Front Page Titles (by Subject) III.: The High-Tax Trap - The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy)
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III.: The High-Tax Trap - Geoffrey Brennan, The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy) 
The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy) Foreword by Robert D. Tollison (Indianapolis: Liberty Fund, 1999).
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The High-Tax Trap
The three main examples we shall introduce are familiar from economic policy discussions of the early 1980s. The “high-tax trap” is a term we shall use to refer to the set of considerations often summarized under “supply-side economics.” Our analysis of this trap, or dilemma, offers a basis for imposing limits on the government’s taxing authority, even in a setting where the taxpayer and the beneficiary groups are largely coincident in membership.2 That is to say, we model government democratically in the sense that it is presumed to be responsive to the demands of citizens both for expanded state services (and transfers) and for lower tax rates. The dilemma emerges here from the disparity in time horizons between the two separate sets of behavior, private and political.
Is it possible to say that tax rates are “too high” except by reference to some value-laden normative criterion that suggests the existence of some “optimal” size of public or governmental outlay relative to the private or market sector of an economy? In a nonevaluative sense, we could say that taxes are “too high” only if everyone expressed agreement on such a proposition, with members of the government (politicians, legislators, and bureaucrats) as well as direct beneficiaries included in the group. But surely the members of the group, the recipients of net transfers in particular, would never agree to any reduction in the size of the public sector, as measured by the amount of outlay and, indirectly, by tax revenues. So it would seem. Without some normative standard for judgment, we would never expect to obtain general agreement on the proposition that governmental outlays are too high.
This proposition is not, however, the same as the statement that tax rates are “too high.” It is at least logically possible that tax rates may be so high that tax revenues are actually lower than they would be at lower rates. In this case, of course, there should be general agreement among all parties on the need for a rate reduction, if not a revenue reduction.
The simple arithmetical relationship between tax rates and total tax revenues came to be widely discussed under the “Laffer curve” rubric in the early 1980s in the United States, since the relationship was brought into political prominence by Professor Arthur Laffer. As many critics pointed out, the relationship was articulated in writings as far back as the time of the Moors, and possibly even the early Greeks. And, indeed, there is little more to the relationship as such than the mathematical properties of a simple functional form. Some such relationship must exist so long as any inverse behavioral response of taxpayers to tax rates is predicted.
Pointing out that such a rate-revenue relationship must exist, however, is not the same as suggesting that modern fiscal systems are described by locations on the “wrong,” or inverse, portion of the schedule or curve, that is, at a position where a decrease in tax rates would increase rather than decrease tax revenues. In some of the journalistic advocacy of “supply-side economics” in the United States of the early 1980s, the arguments seemed to suggest that this position was, indeed, characteristic of the existing fiscal structure.
The initial reaction of public-choice economists is surely to reject the behavioral model that would be required to generate such a position. It would seem impossible that any rationally motivated governmental decision process could have allowed tax rates to reach such levels. Why would rates have been allowed to become so high as to reduce total tax revenues, since such rates would not be to the advantage of taxpayers, program beneficiaries, or politicians? It would seem to be in no group’s interest to sustain such a fiscal structure. Behaviorally, location along the inverse segment of the relevant rate-revenue curve seems bizarre, quite apart from the limited results of empirical studies that also suggest response elasticities that fall far short of those required to generate such results.
The initial reaction of the public-choice economists may, however, be less definitive than at first it seems, and a more sophisticated examination of the political decision matrix within which tax and outlay decisions are made, along with an analysis of individual responses to these decisions, might suggest a plausible scenario that might well produce the position on the “wrong” side of the rate-revenue relationship. The central element in this scenario is the disparity in time horizons between private and public choice.
Let us assume, possibly as a counterfactual, that the fiscal structure is in the position indicated. There is an inverse relationship between tax rates and total tax revenues. Is there any behaviorally meaningful path through which the system might have reached this position?
