This article reflects my personal opinion.
The taxation of income often becomes a controversial issue in election debates (given that those debates actually revolve around factual topics). However, the proposals put forth mostly concern new regulations, new special rules, exceptions and deductions and small rate hikes or cuts and often are nothing more than half-hearted gifts to certain interest groups. In the long run, this leads to a progressively complex tax system that, combined with a similarly proliferating social welfare system, results in a bureaucratic leviathan that can paralyse a society and economy and at the same time fails to mitigate inequality. What if one started from scratch and intended to create an income tax system that is simple while being comprehensive and aims to mitigate growing income inequality and was not afraid of experimenting with somewhat unfamiliar ideas? In this article, I want to briefly explore a little thought experiment and imagine a new income tax system (I will sometimes use Germany as reference case).
Before diving into the issue of devising a new system, what is the general purpose of an income tax? First, it is supposed to generate revenue to pay for public goods such as security, infrastructure, health care and education. Second, and closely connected, it serves as a tool of redistribution of income to guarantee social cohesion and what is perceived as a more just distribution of outcome and opportunity. In Germany, this is summarised in the “ability-to-pay principle”. Given that we agree with these two purposes, our tax system should thus be able to create sufficient revenues and work to mitigate income inequality and its effects.
As a first step, let us combine labour and inflation-adjusted capital income to a general taxable income (capital gains should be included as well – however, this is a very complex topic that I am not going to delve into in this post). This contrasts with the income tax systems of most countries that have different taxes for labour income and capital income with capital income most commonly taxed at a substantially lower rate (in Germany, capital income taxation is rather complex – simplified, there is a flat capital income tax of 25 percent). However, this very common approach can create incentives to exploit tax arbitrage by shifting labour income to capital income and thus cause inefficiencies. Moreover, the argument that taxation of capital income is “double taxation” and therefore unjust is not very convincing. Labour income is a payment for human capital that also has to be built up with costs. Either in the form of tuition payments and other expenditures (with income that has been taxed before) or as opportunity costs in the form of lost labour income. Furthermore, the individual that earns capital income often times has not accumulated the underlying capital stock but has inherited it – just as your parents are likely to have paid for the accumulation of your human capital. Besides, having just one general type of income helps to keep things simple and avoids leeway for arbitrage and manipulation.
As the core feature of the new income tax system we introduce a progressive tax rate combined with a negative flat tax below a certain income threshold for everyone who has finished his education. This builds on the proposal of a negative income tax brought forward by Milton Friedman in his 1962 book “Capitalism and Freedom” (this does not mean late great mister Friedman would have agreed with our system – he would have probably hated it). Let us establish the negative income threshold at an annual income of € 15,000 and the negative income tax rate at 50 percent. This means that everyone who earns less than € 15,000 has the difference taxed at 50 percent and consequently receives a tax payment. For example, a worker who has a before-tax income of € 9,000 receives a tax payment of € (15,000 – 9,000)*0.5 = 3,000 and hence has an after-tax income of € 12,000. Accordingly, an individual who earns nothing receives € 7,500 and an individual who earns more than € 15,000 receives nothing but has to pay taxes instead. In our new system, everyone who has finished his education or has an income higher than the negative income threshold is obliged to declare his annual income. This translates into a guaranteed minimum income of € 7,500 for everyone who has finished his education. Note that this threshold and the corresponding minimum income serves as an example – it should be set on condition that the economy can afford it, not depend on some arbitrarily defined “subsistence level”.
In this system there will be no explicit social welfare system or long-term-unemployment benefits whatsoever. The modern social welfare system has become a bureaucracy monster that wastes resources and treats its beneficiaries like under-age children and with inherent distrust. Additionally, it has dangerous effects on the functionality of the labour market and its participants’ incentives. While a benefit system might even punish those who go to work by making them inadmissible for benefits, a negative income tax system never removes the incentive to work without the need to establish complicated and exploitable tax-credit systems. An example: Assume that in a system without a highly complex credit program, a jobless individual receives € 7,500 in annual social welfare payments. If he takes on a job that pays € 7,500 annually he will lose the right to receive social welfare and ends up with the same amount of money but has to work 20 hours a week. Consider the same situation with a negative income tax. Now the individual decides between staying at home and receiving € 7,500 in tax payments or starting to work and receiving € 7,500 in wages plus € 3,750 in tax payments and thus € 11,250 in total. In our new system, the individual faces an incentive to work and at the same time does not have to beg for money from the welfare state by means of complex bureaucratic processes and is not indignified by being treated like an untrustworthy blighter. A single negative income tax to replace countless benefit systems with complex enforcement mechanisms makes a mushrooming administrative apparatus obsolete. Note that some government incentive programs, such as child benefits or a slimmed-down pension system, make sense and should still be implemented. Additionally, a short-term unemployment benefit system could be reasonable to consider since it might be beneficial to cushion temporary unemployment shocks.
