Saturday, November 7, 2020

Professor Richard Epstein: A Flat Tax Is A Fair Tax

This expert commentary from Richard Epstein dissects the shallow theology behind the new strain of socialism that makes the unfounded claim that capitalism and private markets make us “unfree.” With today’s “New Socialists” calling for universal healthcare, price controls, free college tuition, and a basic universal income, this is an urgent read for anyone who cares about preserving liberty for the next generation.

One of the most contentious political battles of the 2020 election cycle involves the Illinois “Fair Tax” ballot amendment. Supported politically (and financially) by Illinois’s billionaire governor, J. B. Pritzker, the amendment seeks to remove a provision in the Illinois constitution that requires all income taxes to be flat—that is, held at a constant rate regardless of the amount of income earned by any taxpayer. Currently, all income earned in Illinois is taxed at a 4.95 percent rate. The amendment requires a simple majority vote to be passed. 

The amendment does not offer any specific progressive rate scale, but allows for increasing tax rates to be applied to successive tiers of a taxpayer’s income. Notably, the initial legislative plan on which the amendment is largely based—and which was proposed by the Democrat-controlled legislature—is a hybrid between a flat and progressive scheme. Most earners would be subject to progressive rate scales starting at 4.75 percent for the first $10,000 of income earned. Then. as income increases, so would the tax rate, maxing out at 7.85 percent. The legislative plan maintains a flat tax for the financial elite: Individuals reporting income above $750,000 and couples with joint incomes above $1,000,000 would pay a 7.95 percent rate from their first dollar.

This change in tax structure is held out as the fairest because it puts onto the rich the burden of shoring up Illinois’s rickety finances. The argument goes that the poorest 20 percent of the public are disproportionately exposed to high state, county, and local sales taxes, which total 10.25 percent in Chicago. This leads to a regressive system overall, where the poor pay an effective tax rate of 14.4 percent, while the top 1 percent pay only 7.4 percent. The obvious rejoinder is that, in total dollars, the rich pay far larger amounts in all taxes, much of which is used for transfer payments from which they do not benefit.

The Illinois initiative has prompted the New York Times to weigh in editorially by calling on Illinois voters to “Say yes to fairer taxation.” The Times argues that “most Americans accept the commonsense case for progressive taxation: those who have more ought to contribute more to the society that is the foundation of their prosperity.” But this proposition turns out to be wrong. Even under a flat tax, the rich contribute vastly more to society than the poor in two ways. First, someone who earns twice as much as another will pay twice as much in income taxes. Second, rich entrepreneurs supply the capital that allows others to benefit from higher levels of production through lower prices and higher wages. The poor do not fund the infrastructure for the rich; the rich contribute more to taxes than the poor even if their contributions are a smaller fraction of their wealth. Elizabeth Warren once famously said that “you [the rich] moved your goods to market on roads that the rest of us paid for.” But that’s wrong. It’s the rich who paid for the bulk of the cost of the roads.

In light of these complications, it’s difficult to make any solid case for some ideal progressive tax. Besides, no one knows what the ideal rate of progression should be, leaving it unclear whether a top 7.99 percent rate is too shallow, too steep, or just right. If the progressivity is set too low, it raises too little money to be worth the additional administrative costs it imposes. But if the taxes turn out to be too steep, they will disincentivize labor and lead taxpayers to take evasive measures to split income through trusts, partnerships, and other devices. Moreover, the higher tax rate may lead high earners to simply leave Illinois altogether for a lower-tax state, such as could happen with Chicago billionaire Ken Griffin, who has contributed $20 million to the campaign against the tax amendment.

The Times pooh-poohs the argument that Illinois should cut spending rather than increase taxes by insisting that people “flock to high-tax jurisdictions that provide services and amenities,” thereby creating a favorable business climate. What really matters, according to the Times, is how the additional revenues will be spent. But the Times muddles its account of a progressive tax system by rejecting the benefit theory of taxation, which holds that people are taxed according to the benefit received from government services. The basic function of taxation in this model is to provide the non-excludable public goods that ordinary markets are unable to supply, including the preservation of law and order, the provision of infrastructure, the regulation of monopolies, and the operation of a judicial system. Ideally, each person receives a gain from those non-divisible services that exceeds his taxes, leading him to acquiesce to the regrettable necessity of taxation in order to live in a well-ordered society, rather than an anarchic state in which no one pays any taxes.