Let us look first at the utility or preference functions of those who participate in the process from which governmental fiscal decisions emerge. We can, at one extreme, think of all fiscal decisions as being produced by the operation of majority voting rules, with all members of the community equally franchised to participate in the determination of the outcomes. The analysis is sufficiently general, however, to allow for differential powers of collective influence among different groups of constituents. In any case, those persons who participate in the making of collective decisions will wish to make outlays or expenditures through the political unit. They will need such expenditures either to finance “good things” (governmentally financed goods and services and transfers) and/or to line their own pockets or those of their friends and constituents. In either case, we can stipulate that funds, or revenues, are desired by those who participate in collective decision making. Revenues are “goods” in the utility functions of persons who ultimately make fiscal choices, whoever these persons may be.
At the same time, however, the levy of taxes is required for the acquisition of these revenues. (We shall, in this section, ignore the prospects of revenue generation through either money creation or debt issue; these prospects will be discussed in the two following sections.) In some way or another, funds must be extracted from citizens in their private economic roles or capacities. This taxing process will be painful, regardless of the model of governmental decision making that is postulated. In utility-function terminology, taxes or tax rates become “bads” rather than “goods.” In some Utopian sense, persons in collective-decision roles would ideally prefer to spend without having to levy taxes. And the worst of all worlds for these persons would be some requirement that taxes be imposed without any accompanying outlay of funds on desired programs. These results remain true whether or not the taxpayer and the beneficiary groups are fully, partially, or not at all coincident in membership.
Note that to this point, we have said nothing at all about the time dimension. We have not dated the revenue flows the government expects to receive as a result of the imposition of a tax or an increase in the tax rate. We now postulate that those who participate in collective decision making are motivated by short-term considerations, for reasons analyzed in the previous chapter. By “short term” in this application, we mean that fiscal decisions are considered with reference to a time period shorter than that relevant to the private or individualized adjustments to tax-rate changes. We do not need to define the time horizon that informs individual collective choice in more detail than this; we require only that the effective time horizon embodied in governmental fiscal decisions be less extensive than that embodied in taxpayer response to tax-rate changes.
We know, of course, that taxpayer adjustments to tax-rate changes take time. In response to rate increases, persons must seek out and find nontaxable substitutes for the tax base, or at least substitutes that are taxed at differentially lower rates, whether the tax is imposed on a source or a use of income. Persons must shift investment to nontaxed or low-taxed opportunities and must invest in opportunities that are complementary to those directly advantaged. Individuals must learn about, and take advantage of, legal loopholes, which may have to be invented by lawyers and accountants. The whole analysis here depends only on the plausible assumption that in considering the revenue potential of a tax or tax-rate increase, the participant in governmental decision making operates on the basis of a shorter time perspective (a higher discount rate) than the one that describes the adjustment of persons as taxpayers to a posttax equilibrium.
For simplicity, let us postulate that full adjustment to a tax-rate change takes ten years, a period of adjustment that has been informally estimated to be relevant in modern fiscal systems of Western nations. Let us postulate, furthermore, that the time horizon effectively informing the behavior of participants in the making of collective political decisions on taxes (and spending) is five years or less. There are, of course, many reasons to support this postulated disparity in the time perspective for the individuals in the two separate roles, only one of which was discussed at some length in the previous chapter.
Given the postulated discrepancy in time horizons, “political equilibrium” will be established before “taxpayer equilibrium.” That is to say, the individual as a participant in the political decision-making process will try to attain a position where the trade-offs between tax rates and tax revenues faced in fiscal reality, over the relevant time period, are equated with the subjective trade-offs between these two arguments in the utility function. So long as the individual, as a fiscal decision maker, values the “good” measured by increased funds higher than the “bad” measured by the tax rates required to generate such funds, he will “vote for” or support increases in tax rates. Both of these variables will be measured with respect to the period of time over which the funds are anticipated to provide benefits and without direct regard to the period of time that might be required for full taxpayer adjustments. As such, these individual participants in fiscal decision-making processes will be uninterested in the fact that taxpayers will take ten years to attain full equilibrium adjustment to the current tax rates, even when, at another level of consciousness, they may realize that they are the same persons who are involved in the quite separate roles. As political decision makers, individuals are concerned with the flow of revenues from taxes, and with the program benefits therefrom, only for a period of five years or less.
