Free-market economists like myself attack government tax-and-spend policies as being damaging to prosperity, accusing the government of “sucking money” or “leeching resources” out of the economy. We claim that taxes damage not only the welfare of the person from whom they are taken, but the whole country.
Politicians, supporters of state spending, and even questioning students often challenge this negative view of taxation with the positive effects of public spending. In essence, the argument runs something like this:
Say man A makes $100,000 and man B is unemployed. The State decides to create a government job for man B. To do this, they tax man A $50,000 to pay for man B’s salary. Surely the $50,000 that man A lacks is now in the hands of man B, who will spend it in the economy instead? Therefore shouldn’t there be no overall loss to the economy, but more people employed?1
This is the old ‘zero-sum’ fallacy; the politicians’ belief that the size of the economy is fixed and they only have to decide how to divide it up. Austrian economists, with their focus on the real world and human nature, know better; wealth does not just exist, it has to be created, and the disincentive effects of government actions do not just distribute wealth—they actively destroy it.
Taking $50,000 from A through taxation reduces the economy not by $50,000 but by more, much more. Studies in the USA and Australia suggest that the damage caused by $50,000 of taxes could be over $130,000.2 This means that even when the $50,000 taken from A is returned to the economy via B, there is still a net loss of $80,000.
This comes about through a variety of disincentives, of which the most important is the impact on A.
A’s $100,000 job now only brings him $50,000 of after-tax income. Now a $100,000 job commonly involves more time, responsibility and stress than a $50,000 job, hence its higher rewards. A used to be compensated for this by his higher salary, but now part of that has been taken away by the state; as A effectively now has a $50,000 job, he will want to reduce his effort and stress to levels commensurate with his after-tax pay.
Traditionally, economists thought of this being done by working fewer hours, and found little evidence of it happening in the real world. However this downshifting could equally be by working less hard, not working, hidden, unpaid overtime, or even by trading down to an easier job (perhaps even that soft government job created for B).
Economists call this the “substitution effect”; by working hard A can now only get 50% of the salary that work brings, but if he works shorter hours he gets 100% of the benefit of the extra leisure time, as that isn’t taxed. Effectively A opts for leisure (or just a less stressful life) instead of paid work.
Society therefore loses out, by getting less of the useful work that A was doing. Yes, society now gets the benefit of B’s work, but since society wasn’t prepared to pay for that voluntarily through the market it clearly doesn’t value it as much.
The common counterargument to this is that once A is being taxed he will have to work harder, or longer hours, to earn more and maintain his after-tax income. This may have been true in the past, but in the modern economy it has probably been pushed as far as it can without us all dropping from exhaustion. Also greater general wealth means that very few of us are close to the bread line any more; a drop in income will not mean starvation or homelessness, just a drop in lifestyle that can be compensated for by other lifestyle gains from an easier job.
So the effect on A is damaging to society, but what of the effect on A’s employer, X? If A is working less hard, or threatening to leave for an easier job, X faces a loss of profits (more damage to the economy). To prevent this, X could of course increase A’s pay, so that his after-tax pay returns to its old level. Alternately, X could hire someone else to help A, with two people doing the job of one (if possible; A may have rare skills).
The left, especially the unions, like this because it appears to increase employment. Unfortunately it also increases X’s costs, which X will have to attempt to pass on to its customers. In the short term, this will result in an increase in living costs (and therefore a drop in welfare) for the whole of society, as products become more expensive. In the long term, domestic producers like X will be undercut by foreign competitors who do not face these tax costs. If X goes bust (or relocates its activities to a more favorable country) then A’s job goes, and the tax to pay for B’s job goes with it.
Advanced technology can help keep home producers like X competitive despite tax-driven labor cost hikes, but not for long; the rest of the world soon catches up.
So there are two sources of hidden costs, the effect of the tax on A and X. But there is another problem that is even less visible; the effect of the tax on C. Who is C? C is the man who would have come up with a new invention, or improved a business process, or just run a business very efficiently, creating jobs and probably providing real employment for B. If taxes were low then he would try this, because the potential rewards would make the effort and risk worthwhile. However at a 50% tax rate the potential rewards are halved while the risks and effort remain the same, so many Cs will not bother and instead choose the easy life of a less well-paid but more stress-free and risk-free job.
This opportunity cost is invisible, and difficult to measure; it is the loss of wealth that would have been created in the future were it not for the tax. However, long-term comparative studies have suggested that each 1% of GDP taken in tax reduces long-term growth rates by between 0.2% and 0.4%.3 This may not sound like much, but that is an annual loss; if taxes are raised by 3% of GDP (the U.K. government’s current plan) and then kept steady at that higher level, there will be a loss of growth of around 1% a year. Over 25 years, the cumulative effect of this would be a national economy around 30% smaller than it would otherwise have been.
That’s a lot of real jobs that B could have had.
Notice that these problems apply to all taxes (other than a poll tax); even if you could design a perfect non-distorting tax system, it would still have these costs. In reality of course, actual tax systems produce their own additional distortions; special tax concessions for different types of activity that divert too many resources into particular sectors of the economy. There are also the administrative costs of collecting the tax and of advising the taxpayer, resources wasted on merely transferring rather than creating wealth.
The effect of taxation is therefore overwhelmingly damaging. Even if taxes are ‘invested’ in projects that are expected to increase national wealth (an argument frequently advanced in Europe for publicly-funded transport networks), the threshold for success is enormous; the benefits of the project have to not only cover its costs, but also outweigh all the hidden costs of the tax. And that’s without taking into account the massive waste and inefficiencies of the public sector.
If that is the case, then why does public spending still happen? We know that real jobs are a better guarantee of prosperity for the unemployed than welfare. If reducing taxes helps the economy to grow, the main beneficiaries will be the unemployed who find jobs. Why then do politicians insist on higher taxes?
Partly through ignorance, of the politicians and of the electorate, especially of the hidden opportunity costs. Unfortunately though, it is also through something more sinister. The harmful effects of taxation are spread throughout the economy, but the benefits can be concentrated on smaller groups.4 Therefore, although the economy overall suffers from tax-and-spend policies, special interest groups can actually benefit. These special interest groups may be formed on regional, ethnic, class, or even industry lines; anything that allows the politicians to target a bunch of voters. In today’s low-turnout elections, politicians can make the tradeoff between a diffuse, and hidden, disadvantage to the many (who probably won’t vote anyway) and a well-directed and well-advertised benefit to the few.
There is also a marginal cost/benefit problem; the losses due to taxation are spread throughout the population, so to do anything about it the concerned citizen would have to campaign successfully against billions of dollars of public spending to reduce his own taxes by a few hundred. Against him are the special-interest groups who only have to be successful in one campaign to reap massive benefits. In the middle of this sit the politicians, deftly plucking the taxpaying goose without letting it squawk too much.
What can we do? Squawk loud, squawk long, squawk often.
- 1My thanks to a Mises reader who recently sent me the question paraphrased here.
- 2The actual amount is very difficult to quantify; the economy never stands still, and so changes in taxation take place against a backdrop of other changes. For a summary of recent studies, see “The negative impact of taxation on economic growth”, Leach, Reform (London), September 2003.
- 3Again Leach (footnote above) has a very good summary of the various studies over the last 10 years.
- 4See Tullock’s work on “logrolling” for a more detailed analysis of how this works, or just look at your representative’s voting record.
