The Online Library of Liberty

A project of Liberty Fund, Inc.

• 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

Tax Reform: Two Ways to Progress∗
C. Lowell Harriss

If Professor von Mises were rewriting HUMAN ACTION in the 1970's, he would doubtless give more space than the dozen or so pages, out of 881, to taxation. The subject has certainly multiplied in significance. Some of the developments were presaged in Professor von Mises's writings of a quarter century ago. One after another of his sentences could serve as the thesis for a full article. Yet the two subjects which I wish to examine briefly here go rather beyond any explicit discussions in HUMAN ACTION.

For one thing, it seems to me, reliance upon the taxation of “business” should be drastically reduced. For another, greater reliance ought to be placed upon the taxation of pure site or location (land) value.

Discussions of tax policy continue to reflect misconceptions whose survival power bodes ill for mankind. Widely accepted views impede improvements which would reduce the adverse effects of taxation on economic progress.

Men and women whose goodwill cannot be questioned speak and write and vote as if they believe that business taxes are not “people taxes”. Time and again we have heard that corporation and individual income tax changes ought somehow to be “balanced”.

An inferior product will not survive the competition of the market place. But ideas, such as these about taxes, cannot always be subjected to equivalent testing of relative merit. For judging them, analysis may be man's best and only instrument.

Taxes represent the use of the power of government to coerce. They force us to pay over money. And taxes do more. They influence behavior, not only by depriving us of private buying power but also because we know that the amount we must pay will depend to some extent upon how we act. The “we” includes groups—not the least being those known as businesses.

Taxes are paid by people. One may speak of taxes falling on business or corporations, on cigarettes or property, on inheritances or income. Yet it is not things, but people, who are deprived.

All of us dream of a world needing no large defense outlays. Professor von Mises's friends, I suspect, also prefer a world in which nondefense spending rises less rapidly than it does. Yet realities cannot be ignored. Budgets rise to set new peaks year after year. The necessary “tax total” will require “high” tax rates. High tax rates alter human actions.

In the market place, we must pay prices to acquire things; in competitive markets we generally get about as much in value as we pay for. But the services of government which an individual receives are largely independent of the taxes he pays. He has incentive to rearrange his affairs to avoid a tax. The same applies to business organizations.

Taxes do not meet standards of neutrality which are endorsed in HUMAN ACTION. When tax rates are low, it will not often be worthwhile to sacrifice what is otherwise one's best interest in order to save some tax. But when tax rates are high, purely tax considerations can exert a decisive influence. This is especially the case when the differences in the tax consequences of different actions are large. A basically less efficient alternative will sometimes seem best when taxes are taken into account. As taxpayers act accordingly, private benefit conflicts with the public welfare: (1) The part of the cost of government which one person escapes must generally be borne by others. (2) Resources are not used as productively as possible. For one thing, capital investment will flow to take account of alternative tax consequences as well as of productivity; skilled effort is devoted to saving taxes rather than to creating goods and services of positive value or to reducing the input needed for some specific outputs.

Difference Between Taxes and Prices; Role of Self-Interest

Tax laws take from the individual (or prevent him from getting) what would otherwise be his without offering a specific quid pro quo. In the market place, what a person gives up is presumably matched in worth by what he receives. To get what one wants—whether acting as an individual or in a group known as a business firm—one must provide equal value for others. The pursuit of self-interest in a competitive market economy will generally serve the well-being of others by matching rewards on the two sides of a transaction. The pursuit of self-interest through the political process (in government), however, often tends to conflict with the interest of others—dramatically so when taxes are concerned. A person who gets his own taxes reduced will benefit by the amount saved; and he will expect to continue receiving the same governmental service. The individual or a corporate group has more reason to try to reduce taxes than to cut its outlays for labor or materials.

In choosing to use hidden taxes—those on business which “conceal” the costs of government from the persons who pay—society sacrifices one instrument for helping to make better, rather than poorer, decisions on government spending.