Additionally, the fact that everyone has to declare his general annual income without exception works as a control mechanism and data generator in regards to income inequality and social justice issues. It is comparatively easy to implement since a country like Germany already has a comprehensive tax agency in place.
Above the threshold of € 15,000, the marginal tax rate linearly increases from 20 percent to as high as 75 percent at € 300,000 (Note that I have not calculated how the tax system should be calibrated in order to generate about the same revenues as it does at the moment, which it likely should – understand these values as an example). This might seem exorbitantly high to some. Two points should be made: First, if we compare this new system to the current system in Germany, where the top marginal income tax rate is 45 percent, everyone who earns less than € 233,000 from labour would be better off. Second, this would not be unprecedentedly high rates. In the United States, for example, the top marginal income tax rate has been well above 80 percent throughout the 40s and 50s and did not go below 70 percent from 1936 until 1980 (sidenote: do Trump fans consider this the time “America” was “great”?). This time span includes some of the most productive years in US history and does not seem to have suffered from dwindling high-skilled labour. Our new tax system does neither have a middle class hump as most modern tax systems do nor does it favour capital income. Consequently, the middle class would be relieved, effective income inequality could be mitigated and the growing problem of concentrated capital accumulation might be alleviated.
Our new income tax system will know no exceptions or deductions. Despite all the most well-meaning efforts to consider every eventuality, a tax system can never be “just” (because an income distribution can never be just). However, every attempt to make it thus causes more complexity, costs and inefficiency and might cause negative external effects. For example, consider the commuting tax benefit in Germany that allows for tax deductions of the costs of travelling to work. This incentivises inefficient job allocation and probably causes increased greenhouse gas emissions. Moreover, a tax system with countless special rules is prone to manipulation and predominantly benefits those who have access to good tax law advice.
Finally, all the thresholds in our tax system will be anchored at the lagged median income. For example, assume that the median income in 2015 was € 20,000 and in 2016 is € 22,000 and hence rises by 10 percent. Then, in 2017 the negative income threshold would rise from € 15,000 to € 16 500 and the top income tax threshold from € 300,000 to € 330,000. This mechanism serves two purposes: First, it works as an automatic inequality counter measure. If the mean income drifts off far from the median income, the high-income earners will be taxed relatively higher. Second, it eliminates the problem of bracket creep, the process where incomes are pushed into higher tax brackets by inflation. In Germany, this is called “cold progression” and causes political upset seemingly every other year.
What problems could our new tax system cause (abstracting from the issue that thousands of tax experts and social welfare bureaucrats would probably lose their job over night)? First, taxing capital income at the same rate as labour income might cause highly mobile capital to flow out of the economy. This concern is justified and has been supported by a wide array of economic research. However, two points are worth noting: First, capital income in our system is taxed on an inflation-adjusted base, meaning that no tax is paid on capital income that simply covers inflation. Second, foreign capital investments are mostly not subject to domestic capital income taxes and hence should no be deterred by them. In a perfect world, tax rates around the globe should be the same and loophole-free. Nevertheless, in the imperfect world we live in, a high capital income tax, if designed correctly, does not necessarily hinder economic activity. The second problem that our tax system might cause is that its negative income tax can work as a subsidy for low-income labour and thus cause cost-shifting from firms to the taxpayer. Consequently, our system should be combined with a minimum wage (that exempts everyone who is not eligible for the negative income tax, most prominently students). Third, one might be concerned that high top income tax rates might cause the highest-skilled workers to either reduce their economic output or flee the country. Considering economic evidence and looking at historical developments, this does not appear to be a fundamental problem however.
In conclusion, our new income tax system combines the mitigation of inequality by means of progressive taxation of labour and capital income with the debureaucratising and incentive-improving effects of a negative income tax. Of course, neither of those two measures nor any other substantial improvement or simplification of the tax system that one might think of is anywhere near to be implemented in Germany or in any other big developed country. However, sometimes it can be soothing to dream big, especially when the current political reality is characterised by the slow deconstruction of a peace-saving continental union and a nightmare disguised as an election that now seems to be about who of the two candidates can sling more mud at his opponent.
I believe this is a highly controversial topic and one’s own economic situation determines not seldom the political standpoint one adopts (maybe even more so when it comes to inheritance taxation). I would be happy to hear your criticism and suggestions regarding the discussed new income tax system.
Music – Pink Floyd – Money, Johnny Cash – After Taxes, The Beatles – Taxman
Film – The Shawshank Redemption, Wall Street
Written by Jonas