The Online Library of Liberty

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• En Torno a La Funcion Del Capital, Joaquín Reig
• Reflections On the Keynesian Episode, W. H. Hutt
• Ludwig Von Mises and the Market Process, L. M. Lachmann
• Values, Prices and Statistics, Bettina Bien
• The Tax System and a Free Society, Oswald Brownlee
• How “should” Common-access Facilities Be Financed?, James M. Buchanan
• Pitfalls In Planning: Veterans' Housing After World War Ii, Marshall R. Colberg
• Presents For the Poor, R. L. Cunningham
• Restrictions On International Trade: Why Do They Persist? W. Marshall Curtiss
• “human Action”, E. W. Dykes
• The Genius of Mises' Insights, Lawrence Fertig
• On Behalf of Profits, Percy L. Greaves, Jr.
• Tax Reform: Two Ways to Progress, C. Lowell Harriss
• The Future of Capitalism, Henry Hazlitt
• Prices and Property Rights In the Command Economy, Arthur Kemp
• The Inevitable Bankruptcy of the Socialist State, Howard E. Kershner
• Entrepreneurship and the Market Approach to Development, Israel M. Kirzner
• The New Science of Freedom, George Koether
• Financing, Correcting, and Adjustment: Three Ways to Deal With an Imbalance of Payments, Fritz Machlup
• On Protecting One's Self From One's Friends, Don Paarlberg
• Recollections Re a Kindred Spirit, William A. Paton
• Ludwig Von Mises, William H. Peterson
• The Economic-power Syndrome, Sylvester Petro
• Ownership As a Social Function, Paul L. Poirot
• To Abdicate Or Not, Leonard E. Read
• The Book In the Market Place, Henry Regnery
• Lange, Mises and Praxeology: the Retreat From Marxism, Murray N. Rothbard
• The Production and Exchange of Used Body Parts, Simon Rottenberg
• The Education of Lord Acton, Robert L. Schuettinger
• Chicago Monetary Tradition In the Light of Austrian Theory, Hans F. Sennholz
• Hubris and Environmental Variance, Joseph J. Spengler
• An Application of Economics In Biology, Gordon Tullock
• What Mises Did For Me, John V. Van Sickle
• Economics In a Changing World, G. C. Wiegand
• Can a Liberal Be an Equalitarian? Leland B. Yeager
• The Political Economy of Nostalgia, Ramon Diaz

The Tax System and a Free Society
Oswald Brownlee

Most of the modern treatises on taxation deal with the characteristics of a tax system that are of greatest advantage to the state. The canons of taxation enumerated by Adam Smith in The Wealth of Nations - certainty, convenience and economy - were defined from the standpoint of the taxpayer. But, even these terms have been redefined to refer to the certainty of the tax yield to the state treasury and the convenience and ease of collection from the point of view of the tax collector. In this short paper I want to deal with the tax system as it impinges on the taxpayer and to try to set forth some taxing practices that seem to me to impinge on the vitality of a free society.

I hope that there are many tax systems compatible with a free market economy - if we mean by a free market economy one in which there are no artificial barriers to entry into economic activity, the terms under which choices can be made are the same to all participants and are essentially unaffected by the level of activity of any one private economic unit, government does not coerce individuals with respect to their choices and the role of government as a producer is confined to the provision of goods and service which it can produce more efficiently than can private producers. Funds for the operation of government could be secured in many different ways with no important differences in the ability of a free market economy to survive.

If a free market economy could exist in only a few restricted tax environments, prospects for its survival might be dim indeed. Different tax structures will result in different production patterns and different rates of saving and may result in different degrees of income fluctuations for given autonomous disturbances. These differences are important, but they impinge on differences in the vitality of a free market economy in the same way as they would on a socialist one. Perhaps it is in the interest of supporters of the free market system to advocate a tax system which has associated with it a near minimum welfare loss, if the free market is to gain maximum support. However, even this contention would be extremely difficult to prove.

Although I will discuss some aspects of these welfare costs, let me first discuss some aspects of coercion and some tax tendencies that are inconsistent with a free market economy.

II

The validity of my contention regarding the vitality of a free market economy in many different tax environments obviously is dependent on how one defines coercion. Is not the taxation of a particular commodity coercive in that the relative price of that commodity is increased and consumers are thereby induced to consume less of it?