When taxes are not neutral as among alternatives (methods of financing, types of operation, location, and so on), taxpayers will sometimes select ways of producing or consuming which are less than the best by basic criteria of productivity. The true cost to the taxpayer is greater than the receipts by the governmental treasury. The difference is “excess burden.” Something which deprives part of the public of benefit without equivalent compensation of others must obviously be undesirable. Taxes at high rates cannot be completely neutral. But the amount of distortion will be larger or smaller depending upon factors under some control by those who determine tax bases and tax rates. In this power to control the tax laws, man has the opportunity to improve the economy by reducing taxes on corporations and raising them on pure land (location) value, as discussed later.

Justice in the Distribution of Tax Burdens

Taxes, whether borne directly or indirectly, will be not only heavy but also unequal. Some people must pay more than others. Being heavy, unequal, and the result of the use of government's power of coercion, taxes should seem to voters to be generally fair, just, equitable. Notions of what is fair in taxation will differ considerably—and always lack precision.

Yet by any reasonable standard taxes on business income are inequitable. Although the public seems determined to support the continuation of these taxes—levies whose real burdens fall in ways which hardly conform to accepted ideas of justice—the possibility of improvement provides basis for seeking change.

Economic Realities

The supporter of taxes on business net income seems to expect them to “burden the company”. Rather than explaining the expected results, and showing why they are better than alternatives, the advocate of corporation taxes will usually try to change the subject.

The Role of Business. Businesses are the organizations upon which Americans rely for most of what is produced. Although valuable results come from the efforts of government employees as well as from those who work for private universities, hospitals, and other nonbusiness organizations, most real income consists of what people accomplish through business firms.

Business is society's chief agency for organizing labor and capital to produce—and to produce more, rather than less, efficiently. A business firm is a group of people seeking to benefit themselves by serving others. It is this service, whether in producing and distributing things or in rendering services directly, which the public wants.

The process of meeting the desires of consumers can be more or less efficient. A market economy relies primarily upon competition in markets to induce efficiency—and to stimulate economic growth. For it is in business organizations that we find most of the venturesomeness which leads to the innovations that contribute much to rising levels of living.

The public interest calls for each business to do two rather different things. (1) It should turn out products or services which are wanted more than something else, as reflected in freely made consumer decisions expressed in the market, or through government agencies. Part of this task is to identify wants which can be satisfied by new types of goods and services. (2) A second general interest is for each company to produce by methods which economize on labor, materials, capital, and other “inputs” according to their relative scarcities and productivities.

The total accomplishment of people working as business organizations will depend upon many things: the training, inherent ability, and acquired skill of workers; their willingness to exert effort; the amount of capital; the degree of competition; present and expected demand; the state of technology and speed of scientific advance; the competence of management; and other things. Among the “other things” are some for which government is responsible—the system of law and order is one, and the tax structure is another.

Do taxes on business earnings help the community to get the output most desired? Obviously, taxes which vary among corporations according to profits do not improve the process by which consumers indicate the relative importance of their many desires. Nor do taxes on business income help managers learn about the relative scarcities and productivities of inputs. Profits taxes do not relate to the inherent creativities of different resources (capital versus labor or debt versus equity capital) or act to offset deficiencies in the market's guides as to relative scarcities. But taxes do affect the alternatives which a business manager must consider; the incentives open to him when acting for the company do differ as a result of tax laws.

In adopting methods which cut the tax bill, the business does not economize on the “input” of government or reduce in any perceptible way the government's use of resources. Nor in selecting a tax-saving alternative does the firm increase its operating efficiency in the sense of using fewer real inputs per unit of output.

A business, in fact, may wisely adopt methods which as regards the use of resources are “second best.” The tax factor makes some alternatives financially the best when in a more real sense they are inferior. Taxes at high rates thus give rise to an element of conflict between private and public interest. They induce the manager to redirect the firm's activities, away from what is fundamentally most efficient.

