Democracy and taxation


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Government and Institutions
The condemnation of benefit fraud and tax avoidance obscures a difference. Benefit cheats make fraudulent claims upon the earnings of others. Tax avoiders use legitimate means to retain their own earnings. The greater the amount the state attempts to take in taxation, the more resources are directed to rent-seeking and tax avoidance.

Progressive taxation is especially pernicious. That social welfare is served by progressive taxation is contradicted by the relatively meagre extra revenue which is raised. Moreover, given the alternatives of directed tax-based expenditures, subsidised services and entitlements to welfare benefits, together with public provision of education and health services, income redistribution is attainable without progressive taxation.

The damning moral issues are that progressive taxation lacks any principle to determine relative burdens and that it violates the fundamental principle of equality before the law:

‘[t]hat a majority, merely because it is a majority, should be entitled to apply to a minority a rule which does not apply to itself is an infringement of a principle much more fundamental than democracy itself, a principle on which the justification of democracy rests’ (Hayek, 1960).

The democratic flaw lies with its sanction of tyranny: low income earners have a democratic entitlement to impose progressive rates upon a minority of high earners.

Beyond the administrative costs of redistribution, the economic perversity of progressive taxation is its impact upon incentives, innovation and economic advance: it penalises uneven flows of income; it tells against more risk-taking; it sets an incentive for work by amateurs; it discourages saving; and it discourages capital accumulation.

There is a view that progressive taxation offsets a disproportionate burden of indirect taxes upon low income households. While this may be true of current tax payments, greater saving from higher incomes merely defers tax liabilities. Even so, the argument sits at the heart of Friedrich Hayek’s suggestion forconstraining income taxation. In seeking a guideline, by which ‘progression can be made to correspond to a rule which may be said to be the same for all’ (Hayek, 1978), an upper limit is set for the top income tax rate; that it should be no greater than the proportion of national income taken in taxation. The proposal prevents a majority from isolating itself from the consequences of its decisions.

A recent paper (Steele, 2011) provides illustrations that demonstrate the effects of Hayek’s proposal. With two sets of taxpayer (‘haves’ and the ‘not haves’) and income tax levied at two proportional rates, the lower rate is applied to income earned by the ‘not haves’. It is also applied to the income of ‘haves’ over the range of ‘not have’ income, with the higher rate applied thereafter. Tax revenue is also raised from a proportional sales tax levied upon expenditure (of net income). The top income tax rate is set equal to total tax revenue as a percentage of total income.

In all representations, it is only by raising one and/or the other of the two tax rates that apply to both income groups that the higher rate of income tax can be raised. While neither income group is exempt from the consequences of higher taxation, any level of income equality can be achieved, if that is the democratic decision. Somewhat counter-intuitively, for given ratios of total taxation to total income, income inequalities are narrower with high standard rates of income tax than with high rates of sales tax.

In guarding against induced moral hazards and work disincentives, a limit upon the higher income tax rate is an eminently practical suggestion. Hayek’s proposal incites caution while it is permissive of redistributional aims. It also looks for efficient resource usage as reflected in the aspiration: ‘that each should feel that in the aggregate all the collective goods which are applied to him are worth at least as much as the contribution he is required to make’ (Hayek, 1979).



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