If this is coercion, no tax system will be without it, for only a head tax does not affect economic opportunities—and, even it can be avoided by dying. I believe that the important aspect of coercion in a tax system is not what it does to relative prices but whether there are clearly defined rules that establish one's tax liability without the necessity for consulting taxing authorities. Without such rules the government can use arbitrarily the tax system to penalize or reward particular economic units and in effect interfere whimsically with the market mechanism. Some rules may be bad ones, but one will know what they are and can work for modifying them.

III

Survival of a free market economy requires that the government at least establish conditions such that monopoly is not encouraged, even if no active measures are taken to foster competition. Several features of contemporary tax systems violate this condition. Of particular importance are:

• 1) the taxation of imports
• 2) differential tax treatment of income and capital gains
• 3) gross receipts or “turnover” taxation

Few countries employ customs duties as a major revenue source. The objective of such taxation usually is protection for domestic economic activity rather than governmental revenue. The result usually is to cut real national income. However, in addition to the welfare losses associated with such levies, the taxation of imports leads to the growth of monopoly, particularly in countries where the size of the market is small. There probably are not many instances where import duties now encourage monopoly in the United States, but such instances are numerous among less developed nations.

If a national market is large enough so that the output of an economically efficient firm is a relatively small fraction of total sales, monopoly is impossible—without collusion among the firms. Many national markets are so small that the total quantity traded per unit of time is less than the amount that would be produced by a firm of the most economic size. Obviously, such a commodity would not be produced nationally—if it were not for protection. It will be economic for a country to produce a commodity if the size of the market is at least equal to the size of the efficient firm, and that firm can exert no monopoly power. This latter condition can be fulfilled if there are potential foreign producers who can supply the product at the firm's minimum cost. In the absence of import taxation or other forms of protection the problem of private enterprise monopoly usually is not presented.

In the United States capital gains are taxes at a rate of 25 per cent or at one-half the marginal personal income tax rate applicable to the taxpayer, whichever is the smaller. In the U.S. and in other countries where income and capital gains are taxed at different rates, we have had an opportunity to observe the great amount of activity devoted to converting income into capital gains. Although such activity yields a private gain, it is not only an obvious social waste but also gives a lift to monopoly in that it encourages retention of corporate earnings. Rather than receive his dividends and make his own choice as to whether to reinvest them in the same enterprise or some other line of activity, the stockholder leaves them with the corporation where he may gain through capital appreciation even though the capital may earn less before personal taxes than in some other uses.

I believe that this has been an important factor in the recent growth of established large corporations in the U.S. It gives established enterprises a distinct advantage in acquiring funds and thus is a man-made impediment to entry. It encourages firms to engage in activities in which they have no comparative advantage. One can cite such combinations as baseball teams and television, tobacco products and cosmetics and flour milling and boat construction as evidence.

There are several cures for this ailment, the most obvious one being to tax capital gains as income. However, in a system with progressive income tax rates, this cure also taxes persons receiving fluctuating capital gains at higher rates than persons with stable incomes - unless provisions are made for averaging income for tax purposes over a relatively long period of time. This may also have disadvantages in terms of its impact upon the inherent stability of the economy in that it probably reduces the correlation between current tax payments and current spending. There would be no problem if an expenditures tax were to replace an income tax, since when income is received or from where it came is of no significance for tax purposes. Also, a strictly proportional income tax or one with a constant marginal rate in which capital gains are taxed as income would involve no discrimination. I will discuss these possibilities later.

Turnover taxes have been levied at very low rates by a few of the states in the U.S. and are not significant in the tax structure. However, turnover taxation is attractive to under-developed countries because of its supposed low collection costs. A turnover tax induces vertical integration and hence larger enterprises than would exist in its absence. Like the differential tax rates on income and capital gains, it is an encouragement to monopoly and a threat to a free market economy. Small enterprises that might introduce more efficient techniques have less opportunity to enter.

IV

Certain features of the tax structure are inconsistent not only with a free market economy but with a free society because they are coercive, i.e. they permit the government to make arbitrary decisions with respect to the tax base or require the taxpayer to negotiate with the tax authorities in determining his tax liability. The ease with which additional tax revenue is made available as income grows without increasing tax rates also is of importance in determining the extent to which government undertakes activities that would not be sanctioned if put to a popular vote.

