A liberal perspective on taxes – Part II

[This write-up was published in Freedom First, December 2009]

Sanjeev Sabhlok

Last month, in the first part of this article I made the comment that internally consistent theories of public finance simply don’t exist. I then went on to (bravely!) propose an internally consistent theory derived from the basic social contact.

The following principles resulted from that analysis, that (a) citizens (and not companies) should pay taxes; (b) paying taxes must be mandatory unless someone is simply unable to pay; (c) taxes should be based on the annual average of the lifetime worth of an individual; and (d) taxes must price-discriminate with a modest level of progression: the marginal rates approximating the overall share of taxes in GDP.

According to the fourth principle, the middle class should pay an income tax at a marginal rate approximately equal to the proportion of overall taxes to GDP; the rich should pay at a rate slightly above this; and those below the poverty line should not pay taxes, receiving a negative income tax as part of the social insurance scheme, instead.

The right level of taxation

A fifth principle suggests itself: the total amount of tax collected should be neither too much nor too little, being just enough to ensure effective delivery of necessary government services. The liberal believes that when governments are restricted to their proper role they provide us with a crucially needed service. In this regard it may be noted that a society comprising a larger share of honest people (like Japan) will need less policing and hence lower taxation. Corrupt societies will need higher levels of taxation.

In any event, the liberal is not smitten by the mindless fascination of some alleged ‘liberals’ for low taxation. It is crucial to have the right size of government with right services and functions. That is the only correct determinant of the right level of taxation. Today, India’s socialist government imposes an extremely low overall tax burden but then it squanders these precious revenues on totally unnecessary activities.

The consequent under-supply of basic public goods like defence, police and justice – including the defence of property rights – has led to significant crime and poverty in India.

The ever-present specter of regressive taxation

Theoretical models of public taxation are extremely difficult to translate into practice. We noted last month how regressive taxation is the norm across the world. The rich pay proportionately less as they get richer. At the same time, the poor (who, we have noted, should not have to pay taxes) fork out heavy consumption and indirect taxes. The most progressive taxes of all are reserved for the salaried upper middle class, which carries the world on its shoulders.

The rich benefit most from any number of exemptions, including a regressive capital gains tax regime. Assume that A and B have the same level of assets today and that they invest equally in, say, land. Now assume that A receives a windfall gain with his land tripling in value while B’s stagnates. Most tax systems will treat A’s windfall gains very lightly, even though A is now considerably richer than B. It is improper for windfall gains to be taxed proportionately less than income from ordinary hard work.

The reality is that even as the rich continue to influence politicians to give them more and more exemptions, they end up suffering from the effects of the consequent regressive taxation regime. While they can own the best Mercedes, they must then hire heavily armed security guards and drive through sludgy, potholed roads. The quality of life is very low in societies that depend on regressive taxation.

Some other principles of taxation

Other principles of taxation include:

· No taxation without representation (i.e. democratically determined taxes).

· Inflation is the most regressive form of taxation. The liberal therefore opposes deficit financing except in the rarest circumstances (like war).

· Taxes must be levied by that tier of government which administers the relevant service (principle of subsidiarity).

· Since it is citizens who must be taxed, taxation of goods must be avoided, being limited to Pigovian taxes to facilitate the internalizing of negative externalities. Where possible, market-based instruments should be used to control negative externalities.

· The variable cost of a government service to an individual or industry, such as the cost of processing a license, should be recovered from that individual or industry (cost recovery principle).

· The government should not own land except for roads, common infrastructure, Parliament, courts, basic defence establishments, and police stations. This will allow land to be put to its most productive use. The government should therefore sell land and use these revenues to keep taxes low.

· Transfers of assets from one generation to another should be treated seamlessly, thus ruling out inheritance taxes.

Clearly, the liberal is not utopian. He realizes that practical matters related to the ease of collection of taxes will influence the real tax system, even though unavoidable distortions will result. Thing like a mix of indirect and direct taxes; or the use of visible and not discounted future income and wealth; will therefore be unavoidable.

Implications for India

What does this mean for India? A few thoughts are outlined below.

1. India must raise its overall tax level from the current tax share currently of around 16 to 18 per cent of GDP to 25 per cent of GDP (compared with 33-50 per cent of GDP in the West). Note that merely raising taxes without reforming India’s governance model will not improve much. Therefore governance reforms of the sort advocated in my book, Breaking Free of Nehru (http://bfn.sabhlokcity.com/) must form the bedrock of reform in public finance.

2. The only defensible way to increase taxes is to broaden the base by requiring all Indian families to lodge annual income and wealth tax returns. Poverty elimination, a vitally necessary part of the liberal agenda, also depends critically on the information received from such returns (see my article in Freedom First, August 2009).

The result would be to increase the base of tax returns in India from 3 crores to around 67 crores.