The distortion of decisions may produce only trifling waste; or the total may be of enough importance to warrant concern. Productive capacity is not allocated to the uses, and in the proportions, which are fundamentally best. Too much investment goes into forms with less burdensome tax consequences; too little then goes where taxes will be high. The economy loses some real income. The loss is a burden—but an “excess burden”, one which is largely concealing, which cannot be measured.

Reasons Advanced for Taxing Business Income

How can we account for the heavy taxation of business? Accident and temporizing to meet emergencies—notably war—have played a large role.

From time to time “business”, especially big business, has drawn sharp criticism from writers and “reformers.” Whatever the bases for such criticisms, America's school books, fiction, and the writings of persons who probably consider themselves “intellectuals” and other molders of opinion, have perpetuated attitudes which contain hostility to business.

There also seems to be a belief that “business” somehow has taxpaying capacity—“business” or “corporations” as distinguished from people as stockholders, consumers, or employees. The big corporation, seeming to be so impersonal, appears as an inviting target. Moreover, on the assumption that the shareholder bears the burden, and recognizing that shareholders, especially the owners of large numbers of shares, are the more prosperous members of society, advocates of corporate taxation defend it as progressive.

Any resulting progression, however, is crude at best. It is not the type which can be defended as leading to either verticle or horizontal equity. Furthermore, it is not true that a corporation income tax resting on shareholders imposes no burdens on low income groups. Some shares are held by people with “low” incomes. Considerable amounts are held by philanthropic, educational, hospital, and other organizations whose activities serve even the very poor. Pension funds for employees of businesses, nonprofit organizations, and some state and local governments own substantial amounts of corporation stock.

High U.S. corporation tax rates went into effect during time of war and postwar boom when employees, owners, and government could all increase their “take”. Concurrently, the rise in rates of tax on personal income, it was argued, justified substantial increases in the rates on corporations. As the years have passed, justification has also been found in the argument that burdens have been capitalized in the prices of shares and in a sense constitute no disadvantage to present stockholders, especially those who have bought since current tax rates went into effect.

In the formative years of income taxation in the United States, some economists introduced another argument. Pure economic profit, they said, is a true surplus. To tax it is not to burden the reward paid for an essential cost of production. That concept of pure profit, however, is not the income concept used for tax purposes. Lawmakers have defined “taxable income” in terms very much broader than the notion of pure profit as a true economic surplus.

Today's tax in the United States gets some support from another fact. The corporation income tax qualifies as an “automatic stabilizer” of considerable force.

To some extent corporations are separate from their owners—and in ways which can have tax significance. Two aspects demand mention: (1) the equality of tax burdens on incorporated and unincorporated activity, and (2) the possibility of tax avoidance.

Not all corporation profit is paid out in dividends. Amounts kept in the business are not subject to personal income tax. Most owners are not so well off, presumably, as if they had received the income in cash. The persons in control of the corporation, however, must expect those whom they serve to be better off than if they had gotten the earnings in cash and paid the personal income tax. The growth of assets (or decline in liabilities) resulting from the plowing back of earnings enlarges the ownership interest in the business. What would have been dividends will presumably be converted into capital gains. Any such possibility of transforming dividends into capital gains obviously has tax significance, but not in any simple relation. The possibility of delaying payment of tax also has value. Clearly, the existence of the corporation does make a difference in taxes on the owners because of the retention of profit.

For logical solution to the problem of taxing retained earnings, however, one will hardly look to the present tax, one which falls on all corporation earnings.

Uncertainty About “Who Really Pays”

Among those who give serious thought to the shifting of the Federal tax on corporation income as among consumers, stockholders, employees, or others, some will confess to great uncertainty. Others feel considerable assurance.

