Tuesday, July 15, 2003
Epistemology and Duties
posted by James
This post actually isn't about epistemology; in fact, all of the epistemological issues will be assumed away. The result is (hopefully) an intriguing economic thought experiment (told to me by Professor Irons, who taught me macro and positive political economics). Before we get to the thought experiment, though, I should explain a few simple economic concepts.
Taxes, while necessary, have the unfortunate tendency to distort incentives and thus impair efficiency. For instance, a tax on income has two effects. The substitution effect refers to the tendency of people to substitute other activities for work when work becomes less profitable. The income effect refers to the tendency of people to work more when they have less money. These two effects are partially offsetting, but it's widely believed that the substitution effect predominates in an economy like ours. What this means is that income taxes reduce the productivity of our workforce (hence an argument to reduce income taxes in the name of efficiency; this argument is fine so long as it isn't accompanied by outlandish claims about being able to increase tax revenues at the same time).
As a side note, while most taxes distort incentives somehow, this isn't inherently inefficient. Pigovian taxes are taxes that move incentives toward an efficient level, typically because the original incentives didn't take into account third-party effects (i.e., externalities).
Now, imagine that we got rid of our progressive tax system, in which you pay a certain amount of tax on each dollar earned, depending on your tax bracket. We could replace it with a system in which each person pays a set amount of money, equal to the total budgetary needs divided by the total number of tax payers. Thus, the amount of tax you owe has no relation to the amount of income you earn. We have done away with the substitution effect, so we now expect people to work harder.
The problem, of course, is that such a system would be horribly unfair, since we would demand that poor people pay more than they can afford (in many cases, more than they earn). Now, imagine that we know exactly what everyone would earn next year under the current tax code (this is where we have to ignore the epistemological issues). Would it be a smart idea to tax only the income that would have been earned under our current tax law? Thus, a person who would earn $100,000 next year paying regular taxes would pay taxes on the first $100,000 he earns next year, and then no taxes on any additional income. Note that this would effectively eliminate the substitution effect, without losing any tax revenue, and arguably without sacrificing fairness. The result would be more wealth for society, without any loss of government revenue (the usual result of lowering marginal taxes). You would have to be sure that people couldn't game the system; you can picture a rich person somehow setting it up so that you expect him to earn $2 next year, then earning millions. This probably means that you couldn't do it many years in a row, but I'm not sure how that would work anyway.
Of course, this sounds too good to be true precisely because it is; we've been skirting the question of how to determine next year's effort. Now let's examine a policy area in which governments seem to think that they can make such a determination. Ireland started putting duty-free stores in its airports a few decades ago. The idea was that people were leaving the country; they had already spent all they were going to spend. It was the equivalent of having earned all they were going to earn in a year; at this point taxation could be dropped, mutually beneficial agreements reached, and overall wealth increased. The idea spread just about everywhere, so that duty-free shops are ubiquitous in international airports.
The problem should be obvious. The duty-free shops worked as long as no one knew about them, but once they became general knowledge, people were smart enough to wait until the airport to buy Irish whiskey or whatever. It's the equivalent of gaming the system by convincing the IRS that you will earn $2 next year. I don't know what other arguments can be brought forward in support of duty-free shops, but it seems to me that the traditional one fails for the same reason the income-tax dropoff concept fails.
The world of economics is awash with proselytizers who grasp onto a concept and keep prescribing it no matter how the world changes. Some are cranks; others are well paid for their loyal advocacy to causes that benefit the wealthy. The people who came up with duty-free shops were probably neither, so one wonders why they didn't anticipate the flaw in their reasoning. Maybe this post is about epistemology after all, and the policymakers who can't tell the difference between imagining and knowing.
Taxes, while necessary, have the unfortunate tendency to distort incentives and thus impair efficiency. For instance, a tax on income has two effects. The substitution effect refers to the tendency of people to substitute other activities for work when work becomes less profitable. The income effect refers to the tendency of people to work more when they have less money. These two effects are partially offsetting, but it's widely believed that the substitution effect predominates in an economy like ours. What this means is that income taxes reduce the productivity of our workforce (hence an argument to reduce income taxes in the name of efficiency; this argument is fine so long as it isn't accompanied by outlandish claims about being able to increase tax revenues at the same time).
As a side note, while most taxes distort incentives somehow, this isn't inherently inefficient. Pigovian taxes are taxes that move incentives toward an efficient level, typically because the original incentives didn't take into account third-party effects (i.e., externalities).
Now, imagine that we got rid of our progressive tax system, in which you pay a certain amount of tax on each dollar earned, depending on your tax bracket. We could replace it with a system in which each person pays a set amount of money, equal to the total budgetary needs divided by the total number of tax payers. Thus, the amount of tax you owe has no relation to the amount of income you earn. We have done away with the substitution effect, so we now expect people to work harder.
The problem, of course, is that such a system would be horribly unfair, since we would demand that poor people pay more than they can afford (in many cases, more than they earn). Now, imagine that we know exactly what everyone would earn next year under the current tax code (this is where we have to ignore the epistemological issues). Would it be a smart idea to tax only the income that would have been earned under our current tax law? Thus, a person who would earn $100,000 next year paying regular taxes would pay taxes on the first $100,000 he earns next year, and then no taxes on any additional income. Note that this would effectively eliminate the substitution effect, without losing any tax revenue, and arguably without sacrificing fairness. The result would be more wealth for society, without any loss of government revenue (the usual result of lowering marginal taxes). You would have to be sure that people couldn't game the system; you can picture a rich person somehow setting it up so that you expect him to earn $2 next year, then earning millions. This probably means that you couldn't do it many years in a row, but I'm not sure how that would work anyway.
Of course, this sounds too good to be true precisely because it is; we've been skirting the question of how to determine next year's effort. Now let's examine a policy area in which governments seem to think that they can make such a determination. Ireland started putting duty-free stores in its airports a few decades ago. The idea was that people were leaving the country; they had already spent all they were going to spend. It was the equivalent of having earned all they were going to earn in a year; at this point taxation could be dropped, mutually beneficial agreements reached, and overall wealth increased. The idea spread just about everywhere, so that duty-free shops are ubiquitous in international airports.
The problem should be obvious. The duty-free shops worked as long as no one knew about them, but once they became general knowledge, people were smart enough to wait until the airport to buy Irish whiskey or whatever. It's the equivalent of gaming the system by convincing the IRS that you will earn $2 next year. I don't know what other arguments can be brought forward in support of duty-free shops, but it seems to me that the traditional one fails for the same reason the income-tax dropoff concept fails.
The world of economics is awash with proselytizers who grasp onto a concept and keep prescribing it no matter how the world changes. Some are cranks; others are well paid for their loyal advocacy to causes that benefit the wealthy. The people who came up with duty-free shops were probably neither, so one wonders why they didn't anticipate the flaw in their reasoning. Maybe this post is about epistemology after all, and the policymakers who can't tell the difference between imagining and knowing.
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