An amount of tax paid by some taxpayers that is the result of direct negotiations between them and the taxing authorities is characteristic of the taxes levied by local governments in some states in the U. S. on real estate and other property. Property assessment for purposes of determining the tax base usually is performed by low paid and incompetent civil servants, and there are wide variations in the amounts of taxes paid on properties of identical value in a given taxing jurisdiction. Taxpayers have the right to appeal to the courts if they believe their assessment are too high. However, the cost involved is large, and - of greater importance - an appeal is very likely to lead to an increase in the amount of tax paid because all properties are underassessed.

The situation could be substantially improved by such things as permitting the taxpayer to assign a value to the property and giving the taxing authority the right to purchase at the assigned price or paying assessors in accordance with the accuracy of their assessments for properties sold during a particular time period. However, there is much opposition from businesses to improving assessment procedures. A business frequently believes that its negotiator is more clever than that of its competitor and that it has obtained or can gain an advantage through the existing procedure.

I believe that the forces favoring arbitrariness in property taxation are so strong that the tax should be abolished. In its present form it truly gives government opportunities to coerce individuals and is inconsistent with freedom.

To me the most pernicous aspect of income taxation in the U.S. is the exclusion or deductibility of certain items—other than expenses associated in obtaining income—from the tax base (both corporation net income and personal income) for purposes of determining the tax liability. These items include interest paid, selected taxes, medical expenses in excess of a certain fraction of income, interest on state and local government securities, imputed income from owner-occupied housing and contributions to selected “charitable” and “artistic” activities.

If well defined, these deductions and exclusions constitute subsidies to certain activities and, although they may incur substantial welfare losses, are in the same class as taxes on selected commodities. The marginal rate of subsidization, i.e. the ratio of the government contribution to the private contribution, depends upon the marginal rate of taxation. For most corporations, the government (meaning other taxpayers) contributes about equally with the corporations. The contributions of some individuals can be as low as about one-third the amount contributed.

However, in many instances the deductibility of an item is not unambiguously known and is subject to the whim of the tax administrators. Much of New York theater and its cabarets, not to mention its call girls, are dependent upon arbitrary decisions regarding the legitimacy of a claimed business expense. More important, the government may employ its power to classify contributions to encourage the growth of certain organizations and kill others. It was able to obtain ransom for prisoners captured during the Bay of Pigs fiasco by asking businesses to contribute goods, the contributions being deductible at about twice their production cost for tax purposes. The cost to businesses was thus zero, and taxpayers as a whole paid a ransom which they probably would have been unwilling to make had they been asked explicity.

Attempts to alleviate these conditions have been both weak and unsuccessful. Their importance, and hence the pressure to maintain them, is directly related to the tax rates. For this reason, if for no other, the survival of freedom may depend upon lower marginal rates of income taxation than now exist in the United States. A tax structure in which the marginal tax rate increases with money income, as is true of the United States structure, makes the share of income taken by the government increase with the price level, even though real income and the tax laws remain unchanged. In spite of so-called tax cuts, real tax rates increased for some income groups due to the inflation. Clearly the tax structure should be defined in real terms so that the government has less incentive to foster inflation.

The coercive aspects of various social security taxes have been so widely discussed that I need not devote a lengthy discussion to them. That an individual should purchase a minimal annuity or accumulate in some other fashion some minimum amount of assets for his support in old age and that he should also purchase some minimum health insurance has been fairly widely accepted among liberals. However, that he should be forced to make such purchases and that the annuities and insurance be purchases only from the government has not been accepted both because government monopoly is no better than private monopoly and because of the income redistribution which accompanies such taxation. I see no place for such taxes in the tax system of a free economy.

V

There is much interest among true liberals in the consistency of progressive taxation of individual income and a free society. If persons share proportionately to their incomes in the costs of government, I believe that the level of government expenditure is likely to be lower—at any given level of national income—than if most persons give up proportionately little and some give up proportionately much. The present tax structure seems to include a bias for larger than optimal expenditure.

I believe it is more enlightening to discuss whether marginal tax rates should increase with the size of the taxpayer's base, rather than whether the tax system is progressive. I do not believe that progressivity is a threat to a free market economy except for the long-run impacts of its lower economic efficiency on the vitality of the system. Marginal tax rates which increase mildly with the tax base seem to me to be just as compatible with a free economy as constant marginal rates. However, on grounds other than consistency with a free market economy the case for constancy of marginal rates seems to me to be a very strong one. Although marginal rates of taxation on corporate net income are not invariant with income, some excise tax rates vary with the total outlay and there are property tax exemptions so that on some properties the marginal property tax rates is zero; controversy over the nature of the appropriate tax schedule has centered largely on that for personal income.

