Rational Taxation Policy - The Fundamentals

The rational man obtains the great majority of the goods and services he needs and wants from the private sector where individuals enter into voluntary trades and contracts.  In the private sector each individual chooses his own values and is free to act in accordance with his individual values.  In contrast, in the government sector, the government uses force to supply services and sometimes goods, for which it requires compensation in the form of some combination of taxes, mandated services and expenses, and the acceptance of a devalued currency.  The individual may have some say in what services government will provide and how at the ballot box, but on many an issue he is subject to the will of a majority who will evaluate the given government action differently than he does.  Furthermore, most voters will have but a very limited understanding of the effects of government action, so their decisions are not fully informed and not rational.  Despite this, irrational government policies may be imposed on the individual who disagrees.  Even when most voters agree, we have found that our politicians and still less our bureaucrats will often not listen to the will of the majority.  In other words, government provided services are not responsive to the values and needs of individuals.

Individually, we have little ability to choose the services we will acquire from government, the cost of those services, and the manner in which they will be delivered.  We have also come to understand that government services are provided very inefficiently.  For all of these reasons, it is clear that the People are best served with having the private sector provide them with most of our goods and services.  But, it is also true that some government services are required.  Our Founding Fathers and the Framers of the Constitution acknowledged this in the Constitution which provides for a minimal, but necessary, government with very limited powers.  They were always conscious that government was force and it was to be very carefully controlled.

Let us call the total cost of government, whether actually taxes, or effective taxes such as the devaluation of the currency and regulatory mandates of service and provisions of goods, simply by the name of taxes in the further discussion.  Whether the taxes are levied on income, on the size of trade transactions, profits, or taken as forced labor, they can effectively be said to represent some fraction of the Gross Domestic Product or GDP.  Let us note that the higher taxes are, the more they discourage people from working and the more they discourage reinvestment to increase the productivity of the economy.  But, economic or trade activities do require that violent acts such as thievery, assault, fraud, rape, and property destruction be controlled.  They are also aided essentially by the enforcement of contracts.  A region and the people living there also need to be protected from invasion or assault by other countries, if they are to prosper.  For these minimal desirable services, the government will need to have a baseline level of taxation.  That baseline taxation level I would estimate to be between 0.05 and 0.10 times the GDP.  Government requirements for spending above that level are optional, though I would argue that they are also immoral.  Spending beyond this level is clearly dependent upon one's values and upon one's willingness to use force to obtain what one wants from others.

Whatever size government attains, some of its activities ought to scale with the size of the population and some scale with the size of the GDP.  The cost of protection from personal assault and rape scales with the size of the population.  Some types of robbery and fraud do also.  The enforcement of contracts scales more nearly with the size of the GDP, as do some types of fraud and most aspects of property protection.  I suspect that the components dependent on the size of the population and on the size of the GDP would be similar for a constitutional government.  But, in any case, the effective tax rate can be expressed as a fraction of the GDP and we will call that rate t.

Over time, the GDP of a country will change.  We have a long tradition in the United States of watching it grow in many more years than not.  The GDP grows because our population is growing, though in the last decade, our population growth has been just under 1% per year.  This growth assumes that the People do not feel a reason to change their inclination to work during the period in question.  But clearly one factor affecting GDP is the size of the population.  Another is increases in productivity due to machinery, equipment, management improvements, and worker training.

Let us make a simple model of the effect of taxation on the growth of the GDP.  To be more accurate, on that part of the GDP that will be taxable, since at high tax rates, much of the GDP goes underground.  In this model, p will be a constant annual growth rate for the population.  The baseline GDP will be GDPb.  After n years from the time of the baseline GDP, the growth in population would cause the GDP growth by year n to be (n)(p)(GDPb) assuming that tax rates had no effect upon how hard people worked or how much income they reported.  A simple way to incorporate the effect of how people will react to the tax rate is to add the factor 1-t to the growth of GDP due to the growth in the population.  When the tax rate is 1, no one will work, at least they will not report that produce which they must produce to eke out the barest sustenance.  This says that people will work in proportion to how much of what they produce they get to keep.  The strict proportionality may not be completely accurate, but I suspect it is not far afield from reality.  This component of GDP growth is then (n)(p)(1-t)(GDPb) for GDPn of the nth year.