3. Since abolishing company taxes will be impractical and create many complications, an alternative is to reduce company tax level in India to 25 per cent while requiring dividends paid to Indian investors to be franked through an imputation system: thus defaulting to an income tax system.

4. Apart from eliminating indirect taxes (already touched upon) most excise duties and taxes on products will, in due course, need to be abolished. Pigovian taxes, however, may well be needed on a few products.

5. Given that increases in asset prices continuously transfer significant amounts of wealth to the rich relative to the poor, land and capital gains taxes would need to be increased, aiming at the end of all these reforms for a (broadly) overall flat tax system in India from the current regressive one.

Given space constraints I have been able to present only a sketch of a theory of liberal taxation, but I trust that these two articles of mine will be found broadly reasonable by liberals everywhere.

Freedom Team of India

Once again I’d like to remind that FTI (http://freedomteam.in/) continues to look for leaders and seeks your active involvement and support.

Stupidity rules the world

This blog post is perhaps going to take many years to complete. It is a place for me to keep a record of things I come across that reflect human stupidity: i.e. things we do that do not advance our life and liberty. Indeed, some of the things we do directly oppose life and lifberty (and success in life). This concept of stupidity has many overlaps with bounded rationality and neuro-economics (behavioral economics), that lead to dysfunctional or sub-optimal outcomes.

It would seem that we are not really rational, being prone to repeated bouts of stupidity. Economics can explain some of this (i.e. shortcuts we take to minimise transaction costs, which means it may not really be a form of stupidity but efficiency; and negative externalities where we benefit personally but harm others, and so it may be individually rational to do so), but where that is the case, it points to another problem: that we don't understand the costs and benefits of our actions. This particularly happens when we ignore the costs of actions that yield small benefits.

I'm going to start this blog post (13 December 2009) by listing a few things and will build this post over time. I hope to cluster these things into appropriate categories and find out what, if anything, can be done to minimise human stupidity. We need mitigating strategies.

Note that I'm not in any way claiming exemption from stupidity, which seems to be an inevitable human condition.

Jumping red lights and driving recklessly
It is typical for at least someone to jump red lights on a given day. While most times no harm is caused, just today I saw how one cyclist was almost killed when he had started off (on a green signal) but a car rushed past, having jumped the red light. Clearly the driver was being stupid. I would estimate that after a 100 near misses, at least one major incident is sure to occur. A detaild calculation of costs and benefits to the stupid drivers is awaited.

Spread of disease through stupidity
- Doctors have known for nearly 200 years now that not washing their hands spreads disease (see discussion in SuperFreakonomics), yet they continue to not wash their hands. Education is only a partial fix to stupidity. They know about the dangers of not washing their hands, but that doesn't help solve the problem.

- People know that preventing the spread of mosquitos is often as simple as making sure that all vessels (e.g. pots) that are lying in the open in their backyard are turned upside down to prevent water from stagnating in these vessels. But they don't care for such things. As a result of this short-cut, mosquitoes lives a happy life in the midst of cities, making it impossible to eliminate malaria.

- We know that computer keyboards and mouse are a heavy source of bacteria, yet how many of us clean these things regularly?

- We know that overeating causes significant harm including death by heart attack; drinking alcohol in excess causes brain damage and cirrhosis of the liver; smoking causes lung cancer. Yet how many people over-eat, over-drink, and smoke!

- Surely sexually promiscuous know that there are significant health consequences, including STDs, HIV and AIDS; yet there seems to be no end to promiscuity.

- A good number of uneducated women in rural India don't give fluids to infants who are suffering dysentery: thus effectively killing them. (Of course, for this one, education may be a fix).

Arrogance
- Political and religious leaders constantly display great arrogance, as if merely by holding a particular high position, all knowledge lands on their head. Thus the church forced Galileo to 'recant' and long refused to accept evolution. Today, without as much as a clue about the climate, politicians are running about trying to fix the 'problem'. This will cause significant harm, with no mitigating benefits.

- For thousands of years, men were arrogant enough to think that women could not know much, hence did not educate them. Today also, at least parts of the Islamic world and in many parts of rural India, the girl child is not highly regarded and hence is not educated. The reality is that it is the men (indeed, entire societies) who lost out in this process. How stupid were these men!

- Central planners of all sorts suffer from the disease (of paternalism: being disguised arrogance). Statist solutions which are invariably sub-optimal come easily to the minds of such central planners. The divine right of kings was one way to empower people who would then impose their ridiculous ideas on others (e.g. Tuglak and his Tughlakabad).

- Most wars are entered into through such arrogance.

Intolerance
- Islamic terrorists know that they will likely die as a result of their stupid fascination with spreading Islam through violence; yet they do it, thus destroying the only guaranteed life they are going to get (the rest is imaginary with absolutely no empirical proof available to us of its existence).