In the illustration here, however, taxpayers will not have made the full behavioral adjustment within five years. From this result follows the simple fact that the government can expect to collect more revenues per period at any given tax rate (above some initial starting rate) within a five-year period than it can expect to collect over the full ten-year sequence.3 Hence, the fiscal process that embodies the shorter time horizon will exploit taxpayers more fully than would a process embodying a time horizon equal to, or longer than, the period of taxpayer adjustment. Taxpayers can be squeezed more fully by a governmental decision process that reflects interest in short-run revenue flows than by a process that incorporates a genuinely long-term perspective. As a familiar nontax example, the OPEC oil cartel was able to exploit oil consumers more before individuals adjusted the size and efficiency of the vehicle fleet than it was able to do after the adjustment took place.
Given sufficient time, of course, taxpayers will adjust to any given tax rate, and the coincidence of political and taxpayer equilibrium must ultimately be attained. In this full equilibrium, two separate conditions must be met. The trade-offs within the calculus of the persons who participate in governmental decision making must be equal, and taxpayers must be fully adjusted to the current tax rate. Such a full-equilibrium position might well be located in the range of the long-term rate-revenue schedule where rates and revenues are inversely related, although the precise location would have to be empirically determined. But the analysis suggests that because the long-term relationship is irrelevant to the political decision process, the generation of a position on the inverse segment of this relationship or schedule is not “collectively irrational,” in that there need be no violation of the precepts of rationality by those who participate in political decision making.
If, however, such a position were reached, and if it were recognized as such, why would political decision makers not react by reducing tax rates? The answer is the reverse side of the tax-rate increase coin. By cutting tax rates, government would find revenues reduced in the time period relevant to those who participate in political decision making. Even a shared presumption that a reduction in tax rates would generate an increased stream of revenues per period, after, say, ten years, would not affect the decision of those who, by our postulate, remain interested in revenue flows only over a five-year sequence. The maintenance of high tax rates would ensure higher revenues over this relevant period. The revenue-enhancing effects of a possible tax cut are long run, not short run.
Within the time perspective of the early 1980s, the critics who opposed the naïve supply-side economic arguments were correct. Tax-rate cuts were predicted to and did reduce revenue flows; budget deficits were increased, especially since outlays were cut very little, if at all. Whether the critics would have been correct within a time horizon allowing for full taxpayer adjustment will never be known, because pressures for tax-rate increases, for short-term revenue reasons, emerged as early as 1982.
This is the setting for what we call the “high-tax trap.” Individuals who participate in the making of political decisions cannot, even if they fully understand the situation they are in, readily escape from this dilemma. Given the absence of constraints on the fiscal proclivities of the collectivity, along with the existing rules and procedures for generating fiscal decisions, the individual who adopts a genuinely long-term perspective in his role as a participant in politics is behaving irrationally. In this setting, the argument for binding constraints on governmental fiscal authority becomes evident. Only if some means can be found to limit the ability of governments (political coalitions) in subsequent periods to depart from a reflectively evaluated and presently preferred long-term fiscal program will the individual participant find it advantageous to support the separate elements in such a program. Only through constitutional change can the institutions of modern politics be adjusted to ensure that, within these institutions, persons will have incentives to act in accordance with what they recognize to be the long-term interest of the community, as well as their own.4
[2. ]The basis for imposing tax limits that emerges from the argument here is quite different from the one we offered on the basis of a contrasting political model in our earlier book, The Power to Tax (Cambridge University Press, 1979). There, we stated that taxes tend to be “too high” because of the revenue-maximizing proclivities of government, which was modeled as one player in a two-player game with taxpayers. In that analysis, there was no dilemma aspect such as is examined here, and the set of questions concerning the time horizon for adjustment did not arise.
[3. ]In terms of simple geometry, this result becomes immediately apparent. Although we shall not depict it here, the short-run “Laffer,” or rate-revenue, curve above the initial tax rate will always lie outside the long-run, or full-adjustment, curve.
[4. ]In collaboration with a colleague, one of us has developed the “high-tax trap” analysis in some detail. See James M. Buchanan and Dwight R. Lee, “Tax Rates and Tax Revenues in Political Equilibrium,” Economic Inquiry 20 (July 1982): 344-54; “Politics, Time, and the Laffer Curve,” Journal of Political Economy 90 (August 1982): 816-19; and “The Simple Analytics of the Laffer Curve” (paper presented at the 38th Congress of the International Institute of Public Finance, Copenhagen, August 1982).