Increases in productivity also play a role in growing GDP.  If productivity is improving at a fractional rate of e per year in the economy with a very minimal government providing adequate freedom from violence and enforcement of contract that e is at its maximum value, then the GDP in the nth year after the baseline GDP would be about (1+e(1-t))^n (GDPb), since the amount of money available for investment in increasing productivity is proportional to what people have left after taxes.  This formula is akin to the principal owed on a loan at an interest rate i where e(1-t) takes the place of i.  The nth power is due to the compounding nature of the interest, or in this case to the compounding nature of productivity improvements.  To this point we have neglected the fact that no one will make such investments if the tax rate is 1.  So we will add a factor of (1-t) here also.  The net equation for the GDPn in the nth year after the baseline GDPb with a minimal government is then about:

GDPn = [(p)(n) + (1 + e(1-t)^n](1-t) (GDPb)

Admittedly, this is a simple model and it is not going to be a highly accurate replica of a real economy.  But, it will be very hard to have any understanding of a real economy if one does not develop a feel for the growth rates of a GDP predicted with some reasonable disincentive effect attributed to taxes.  Let us learn such lessons as we can from this model.

Let us use the following values to evaluate a family of GDP curves over a period of 30 years.  The tax rate t will be the variable for each curve.  p will be taken as 0.01, which is very close to the U.S. population growth rate over the last 10 years.  e will be taken as 0.08 or an 8% productivity growth rate per year with ideally minimal government.  The graph below then shows us GDPn/GDPb, the ratio of the GDP in year n to the baseline GDP, or the GDP growth factor.

Now I am not sure that the 0.05 tax rate is adequate to meet the assumption that an e of 0.08 is possible, since the government might be too weak to prevent violence and enforce contracts.  I am sure that a tax rate of 0.10 is high enough to meet that assumption, though.  The tax rate of 0.05 is the only rate shown which allows the first year with the tax imposed to actually have growth in the GDP.  The 0.10 tax rate causes the economy to shrink in the first year by 2.62%, but it has grown by 5.2% in the second year.  At a tax rate of 0.05, the GDP in 30 years is 8.84 times as large as in the base year.  At a 0.10 rate, the GDP in year 30 is 7.52 times as large.  Unfortunately, we presently have an effective tax rate of more than 0.45 and maybe 0.5 in the United States, counting taxes, devaluing of the currency, and regulatory mandates.  That GDP in 30 years at t = 0.45 is only 2.17 times the baseline GDP and at t = 0.50 it is only 1.77 times the baseline GDP.  Many socialists want the tax rates to be much higher.  Note that if the tax rate is increased to 0.60, the GDP in year 30 is only 1.15 times its original size.  This is only half the growth rate of the population alone in 30 years, which means the per capita GDP is shrinking.  Only in year 26 does the GDP at this rate become greater than that in the baseline GDP.  At t = 0.45, the economy immediately shrinks to 0.58 times the baseline GDP and it does not exceed that until year 13.

This model says there is every reason to believe that high tax rates stunt an economy.  We do not see the sudden onset of GDP reduction on the scale shown here since our taxes have long been high and they have been increased gradually.  But when we increase taxes from a fractional rate of t = 0.4 to t=0.45, there is some immediate reduction in size of the GDP or its growth rate.  Commonly, that reduction is partially hidden by a devaluation of our currency.  Note also that each reduction in tax rate by 0.05 causes an increase in the 30 year GDP which is larger than the last such reduction in tax rate caused.  The actual amount of the effect on the GDP is surely not what is produced by this model, but the fact that high tax rates greatly suppress the GDP over time is the important lesson.

When the Congressional Budget Office is asked what the effect of doubling the tax rate is, they always respond that the tax revenues will double.  When asked what the 10 year effect on taxes is, they say that the taxes collected over ten years will double.  A realistic model will agree with this one in one very important respect.  It will say that a tax increase from current levels will result in much less revenue than that proportional to the tax increase.  The GDP ten years down the road will be much smaller with a doubling of the tax rate.  This has been observed time after time.  When Coolidge decreased the tax rate in the 1920s, government revenues actually increased and the GDP grew greatly.  When Kennedy did the same in the 1960s, the same result re-occurred.  The same was true for the Reagan tax cuts and for the Bush II tax cuts. 

