A Robin Hood State?

The advent of our national budget rightly sparks a number of tax debates, one of which concerns the ideal mix between income and consumption taxes that a government should devise. The unfortunate reality is that there exists no ‘magic formula’ that dictates an optimal mix. A conundrum faced by public sector policy makers was eloquently described by Nobel laureate J. Stiglitz: as five apples are redistributed from individual A (who initially has ten) to individual B (who initially has none) some of them are unfortunately lost in this process. This is wasteful -or economically inefficiency- as the total number of apples following the redistribution process is less than the original total amount.
Taxation happens to be an important policy tool with which a government is able to redistribute wealth. Goode (1984) identifies three main characteristics that tax policy should possess: ease of administration, equity and economic efficiency. The first characteristic is self-explanatory, the latter two however, are less so. Equity is tied to fairness, surely a very subjective concept, but in this context it is usually related to the “ability to pay” such that people with higher income streams/assets should pay more taxes. The design of progressive income taxes (in many countries including Malta) is an example that serves this purpose as higher income is charged at a higher marginal tax rate (according to the stipulated income tax bands) such that the tax paid per €1 earned above a certain amount is a higher (say €0.35) compared to what earned below other thresholds (e.g. €0.25 and €0.15).

Perhaps the question at this point is the following: should the state raise its finances solely through income taxation given that they serve the redistribution purpose so well? Firstly it must be recognised that redistribution is just one of a multitude of objectives that the government chases and that different tax and expenditure tools serve different purposes respectively. Secondly, the cost to society of virtually all taxes is greater than simply the amount of revenue collected by the government; in economic jargon this is commonly referred to the deadweight loss of a tax (the apples lost). Society bears a cost whenever a tax that provokes behavioural distortions is introduced, for instance in the case of progressive income taxes the incentive to move towards higher productivity/wages is dented as the individual will not be able to reap such benefits entirely; say for every €1 increase in gross income, net income only increases by €0.65. In other words income taxes are somewhat economically inefficient hence working against the third characteristic mentioned above!

Economic distortions are kept to a minimum when the same tax is levied on a wide-ranging pool of activities and at low rates. This makes certain consumption taxes such as VAT better placed in this respect: (in theory) a consumer would not be able to switch to a lower taxed consumption activity as the majority of consumer products are taxed at the standard rate of 18% – curtailing behavioural distortions. However the policy maker faces a dilemma as consumption taxes are by definition not linked to the ability to pay and hence tend to fall foul of the equity principle.

The debate on an ideal or rather a suitable tax mix goes on and is likely to be affected by many other variables such as the inbuilt societal preferences towards equity (as supposedly reflected through elected politicians in a parliamentary democracy), economic development, and the level of tax evasion amongst others. However it is perhaps useful to remember that when devising tax policies the policy maker is more likely to be walking on a very tight rope rather than cruising freely on an empty highway.

One thought on “A Robin Hood State?

  • Reply CJohn Zammit 16th November 2013 at 7:44 pm

    Tennyson’s mythical King admonished us that, the old order changeth … lest one good custom should corrupt the world. And a certain chap from Tarsus asserted that, money is the root of all evil. Taxation epitomizes the folly of not heeding the wisdom of the poet and the apostle: the system has long been bankrupt and corrupt, and money is a myth-turned-God before whose altar we are all prostrated.

    For government to solve the problem, economists must go back to first principles …

    We all know about the birds and the bees, but where does money come from?

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