University College of Business, Davenport, Iowa.

By justice a king gives stability to the land, but he who imposes heavy taxes ruins it.
—Proverbs 29:4 (New American Bible)

In a free society government has an important but limited role to play. Adam Smith, for instance, acknowledged the necessity of providing national defense, maintaining law and order, implementing a system of weights and measures, as well as defining and protecting property rights. Further, he advocated government provision of goods for which there were substantial positive spillovers, though experience has led many modern classical liberals to question the appropriateness of this role. Even in Smith’s vision, however, the ultimate public good is a nurturing environment within which voluntary exchange can flourish. Government should be umpire and rule maker, not participant, in the economy.

Of course, to perform any of these functions government requires taxes. All taxes are costly, since they divert resources from other useful purposes. Moreover, most taxes distort the economy. The deadweight costs associated with the tax wedge are a fact of life. If government were to concentrate on its proper objectives, it is likely that the benefits of government operations would outweigh its costs. But government is now far too large, and is generating more costs than benefits.

A 1995 International Monetary Fund study concluded that every one percent rise in taxes cuts GDP output per worker by about two percent. In the same year Congress’s Joint Economic Committee estimated a deadweight cost of 40 cents per dollar of additional government spending. An earlier analysis published in the March 1985 American Economic Review figured the deadweight cost per dollar of tax to be between 20 and 50 cents. Not surprisingly, high-tax U.S. cities are losing jobs to low-tax cities and high-tax states are losing jobs to low-tax states. Similarly, countries with highly interventionist governments are growing more slowly than countries with less state intervention.

The perceived benefits of government are well understood. The distorting effects of taxes are generally less visible. These could be called the seven deadly sins of high taxes.

1. Favoring leisure over work.

Few people would work as hard as they do for as long as they do except for the fact that they receive payments which can be exchanged for goods and services. Most would consume more leisure if its price were lower, just as they would consume many other goods if their prices were lower.

The price of leisure is the income forgone when one does not work. In a mythical no-tax world in which one could earn $10 per hour, $10 would also be the price of an hour of leisure. But taxes change that. With a 30 percent marginal tax, the price of leisure artificially falls to $7 because that is all one gets to keep after taxes. This increases the consumption of leisure. Yet it is work that is necessary to create wealth (which, ironically, ultimately makes more leisure possible). The size of the economic pie is arbitrarily reduced.

2. Work takes inefficient forms.

A capitalist economy is a positive-sum game. As a result of free exchange, the size of the economic pie is continually increasing. One reason for this is the phenomenon of economic specialization. People tend to specialize in those activities in which they have the greatest comparative advantage, thereby increasing their output. They then obtain the other things that they desire through exchange.

Consider an accountant in a mythical zero-tax world. If he earns $25 an hour, he will hire other people to mow his lawn, paint his house, and perform similar tasks so long as they charge less than $25 an hour. But taxes change this. With a 50 percent marginal tax, the accountant ends up earning only $12.50 for every additional hour of work. Instead of hiring a painter who charges, say, $15 an hour, the accountant will paint his own house. In this example, this results in a loss of economic output to society of $10 an hour.

3. Favoring consumption over investment.

Consider an individual living in our mythical tax-free world who is attempting to decide whether he or she should invest $10,000, and thereby earn $700 per year forever, or spend the $10,000 on a vacation. He cannot decide between the two because, in the language of economics, he is indifferent.

Taxes change that. Suppose a tax of 50 percent on marginal income is imposed. Now a $10,000 investment will generate only a $350 income stream. If he was indifferent before, he will choose the vacation now. As a consequence, high taxes reduce the opportunity cost of consumption relative to investment, reducing the capital stock and ultimately economic growth.

4. Reducing respect for the law.

When government concentrates on its core functions, taxes are relatively low and the benefits are clear. As a consequence, tax evasion is minimal. But as government grows, it tends to operate increasingly for the benefit of one group at the expense of another. People feel less moral imperative to pay their taxes. Some lobby for “loopholes” and other tax breaks. Others creatively “interpret” the law. And higher tax rates increase the financial return on avoidance and cheating.

