Tax Cut Fairness

Sinclair Davidson has a piece on the tax cuts in today’s AFR, which he’s generously allowed me to reprint over the fold. I have some quibbles with it, but it seems more appropriate to put them in a separate post.

Perverse logic in tax-cut ‘fairness’
Sinclair Davidson
Australian Financial Review, 25 May 2005

Kim Beazley’s alternative tax plan is just a different set of numbers, not reform, writes Sinclair Davidson.

Kim Beazley, in his budget reply, set out a tax plan that built on existing tax relief, yet "delivered genuine reform of the tax system". Under his plan, low-income earners get $12 a week and not $6; high-income earners get $40 a week, not $65. Under this plan, low-income earners get to super-size their sandwich and milkshake. This is hardly a "reform". Yet, Beazley would have us believe it is "fair" and does not skew tax cuts towards the rich. It is hard to understand how the ALP proposals constitute "genuine reform"; they simply constitute a different set of numbers. The difference between the government and the ALP, in this matter, is entirely arbitrary. But then, the whole notion of "fair" in progressive taxation is entirely arbitrary. Note that high-income earners still get more than low-income earners under the ALP alternative. Any number of combinations of tax rate, or income threshold, could provide tax relief. All of those proposals would result in high-income earners having a higher tax cut than low-income earners. The only principle at stake in the current tax debate is that the ALP doesn’t like the government’s numbers.

The basis of progressive taxation rests on notions of "fairness". To disguise the unorthodox definition of fairness, economists use the terms horizontal and vertical equity. Horizontal equity means that equals should be taxed equally, while vertical equity implies that unequals should be taxed unequally.

As unequals, high-income earners are taxed unequally, brutally and progressively. I have calculated, using Australian Taxation Office data, that the top 25 per cent of income earners paid 63.8 per cent of net income tax in 2003. The 3.5 per cent of taxpayers earning above $100,000 pay 25.5 per cent of net income tax. Beazley made a big deal about taxpayers earning between $100,000 and $125,000. That group make up one half of 1 per cent of taxpayers (including parliamentarians and university professors). Our tax system is extremely unequal, yet somehow "fair".

That notion of fairness is based on an economic theory called "equality of sacrifice". This perverse concept of equality, in turn, is based on a first-year economics exercise whereby economic agents are endowed (by magic) with resources, normally beer and pizza, or some other consumables. Those agents with lots of pizza, but no beer, will trade pizza for beer. Why? Because they value the pizza less than they value the beer. This demonstrates an idea called diminishing marginal utility. Public-finance economists have imported this notion into tax theory. Those individuals with lots of money value it less than those with little money. Therefore, we can take more from high-income earners than from low-income earners for the same level of unhappiness at paying tax.

There are, at least, two problems with this analogy. First, the pizza-beer story takes place in a barter economy. Diminishing returns have their place in theory, but in the real world we don’t barter, we have money. Second, as we are often told, "You can’t eat money". There are no diminishing returns to money. After all, why would people work hard to acquire more of an asset they value less? Money is fungible [interchangeable]. An individual, with money, can choose to buy a whole range of products, and stop buying before diminishing returns set in. Money can be saved, or invested. Of course, unlike the classroom example, money is generally earned and not endowed by magic.

Imagine the following counter-example: If the government had increased the bottom tax rate, and lowered the income thresholds, taxes across Australia would have increased. High-income earners would be paying about $65 a week more, and low-income earners about $6 a week more. That is how a progressive tax system is designed to operate, and we are told this reflects vertical equity. Why doesn’t the same happen in reverse? By this logic, low-income earners must value a tax cut of $6 just as much as a high-income earner values a tax cut of $65.

The Revenue Lobby, that group of politicians, academics and welfare lobbyists who continually agitate for higher taxes, are hoist on their own petard. Progressive tax cuts return the money at the same rate as it was raised. In essence, tax cuts are an application of the unionist ideal: Last in, first out.

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