Taxation 101

We need government and that means taxes. But when we think about government spending, and the taxes needed to finance its spending, we should also think of the effects of taxation.

Suppose I hire you to repair my computer. The job is worth $200 to me and doing the job is worth $200 to you. The transaction will occur because we have a meeting of the mind. Now suppose there's the imposition of a 30 percent income tax on you. That means you won't receive $200 but instead $140. You might say the heck with working for me - spending the day with your family is worth more than $140.

You might then offer that you'll do the job if I pay you $285. That way your after-tax earnings will be $200 - what the job was worth to you. There's a problem. The repair job was worth $200 to me not $285. So it's my turn to say the heck with it.

This simple example demonstrates that one effect of taxes is that of eliminating transactions and hence jobs. But politicians have what we economists call a zero elasticity vision of the world. They think people will behave after taxes just as they behaved before taxes and the only effect of a tax is to bring in more revenue. Here's a question for you: would we and society be better off if you and I agreed to the repair job but not tell anybody? I'd say yes but we'd be criminals.

Here's another tax question: which worker receives the higher pay on a road construction project: a worker moving dirt with a shovel or a worker moving dirt atop a giant earthmover? If you said the guy on the earthmover, go to the head of the class. But why? It's not because he's unionized or that employers just love earthmover operators. It's because he's more productive and the reason is that he has more capital (tools) with which to work. In general, the more capital workers have to work with, the higher their pay.

So what's a good policy for higher wages? One is to keep the cost of capital formation low so companies will do more of it. Policies that raise the cost of capital formation and lower risk-taking are: high corporate income taxes, low allowances for depreciation, and capital gains taxes. Those who want to see higher productivity gains and higher wages, of which I'm one, should champion tax reductions.

How in the world can tobacco companies survive and remain profitable in the wake of punitive taxes, penalties and court settlements? If the government and the courts imposed these multi-billion dollar sanctions on the beef industry, it would have been long gone. The answer's easy. Corporations do not pay taxes, penalties and settlements. A subject area in economics, called the incidence of taxation, says that the party upon whom a tax is levied does not necessarily pay the tax. They might shift it onto some other party. That's precisely what corporations do. They are merely tax collectors. In the case of tobacco, the punitive taxes, penalties and settlements are shifted forward to consumers in the form of higher prices; thus, government has punished smokers much more than tobacco companies. If the government made a similar attack on the beef industry, it would be out of business. Why? There are many substitutes for beef that consumers would turn to whereas there're few substitutes for tobacco. Imposition of oppressive taxes on goods having few substitutes is standard fare for government. King George III did it with what our ancestors called the Intolerable Acts (Stamp Tax, Tea Tax, and others). But not for long. Americans of that day hadn't learned the lessons of submissiveness and compliance; they rebelled.

Walter E. Williams
December 2, 2002
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