Let us assume that current personal income including capital gains constitutes the entire tax base. If the marginal tax rate is a constant, the time pattern of the receipt of income plays no role in the total tax paid over a given period of time for a given total income. Individuals with identical lifetime incomes pay identical taxes—assuming no change in the tax structure. Note that an invariant marginal tax rate means that the tax paid will be negative if income is less than a given number—which may be greater than, equal to, or less than zero.

In the taxation of expenditures, the time distribution of expenditure is of importance if the marginal tax rate is not constant. To avoid discrimination among taxpayers with the same totals, but different time distributions, of expenditure, a constant marginal rate is desirable. The tax can be made progressive by introducing an exemption, and there could be negative tax payments for taxpayers spending less than the amount of this exemption.

VI

As I stated at the beginning of this paper, many tax systems are consistent with a free economy. Elimination of property taxes, import duties and turnover taxes; inclusion of capital gains as income, elimination of deductions of expenses that are not associated with earning income and requiring that marginal tax rates be constant still leaves us with an infinite number of combinations of, say, income and expenditure tax rates all of which would yield the same revenue. However, other criteria can and should be introduced to further restrict the possibilities. I shall rely on the welfare cost—i.e. the amount by which national income is made smaller than it could be because one tax rather than another is used.

One difficulty with this criterion is that one must know a great deal about the economy in order to know when the welfare cost is minimized. For example, a system of excise taxes is not optimal—for a given amount of revenue to be raised by excise taxation—when all of the taxes are levied at the same ad valorem rate unless the elasticities of demand for all commodities are identical, all commodities being produced at constant marginal costs. Thus, an expenditures tax probably is not a welfare maximizing collection of exise taxes. Similarly, because an income tax is a subsidy to leisure, it also cannot be welfare maximizing. However, some things about taxes still can be said knowing only some general properties of the economy.

• (1) The tax on corporate income is a tax on capital used in the corporate sector of the economy and leads to too much labor and too little capital being used in that sector. It should be eliminated unless labor use is to be taxed similarly to capital in the corporate sector but not in the non-corporate part. Although most countries tax labor use through so-called social security taxes, the tax rate usually is the same in all uses—except leisure—so that one should eliminate the corporation income tax even though social security taxes were retained.
• (2) An expenditure tax does not tax leisure whereas an income tax subsidizes this activity. Hence, a combination of an income tax and an expenditure tax could be less efficient than either used alone. However, the price elasticity of demand for leisure is not very large and equal rates of excise taxation on all commodities except leisure (which is the outcome of the expenditure tax) also is not optimal. Consequently, I would guess that some combination of an income tax in which saving is exempted and an expenditure tax would be nearly as good as is achievable.
• (3) Some taxes other than the income and expenditure tax and yielding minor amounts of revenue should remain in the tax system as approximations of charges for services distributed in accordance with the amount of taxes paid. Motor fuels taxes and license fees to pay for highway services and per capita taxes to pay for police and fire protection fall in this category.

VII

Economists usually discuss the expenditure and tax decisions of governments as if they were (1) a selection of how much to spend based on a comparison of the marginal values of government proposals and the product that would be yielded if the resources were used in the private sector of the economy and then (2) a decision as to how best to finance these projects. Obviously, an expenditure should not be made if its marginal value is less than that in the private sector.

In practice, this procedure is not that which is followed. A better simple model might be that governments estimate how much they can extract from their constituents and then determine how to spend what they can get. Actually, spending often exceeds what the government believes it can extract by means other than inflation, budget deficits having been responsible for inflations in many countries. In the United States, there sometimes have been reductions in Federal tax rates, but combined state and local rates have almost invariably been marching upward during the past 3 decades. Although local rates have sometimes been cut, such decreases have taken place only when revenues from state or Federal sources replaced them.

In view of current practice, it has been suggested that a ceiling be placed on the share of a country's income that can be used by government. Usually this is expressed as a ratio of government expenditure to total income, and numbers such as 0.25 have been suggested. It does not increase the welfare of a nation when it fails to push government activities whose productivities clearly exceed those of activities that might be undertaken in the private sector. However, it is highly unlikely that a restriction of say, 25 per cent on the share of total income that could be used by government would rule out any government projects that yield more than private ones—if government appropriately ordered its activities. There is no assurance that such a ceiling would force government to perform more efficiently at a reduced scale. However, it would induce an ordering of possibilities instead of an attitude that there is no limit to the scope of undertakings available to government.