Blind hatred
- Mega-criminals seem to get to powerful positions in human society very quickly. People like Hitler manage to spread the message of hate and thousands of people follow them like sheep.

Inability to share
- There are those who somehow manage to get a lot of wealth in their life, but are unable to open their heart to others. Neither does there seem to be an end to their personal quest for wealth nor any purpose to their life beyond making money for themselves.

Lack of consideration for others
- this can be as simple as lack of consideration for others' time. Businesses don't seem to care for customers, although one would imagine that they would do so, because customers keep them in business!

- within a marriage, people behave stupidly towards their partners, knowing full well that if only they behaved better, their marriage would grow stronger and durable.

Tendency to panic
- Humans are prone to social panic - entire groups undertake suicide under the guidance of cult 'leaders'.

- Humans panicked in the 1970s about the potential onset of the ice age; now they are panicked about the earth melting. It is important that the 'precautionary principle' is not used as a rationalisation for really bad policies just because we have stopped using our head and have started panicking.

Leaving cash on the table
- There is an endless list of potential public policies which are designed sub-optimally, i.e. which do not optimise the benefits society could obtain from the policy. Billions of dollars are therefore 'sitting on the table' but no one picks them up.

Bills left on the sidewalk
-cf. Mancur Olson's famous (1996) paper: "Big Bills left on the Sidewalk: Why Some Nations are Rich and Others Poor", a paper which showed that poor nations can readily solve their problems if they want to, but they don't seem to want to. Is that not plain stupidity?

Stupid predictions by eminent people
- E.g. 'The Population Bomb' by Paul Ehrlich (see Julian Simon's 'The Ultimate Resource' for a number of other stupid predictions by others (not by Simon - one wise man!)). The thing is that these eminent people seem to get hung up about their predictions and stop thinking: they refuse to consider alternative arguments and block their mind to all data that may contradict them.

- the surfeit of thick-headed economists who keep coming out with new predictions in newspapers/TV (most predictions being wrong!) about how the economy, house prices, foreign exchange rate, interest rate, etc., is going to behave in the future.

- The Black Swan phenomenon whereby people simply don't anticipate random shocks, which are far more common than they think they are.

"Neem Hakim Khatra Jaan" (being half-trained is worse than being untrained)
- Robert Frank reports that those who learn basic economics can end up worse off (in terms of common sense) than those who did not learn economics: "exposure to introductory economics instruction was strikingly counterproductive. Among those who had taken a course in economics, only 7.4 percent answered correctly, compared with 17.2 percent of those who had never taken one." (see Robert's paper in NY Times, September 1, 2005).

And so on... Will add to this list as time permits and ideas come to mind.

REQUEST
Please help me add to this list by sending examples of human stupidity. You can write to me at sabhlok AT yahoo DOT com.

WHY STUPIDITY?
It is time to jot down a few thoughts on the causes of stupidity.

- Ignorance
Perhaps more than half of what we think we 'know' is wrong. This includes false deductions, false assumptions, superstitions, etc.

- Forgetfulness
Robert Frank shows in one of his articles how even PhDs in economics forget the concept of opportunity cost. Such forgetfulness of learned knowledge can lead to bad (stupid) decisions.

- Arrogance
This is self-explanatory.

- Rush to judgement
We tend to rush to conclusions without waiting to assess all the relevant facts.

- Lack of time to think through things
This can happen where there are high transaction costs involved in studying and understanding something in detail, so we take shortcuts (rules of thumb).

- Emotional fascination
We may get emotionally involved in something, which will invariably skew our rational thinking.

- Absent mindedness
I find this happens to me when I'm thinking too many thoughts at the same time. Certain unintended actions can then occur.

- Herd instinct
In 'The Return of the Economic Naturalist' (p.156) Robert Frank shows how we can go very wrong, following the herd (particularly if it is a setup).

- Imagined immunity
We imagine that bad things won't happen to us, or that the odds don't work across the board.

- Imagined superiority of some
It is easily possible to grossly over-estimate the value provided by others. For instance, there is very little difference between someone with an IQ of 130 and 170 in terms of real-life performance. Indeed, estimates of IQs of many influential people put them in the zone of 120 to 140 which is generally superior enough to perform in any profession with significant competence. Most doctors, for instance, perform the same. However, small differences among them (such as who was able to gain admission to a more prestigious course) can lead to dramatic differences in lifetime earnings because their clients mis-judge their competence based on their university. The truth about performance is that except for perhaps one or two exceptional individuals, the rest are all very similar. Yet the winner-takes-all mentality denies those from lesser universities a suitable place in life. The fact that we value a degree from Harvard much higher than a degree from, say, a top-50 university, is basically a stupid decision.

- Our imagined superiority about ourselves
This is not about arrogance, but simply over-estimating our abilities relative to others. Thus, apparently, 90 per cent of workers consider themselves more productive than their colleague/s (Robert Frank - return of economic naturalist, p.167).