One problem is to distinguish between shifting in the short run of a year or two and over the longer run. Changes in tax on business earnings—whether resulting from fluctuations in pre-tax earnings or from a change in the tax rate or the definition of the tax base (depreciation deductions) or the tax structure (investment credit or treatment of multiple corporations) or in the case of regulated public utilities the decisions of regulatory authorities—will be reflected for a while in what remains for stockholders. As time passes, however, adjustments take place.

A business must have equity (ownership) capital. Supplying it costs something. The stockholder sacrifices the opportunity to use his wealth in some other way—lending or buying assets such as real estate. Such sacrifice is an economic cost. Although income tax law and traditional accounting do not recognize this cost as a deductible expense of doing business, consumers of the output of corporations will not get equity capital to work for them—and employees will not get equity capital to work with—unless the people who can provide ownership capital expect to receive total net benefits which will equal those obtainable elsewhere.

In other words, suppliers of capital in equity (ownership) form expect to be rewarded. What counts are the rewards after tax.

A “normal” after-tax return on equity capital is an essential economic cost. The net after-tax yield which a supplier of equity capital will insist upon, in expectation, will be as high a yield (conceived as a total net benefit, including growth in the value of stock, and hope of sharing in economic growth) as he could obtain from any alternative use of his funds.

The equity capital already in a business, of course, is largely sunk, except as depreciation permits gradual withdrawal. Expansion of an enterprise, however, calls for new capital; in the modern world mere survival of a business in fact often requires growth. To get new capital, the firm must offer attractions which are equal to those otherwise available to the suppliers of funds. Where can the company, in turn, get dollars to compensate the persons supplying capital? It must look to customers. If the corporation income tax rate is 50 percent, and if potential suppliers of new equity capital insist upon an expected return over the years of 8 percent, then the corporation must expect to get a price from customers which will give a pre-tax yield of 16 percent on ownership capital. Then only those new projects which offer a firm prospect of a 16 percent gross return will get equity financing in competitive markets.

The corporation will not succeed in selling new stock unless the prices which it expects from its customers will bring an adequate after-tax yield. The expansion of output (in a growing economy) will lag until prices are high enough to give profits which after tax do satisfy investors. In relation to demand, the supply of output from corporations adjusts to affect product prices. Over the long run, then, some or much of the corporation income tax will be paid by consumers. The indirectness of the process conceals most of it; but the result does include a tax on consumption. Some tax, however, will fall on shareholders whose expectations have been disappointed perceptibly. The tax falls capriciously, unevenly, and not in line with any concept of fairness familiar to me.

Will a reduction in tax on corporation earnings be followed by price reductions? Not obviously within the month. But competition works. Gradually rather than quickly, the decline in the cost of equity capital will increase productive facilities, and larger supply will mean lower prices.

The actual shifting to the consumer of a tax increase or reduction will depend to some extent upon what happens to the total supply of, and total demand for, capital. The amount of capital available for new investment in business is not fixed. The amount available for equity investment in corporations is certainly not fixed.

Let us assume that the tax on corporation earnings rises to make the prospective yield on corporation earnings less than otherwise and less after tax than will be available in some alternative uses. The potential supply of equity capital for corporations (out of a given total of funds for investment) will decline; more of the total of new savings will seek investment in debt form. The rate of return on debt will then fall. Thus, a rise in the tax on corporation income will tend to reduce, not only the after-tax yield on equity capital (until shifting to consumers gets under way) but also the yield for suppliers of debt capital. The corporation tax thus becomes a more generalized burden on the suppliers of capital. The magnitude and the distribution of this burden cannot be measured nor compared with the amount passed on to consumers. Nor do we know how the amount of saving and the type of capital formation are affected.

This country apparently tries to put more of the cost of government (per dollar of income produced) on people in their capacity as suppliers of capital rather than as consumers or recipients of earnings from labor. What are the reasons and the results? The role of capital is central to economic progress. Extra taxes burdening those who supply it cannot help, and will hamper, the achievement of objectives which most of us believe are important—output and efficiency.

