In Praise of Progressivity
March 25, 2011
(This item originally appeared at Forbes.com on March 25, 2011.)
You could make a list of history’s worst tax systems. It would certainly include France’s arrangement just prior to the Revolution. At that time, the aristocrats paid no taxes at all, while peasants paid 50% or even 80% of their income. Even the aristocrats thought this was a terrible arrangement, but they were loathe to allow themselves to be taxed by a government then grasping at every franc that was not nailed down. This impasse was resolved by a total collapse of the system.
Spain had a similar system during its long decline in the 17th and 18th centuries. The aspiration of every middle-class merchant was to make it into the ranks of the hidalgos, a lower classification of Spanish nobility that did not pay taxes. The peasants, on the other hand, were crushed by government demands, leading many to immigrate to Spain’s American colonies to escape the Spanish taxman.
Britain also had a long discussion, spanning centuries, about whether it was best to fund the government with an income tax (essentially a British innovation) or whether to rely on excise taxes, the old-fashioned version of a sales tax or VAT. The old, pre-1800 system of relying primarily on excise taxes was eventually considered unacceptable.
After hundreds of years of these experiments, I think we can conclude a few things. There might be a place for a system that relies solely upon a simple sales tax. However, this might be best when the government itself is quite small, perhaps 5% to 10% of GDP. If you have a larger government, of 20% to 30% of GDP, you will need more taxes. The burden upon the lowest earners becomes excessive if a sales tax alone is used.
Thus, we introduce an income tax. An income tax works best when its rates are low, with top rates preferably under 25%, and under 20% is better. A “flat tax” type plan is a good template to use. The last century’s experiments with high penalty rates, of 40% or higher, was generally a failure in my opinion. However, we should still have an element of progressivity, that the burden should fall lightest upon those who have the least. Most recent flat tax plans have some sort of basic deductible, a portion of income that is tax-free.
Over 30 governments have adopted flat-tax type plans, with top rates typically below 20%. This has generally been a great success, as the new systems are far better than the income tax systems they replaced.
However, the result is that many such governments have been left with very high payroll taxes (which are just another form of income tax), coupled with very high VAT or sales taxes. For example, Russia is often cited as a flat-tax success, as indeed it is. However, the VAT in Russia is a whopping 18%. On top of that, payroll taxes add up to another 24% on the first $16,000 of income, which is still a high cutoff in a country with a per-capita GDP of $10,522.
Capitalism has a nasty habit of bifurcating into rich and poor. For many generations, we have struggled with solutions to this tendency. One type of solution is to provide lower-income people with some sort of universal government service, such as public education, a public pension, and a public health care system.
Another solution is: Don’t take their money. Any tax system introduces distortions upon the capitalist economy. You disadvantage that which you tax, and advantage that which you do not tax. In general, the skew should be towards taxing higher incomes more, and lower incomes less, while nevertheless keeping overall taxation modest.
In Russia’s case, I would aim to eliminate the Unified Social Tax entirely, over a period of years, leaving the 18% VAT and the 13% income tax. The UST was cut to 24% from 35.6% in 2004, with no ill effects.
I would be wary of similar impulses in the U.S. or Europe. Reagan is rightfully cheered for slashing back the terribly high tax rates of the 1970s. However, Reagan also oversaw an increase of payroll taxes, led by the Greenspan Commission. It was rather modest, increasing the rate from 6.7% before to 7.65% afterwards. Employers paid the same, so the rate was effectively double, or 15.30%. However, the trend was toward higher taxes on the lowest incomes, exacerbated today by rising sales and property taxes at the state and municipal levels.
The basic rate was 4.8% in 1970 and 1.5% in 1950.
A similar sort of thing happened in Britain. Margaret Thatcher slashed the top income tax rate from 83% to 40%. The corporate rate fell from 53% to 35%. Top capital gains tax rates fell from 75% to 30%, and were indexed to inflation. However, the VAT rose from 8% to 15%. This was pressed on Thatcher by government ministers and her advisors.
If you go down this road too far, you could end up in pre-Revolutionary France.
Keep taxes low, but keep taxes on the lowest incomes lower.