In practice, flatter tax rates are the best proxy for that ideal. By contrast, the progressive overlay is at its core unconcerned with providing public services but is instead chiefly aimed at achieving redistribution from rich to poor.

Some progressivity may be tolerable, or even desirable, where it corrects for regressivity elsewhere in the tax system. Unfortunately, that program, if pushed too far, will have dire consequences for the fiscal health of the economy by stripping a state’s tax base. Outsiders who flock to Illinois as taxes become more progressive are anticipated net gainers from the tax reform and subsequent expenditures. On the flip side, higher earners will tend to flee the state because they have little appetite to provide these benefits to others. This happened in Maryland over a decade ago, when its sharp income tax increase led to a 30 percent decline in millionaire filers and a 22 percent decline in tax revenues from that same group. The anticipated $106 million revenue haul from the tax increase turned into a $257 million loss.

Illinois is already subject to just these economic pressures and more. For example, its population declined from 12.90 million people in 2013 to about 12.65 million in 2020, one of only four states to achieve that dubious distinction. (Low-tax states like Texas and Florida saw population surges during the same period.) This outcome is no surprise, given that Illinois is ranked the ninth-worst state for business in the United States, an unenviable position sure to be exacerbated if the “fair tax” amendment becomes law.

The Times acknowledges Illinois’s long history of fiscal mismanagement. But the paper takes the sunny position that the progressive tax increases will raise revenue and increase funding for much-needed services, such as high-quality education. This argument is doubly wrong-headed. The Illinois fair tax does not earmark the new revenue to any particular program; and even if the funds were, for instance, earmarked for education, there is nothing to prevent a huge fraction of those funds from being captured by teachers’ unions through an exertion of their monopoly power, or for some students to take jobs out of state upon graduation. Furthermore, fiscal stabilization is not guaranteed even if the “fair tax” raises funds. A 2011 tax hike, for example, raised $32 billion in additional revenues, but reduced the deficit by only $1.3 billion, from $7.9 to $6.6 billion. The bulk of the tax revenues were quickly diverted to new spending programs.

Two simple explanations account for why both Pritzker and the Times have gone astray. First, they implicitly assume that the major impact of any tax increase is distributional. In their fairy-tale version of the world, productive activities will remain just as they were before; the size of the economy will remain constant even as the tax rate increases. But changes in taxes alter the incentives for both public officials and private parties alike. The former will use the additional funds to curry favor with their preferred constituents in exchange for political votes. At the same time, high-income people will alter their business plans and personal expenditures to minimize their tax burden. And these high earners are likely to perceive the first set of tax increases as a harbinger of tax hikes to come, intensifying their tax planning efforts.

Second, Pritzker and the Times underestimate the power of the flat tax. By applying a single rate on the incomes of all taxpayers, the flat tax requires that voters impose a proportional tax increase on themselves while seeking to raise revenue from their high-income neighbors. Such a move, of course, proves less attractive. To be sure, the unlimited ability of the state to enact various transfer programs partially undermines the effectiveness of the flat tax. But progressives want to remove the constraint imposed by the flat tax because they know that people are less willing to raise taxes on others when they have to raise them on themselves. It’s just for that reason that Illinois and other cash-strapped states should resist the siren call of a progressive tax.

Professor Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago.  This article was first published by the Hoover Institute's Defining Ideas.

1 comment:

Barend Vlaardingerbroek said...

Major differences between American and European conceptions of the role of the State emerge here. We Europeans tend to regard the duty of care of the State as encompassing health care and free education. This has nothing to do with what Americans call 'socialism'.
NZ leans strongly towards the European conception of the role of the State so this article is of very little implication for NZ.