Let us look at the results here to compare the effects of a 0.20 and a 0.40 rate on taxes in 30 years.  At 30 years with t = 0.20, the tax revenue is (0.20)(5.38) = 1.076 GDPb, while at t = 0.40, the tax revenue is (0.40)(2.63) = 1.052 GDPb, so the tax take is actually less at the higher tax rate.  What is more important, in the lower tax case, the people are keeping 4.308 GDPb, while with the higher tax rate they keep only 1.577 times GDPb!  It has to be perfectly clear that the People are much, much better off with a tax rate of 0.20 compared to one at 0.40.  The tax revenue increase in this model is understated because it does not address the frequency of taxable transactions.  Lower taxes take less per transaction, but if the number of transactions increases because the tax take is modest or minimal, the total tax revenue sum over a longer time may bring in much more money to the government.  The record shows that this is exactly what happens.  People also have less incentive to put their money into tax-free municipal bonds where returns are modest, but there are no tax requirements.

Despite this clearly deleterious effect of high taxes, the Democrats and the Socialists are constantly trying to tell us that high tax rates are an investment in our economy.  Nothing could be more ridiculous and foolish.

What is a Rational Tax Policy?

The last few posts have been for the purpose of establishing a foundation for a discussion of what a rational tax policy would be and then to proceed with such criteria to examine the tax policies of the Presidential candidates McCain and Obama. It is not possible to evaluate the soundness of their policies without thinking about the proper purpose for taxes and the least harmful ways to impose them upon the people.

First, the amount of tax money needed to operate a government should generally be determined by which derivative functions it can legitimately pursue as compatible with its fundamental function of protecting the right to life, liberty, and the pursuit of happiness of the individual. If our federal government carried out its work consistent with this constraint, the total federal budget would certainly be less than 40% of what it is now. This would allow huge tax reductions. Both state and local government functions are probably just about as bloated with respect to this purpose.

Second, all government budgets should generally be balanced, with tax income equaling government expenditures. Under severe depressions and during a life-threatening war, the last of which was WWII, government deficits are reasonable.

Third, taxes are not to be used to punish people who are either making high incomes, or who do not wish to buy a home, or who do not wish to install a photovoltaic panel on their rooftop, or who smoke or drink alcoholic beverages. Taxes are not to be used for social engineering purposes, since there is no way to do this which will not derive some people of their right to life, liberty, and the pursuit of their happiness.

Fourth, having satisfied the above conditions, taxes should be levied such that the economy as a whole will be able to sustain a maximal growth rate. The fundamental reason for this is based on the observation several posts ago that personal compensation income, including benefits, has been approximately fixed at 70% of national income for about the last 40 years. People across all income levels see their income grow as the national income grows. Thus, if you hold the best interests of anyone, poor or wealthy, at heart, the way to best improve their lives without doing actual harm to anyone else, is to establish policies which allow everyone the freedom to contribute to the growth of the economy. Putting excessively high marginal tax rates on the wealthy simply discourages them from working an additional hour they would otherwise have chosen to work. Or, it causes them to invest their income in a bigger home instead of more efficient machinery for their factory. With less efficient machinery, they cannot hire more employees or they have to fire employees, because a factory in China is making similar items for less. Or similarly, they invest their money in municipal bonds for the tax deduction, but what municipal activity grows the economy as well as their equipment investment would or as their hiring a new worker and providing him training so he can become productive?

Fifth, taxes should be simple and so straightforward that every voter knows very well how much he is paying in taxes each year. From this standpoint, pretending that an employer is paying half of the total Social Security and Medicare taxes is wrong. It is also wrong to tax corporations, because all of the taxes they pay are passed on to individuals in ways much too complicated for anyone to figure out. Ultimately only individuals pay taxes, so the tax should be levied on them directly so they can be aware of what the cost of government is to them. They must be in a position to determine whether the value of government programs equals their cost. Taxes are the equivalent to prices in the free market for government. In the free market each consumer decides which products and services and how much of each product or service he will buy based on his needs, desires, and prices. The voter should be doing the same with respect to government, albeit government limited by the principle of protecting individual rights, and the cost of government, which is given by taxes.