Today, Money magazine estimates that tax resistance denies the government $150 billion annually. It is not a much larger step from tax evasion to broader disregard of the law. Yet stricter enforcement measures both threaten individual liberty and consume valuable economic resources: as a result, the size of the economic pie is again made smaller.

5. Encouraging the development of the underground economy.

A related impact of higher taxes is the people’s desire to put commercial transactions “off the books.” It has been estimated that the following percentages of services are supplied by the underground economy and escape taxation.

Lawn and garden maintenance 90 percent
Domestic help 83 percent
Child care 49 percent
Home repair/improvements 34 percent
Laundry/sewing services 25 percent
Appliance repairs 17 percent
Car repairs 13 percent
Haircuts/beauty services 8 percent
Catering 8 percent

It is, of course, difficult to estimate the total output of the underground economy. Estimates range from 4 to 25 percent of GDP. Even 10 percent would represent $700 billion. Moreover, nations with higher tax rates, such as Italy, have even larger underground economies.

Commercial activity hidden from the tax collector represents a drag on the economy. It takes an effort to remain undetected. Payments must be “washed” or otherwise hidden from view. Double sets of books must be maintained. Often vendors are unable to maintain permanent retail establishments or advertise normally. In addition, respect for the law again is reduced. Indeed, the very nature of such secret activities, and the likelihood of coming into contact with others engaged in similarly illegal activities, may facilitate the expansion into genuine criminal enterprises.

6. Encouraging nonproductive rent-seeking.

One can acquire resources from one another through voluntary exchange or coercive transfer. Voluntary exchange is a positive-sum game, increasing the wealth of everyone involved. Coerced transfers, however, make everyone worse off. The case of theft is obvious: not only are resources devoted to commit crimes and defend against crime, but goods are taken away from those who value them the most and use them most efficiently.

Forced transfers through the political process—what goes on in Washington every day—have a similar impact. As government collects, and hands out, more money, various groups have a greater incentive to try to become a beneficiary of government largess and to protect their wealth from the attempts of others to gain from coerced transfers. Practical evidence of this effect is the steady move of corporations and associations to Washington, D.C., the growth in the number of lobbyists, and the steady increase in campaign contributions and spending.

7. Fostering envy.

An egalitarian society will also be a poor society. No society has yet found a way to induce individuals to work hard, invest in human capital, and engage in enterprises for uncertain profits if they are unable to earn a differential return. But these are all essential elements of wealth creation. In short, unequal income distributions are necessary for economic growth which benefits all people, poor and rich alike. (Of course, the poor in the United States today are poor only relative to the rich in the United States. Compared to people through human history, the poor are rich indeed.)

In a market economy one can, with considerable conviction, maintain that income is not “distributed” in the sense that social planners use that term. Income is earned through a combination of hard work, imagination, and faith in one’s ideas and in the future. Eighty percent of those who make up the Fortune 500 list represent “new,” not inherited, wealth. As such, the money belongs to those who earned it and should not be forcibly redistributed by government. Even if the rich have a duty to give to the poor, other people have no right to steal, acting either as individuals or collectively through government.

But when the government starts to make widespread wealth transfers both directly by taxing and spending and indirectly by regulating, it inflames envy. In such a world, many people believe that they have a claim not only to a portion of the nation’s overall wealth, but to the wealth of anyone earning more than them. Society risks slipping back into the jungle described by Thomas Hobbes in Leviathan, in which work is in vain because the fruits thereof will be taken from the producer.

When properly constrained, government can be a productive institution. Even then, it should perform its functions with utmost efficiency and minimal economic distortion. But we have gone well beyond the point of positive marginal benefits and that improvement now requires a much smaller government. In deed as well as word we need to resolve that “The Era of Big Government Is Over.”