The Trouble With Taxes

“There is no more persistent and influential faith in the world today than the faith in government spending,” wrote economist Henry Hazlitt in 1946. If that was the case then, what about today? Nearly every problem in the world calls for the government to solve it. In return for these services, the government needs money—a lot of money.

Now, the Trump administration has been in the news for proposing a reform of the tax system, including some significant cuts. However, rather than bicker over the costs and effectiveness of that particular proposal, let’s take a step back and look at the big picture on taxes. We may even consider asking the question of whether we need taxation at all.

The first is that taxes prevent private economic activity, the core provider of employment and the products we need to sustain our lives.

From a cost-income perspective, high corporate taxes make many business ventures not profitable, especially for small entrepreneurs and innovators. This is exacerbated by the fact that taxes artificially increase the risk-reward profile for any operation, regardless of profits. Taxes immediately reduce the profits, but losses can only be offset after a new profit is earned. This leads to less investment and lower employment because entrepreneurs have to factor in the higher risk and lower savings to buffer for unforeseen circumstances.

“Improved machinery and better-equipped factories come into existence much more slowly than they otherwise would. The result in the long run is that consumers are prevented from getting better and cheaper products, and that real wages are held down,” wrote Hazlitt, in his classic book “Economics in One Lesson.”

So instead of two private parties meeting directly, the government inserts an unnecessary and costly bureaucracy in between. The government justifies this bureaucracy because someone must administer the money brought in through taxes and pay it out in subsidies and transfer payments.

Because the bureaucrats do not have perfect information about the needs of different individuals who are affected by these programs, they cannot know which amount or program suits whom, but rather offer one-size-fits-all solutions that lead to inefficiency.

In addition, since the bureaucrats are not handing out their own money and usually are not liable for mistakes made in disbursing the funds, the process inevitably leads to waste. And the private education and health care companies happily make use of this bad incentive structure by charging more than they could in a competitive marketplace. Add in a bit of corruption, and prices rise more than they should under normal conditions.

For those who think that less government involvement would inevitably lead to people dying in the streets because the health care system would collapse and nobody would be able to afford college education without the subsidies, consider the following:

First, these services would become much cheaper under a competitive system for the reasons cited above. Second, imagine how many more resources every household would command if they didn’t have to pay federal income taxes. If you add more opportunities for business and employment because of lower taxes, you may even be able to pay for health care and college without having to go into debt.

In fact, history suggests the opposite, as most income inequality, which has more causes than just taxes, has arisen after the introduction of a heavy progressive tax system.

In a system in which the government takes the backseat, the wealthy would have two choices about what they could do with their extra money. They could spend it, leading to increases in economic activity, which should benefit everyone. Of course, well-off people spend a lower proportion of their income on consumption because there is a limit on how much any one person can consume.

So they would be forced to save the rest. Normally, these type of savings would go into private capital markets, leading to an increase in investment, business activity, and employment.

Even though interest rates are low at the moment, the average taxpayer is paying this interest for households who can afford to save and invest in government securities, although this includes many middle-class families as well. However, the relatively poorer taxpayer doesn’t have any savings, yet may not qualify for government transfer payments because he has a job. This person gets nothing in return, making his situation worse, not better.

So if the government kept a balanced budget by getting out of most non-essentials sectors, saving too would level the playing field.

Of course, reducing taxes to 1913 levels is completely against the incentives of politicians and bureaucrats whose bread and butter is to design and administer government programs that need funding. This is one of the reasons even President Donald Trump’s relatively modest tax proposal will take so long to pass.