Personal exemptions on income taxes should be based on the cost of a person having sufficient, but just sufficient, means to feed, clothe, and house themself. No other tax exemptions should exist except qualifying medical expenses, which would not include certain types of cosmetic surgery, for example. This deduction should include the cost of medical insurance. This keeps income taxes fair and simple. The tax rate applied to taxable income should be the same for everyone. Programs such as Social Security and Medicare should be phased out since they are not a proper function of government and their functions should be handled by private industries, such as investments and insurance.

Unfortunately, governments have caused many incredible distortions of the free market with their tax policies of the past and present. People have bought homes eagerly of a size more than adequate to their needs in order to have some tax relief. Ending the home mortgage interest deduction would cause a collapse of the housing market. This is admittedly not an easy problem to solve. But, a drastic cut in the cost of governments as they retract to the size they should be, will allow those with homes to at least not be hit with a tax increase due to losing their deduction for the mortgage interest paid. Over time, a great reduction in the size of government and of taxes, will allow the economy to grow so much faster that people will want larger homes due to their greatly increased wealth. So, how do we get to no mortgage interest deduction from here without collapsing the value of homes on the market? Clearly, the deduction will have to be phased out slowly as the size of government is decreased. In year 1, 97% of the mortgage interest could be deducted, then in year 2 the deduction would be 94% of it, until 33 years down the road, there would be no such deduction. This schedule should be viewed as unchangeable by Congress so that everyone can calculate out the consequences of buying a home with a given size mortgage and not have to worry about arbitrary Congressional tampering with their biggest investment decision. Probably the same should be done with the deduction for state and local income taxes. This gives people a fairly long period to re-adjust their decisions on which states and local areas they will live in. These are long-term commitments that need to be made as a sacred covenant on the part of the government toward the people.

Social Security should also be phased out. The proposals to allow young people to invest a part of the present 12.4% in private investments is the way to go here. The part they are allowed to invest will increase over the years. On the other side, people are living much longer now and are much more healthy and generally can more easily find jobs which are not backbreaking than was the case when the Social Security system was begun. This means that people should be expected to work longer before drawing Social Security benefits. They have no right to draw more in benefits than younger people can afford to pay out in taxes. They voted over and over again for this Ponzi scheme, knowing full well that private investments would have provided them a much better retirement. So, benefits given out should not be extravagant. There should be consequences for choosing to do stupid things!

Similarly, Medicare should be phased out. This can also be handled in a very similar manner as with Social Security.

Corporate taxes as mentioned are simply passed on to individuals in many complex ways. If they were eliminated, then American corporations would be much better able to compete in the world economy. Prices for many goods and services would drop, corporations could make wise business decisions without having to worry about disrupting tax issues, they would export more goods abroad, they would hire more people and pay them better salaries, and they would invest more in equipment modernization and personnel training. There would be a serious resulting boost to the economy as a whole. At the least, corporate taxes should be as low as capital gains taxes, since the role of a corporation is largely one of making capital gains.

Capital gains are taxed without regard to the effects of inflation and without regard for the fact that defering the use of money for a period of time has an interest rate associated with it which should not be taxed for sure. So, what part should be taxed? This becomes complicated. Frankly, it is too complicated, so it is best to set this rate low and just be happy that with a low rate on capital gains, the economy is going to grow at a higher rate and in the end everyone benefits from getting their 70% share of the bigger economy. The capital gains rate should be considerably lower than the tax rates paid by the middle class on income at least. This gives the middle class incentive to invest and recognizes that capital gains are not corrected for deferred use of the money and for inflation. Of course inflation is supposed to vanish as governments learn to live within the much smaller budgets needed to fulfill their legitimate functions.