Any process of shifting operates in an environment in which conditions constantly change. Lags and frictions inevitably slow the process. No single set of forces has an opportunity to work itself out fully. Profit results depend on all the many factors which affect a company's costs and selling prices. The reasons why some corporations are more successful than others differ widely. Businesses competing with others which are free from tax—perhaps those operated by government—must expect considerable difficulty in passing the tax to consumers through the market process. Other factors are foreign competition, the extent of production from firms with large proportions of debt finance, and “special features” of the tax law (or its administration) such as deductions for depreciation, depletion, and reserves for losses. In a dynamic economy flows of new equity capital depend upon many factors, a few of which are neither rational nor farsighted. But exceptions are just that, not typical.

One conclusion seems clear to me: A major tax whose economic effects are so difficult to identify and measure—but some of which wise men of goodwill must shun rather than seek—can hardly be the best that men can devise. As a tax on consumption the levy on corporation income is haphazard and capricious. As a burden on suppliers of capital it has effects which are certainly not clear but which include both reduction of capital accumulation and investment in the equities of business.

Taxation of Land Values

Although it may seem impossible that man fails to take advantage of one good means of getting revenue, such is the case. We fail to tax land, especially in and near cities, as thoroughly as would be desirable. If government must be financed, then in land values we have a most appropriate base to tax—and tax heavily.

Land in the sense of space is the creation of nature far more than of man. And land as location value depends largely, as a rule, upon the developments of society rather than of the individual owners. The quantity and quality of human effort and of capital offered for production will differ according to the weight of tax. Not so, land. It cannot get up and walk away or take a vacation. The amount in existence does not depend upon the tax, but the tax can influence the way in which land is used. The kind of tax policy which will get substantial revenues from (urban) land without reducing the quantity will also tend to direct land use into better rather than poorer channels—“higher and better use”.

God, or nature, created land—certainly not the owner. The quantity is limited, most strikingly in cities. As demand presses on supply the price goes up. To get the use of space, even the little space of congested city living, people pay “high” prices. Such payments are necessary to allocate a scarce resource efficiently. But the high prices do not, as for other items of production and consumption, call into existence more, rather than less, land.

Obviously there is an excess of payments over what would be needed to make this resource available in the sense of existence. Such payment is an “economic surplus.” Here is pure land rent in the Ricardian sense. It serves a constructive economic purpose in allocating the scarce resource—but not in calling it into existence. The “payment” can be a periodic amount, so much per year. Or it can be converted into a capital sum and realized upon sale.

Use of land is a continuing thing. Payment will be made continually, as an outpayment to a landlord each month or in the form of an owner-user's sacrifice of alternative uses of what he paid in buying the land (adjusted for what he could get from sale currently). Since the periodic cost does not go to create the land, as the payment for shoes goes to get them produced, government can interject its authority and take much of the payment to pay for governmental services.

Rising population and rising purchasing power (excluding inflation), lead to higher land prices (rents). In the United States, and many other places, the rise in urban land values rests to considerable degree upon school buildings, streets, and other governmentally supplied capital facilities. In places the governmentally provided facilities costs, apparently, over $15,000 per residence. Would not society be better off if much of the rise in land prices went to finance local government? Yes.

Taxation can do more than recapture for public treasuries much of the values created socially. It can put pressure on owners to find the best use possible of land. Withholding of land from a more productive use imposes costs upon society. For a variety of reasons, some logical, some not, landowners (“speculators”) do keep land below the most productive use possible. A tax based upon values representing the best potential use will induce owners to seek out higher yields.

For reasons which I have developed elsewhere, present property taxes as they fall upon buildings and other improvements have substantially undesirable results. One possible means of reducing them would be to raise the tax rates on land while lowering them on buildings. These changes would alter profoundly the economics of land use and investment in structures. The net benefits to society could be many times the cost of making the shift. The communities moving first in this direction would benefit far more than those coming later because of the greater ability to attract new capital.

[∗]Views expressed are the author's and not necessarily those of any organization with which he is associated.