The Death Tax, which causes governments to dance upon the grave of the recently deceased, while they rip what remains out of the heart of grieving relatives and destroy businesses, whether farms or small manufacturing, retail, and services companies. This allows government to deprive employees, who may already have a struggle to keep the business going without the guidance of the owner, of a job. What sound government tax policy this is! This death tax is clearly all about punishing people who spent a lifetime building wealth and commonly providing many others with jobs. This is envy of the worst kind run amok. Sometimes it is claimed that relatives have not earned the income of an inheritance, therefore the government should keep them from getting it. This is not always true. Often family members have played a major role in helping to build a family business. Besides, if they are undeserving, they will commonly lose the inheritance soon enough. In any case, the on-going business and the wealth assets will be taxed into the future in the normal ways, so governments will get their income. Such businesses as do survive the death of the owner will often generate far more taxes over time than will a business sold in a fire-sale in order to pay inheritance taxes. The death tax is a clear example of political tom-foolery. We citizens who accept this disgrace are the Toms made fools of.

Now, I am not unrealistic enough to believe that this entire goal of returning government to its legitimate functions and thereby reducing its size is going to be accomplished in this upcoming election cycle. First, the people have to become committed to the essential principle of government limited to the purpose of protecting individual life, liberty, and the pursuit of happiness. Given that this will not happen soon, it is still advisable to judge the tax policies of politicians on your rational goals, rather than as a cost-free promise of Christmas gifts all year long, as many voters do.

Politicians will always skew their tax plans in a direction designed to win enough votes to be elected to public office. Some count on the electorate being absolutely uninformed about the economy, business, and of course the function of government. Some are in love with class warfare and play on people's envy for those who might have more worldly goods and income than they do. They know that few voters have even read the Constitution. They know that few voters have read much history and tried to learn its lessons over the ages. They count on voters only seeing the first and most obvious effect of any law, including any tax law. They describe the economy as a pie of fixed size, simply to be cut up in different ways. They count on being able to fool most of the people most of the time. And, they have a long track record of showing that they are masters at doing so! They almost never get voted out of Congressional office until they wish to leave. Yet, most of them vote for bills which are clearly not in the best interest of the people and are certainly not limited to functions necessary to protect individual life, liberty, and the pursuit of happiness. They are masters at using the tax code to manipulate one group of people against other groups of people and give out favors to those they want campaign donations from and whose vote they want.

Still, there are sometimes politicians whose tax plans are more fair and more likely to encourage the growth of the economy than are the plans of the completely committed socialists and demagogues. There are politicians who are counting a bit less on the ignorance of the mass of voters. There are some politicians whose time-horizon is a bit further out than that of others. I will try to judge the plans, as best they are known, of the candidates for the presidency. I will also try to assess the commitment of each based on his prior commitments and his prior votes.

Obama on Taxes

Barack Obama warns that McCain's tax policy, spending plans, and energy plans will continue the economic slowdown he likes to pretend is a recession. However, his higher taxes on oil companies and wealthy individuals, even though accompanied by a $1000 tax break for most working families, will do much less than McCain's plans to straighten out the economy. The plans of either to institute carbon taxes are likely to send the economy into recession, if implemented, especially as some sort of additional tax.

Not happy to only make the economically absurd claims above, Obama claims that President Bush sacrificed investments in health care, education, and energy and infrastructure on "the altar of tax breaks for big corporations and wealthy CEOs." The truth is that the Bush tax cuts enabled the economy to grow so fast and steadily that much more money rushed into the government coffers and both Republicans and Democrats in Congress gleefully spent every last additional penny and then spent some a second time. Chris Edwards, The Cato Institute director of tax policy notes that the Department of Health and Human Services increased spending by 67% in 7 years under Bush, while the Dept. of Education increased spending 92%, the Dept. of Energy spending was up 42%, and federal capital investment outlays were up 35% for non-defense investments and 131% for defense investments. The big tax breaks for corporations resulted in an increase of 128% in federal corporate tax revenues. I suppose Obama's claim that they got those big tax breaks means that he thinks their taxes should have gone up much more than 128%! Hey, Obama, way to ship hordes of jobs to China and India!

The fact of the matter is that the Democrat goal of hugely expanded government expenditures was much better realized by President Bush with his tax cuts than it ever will be by Democrats with their punitive tax schemes on the higher income earners and windfall profit taxes on whichever industries earn the disfavor of the Democrats. Why do the Democrats never talk about windfall taxes on the movie industry? Is it because so many movie stars and producers are giving them a lot of campaign money? Just wondering.

Barack Obama has genius in fooling many of the people most of the time. Other than that, he does not know at all what he is doing.