One Saturday afternoon, a great teacher of ethics told his students that their class session would take place at a local temple. The teacher had an important lesson about paying for public programs—in essence, about tax policy.
The teacher and his followers arrived at the synagogue just before the service started and stood in the rear, watching as the worshippers filed in. It was the custom then that the front rows were reserved, for a fee, by wealthy families. The benches at the back were left for the poorest members of the community, those who couldn’t pay for a better row. Shortly after the service began, the rabbi called for a collection, to pay for the maintenance of the temple and for its social programs in the neighborhood. When the plate was passed, an imposing man in the first row, beautifully dressed and flanked by a retinue of family and servants, ostentatiously donated 1,000 ducats. A couple rows back, a man with even fancier clothing and even more servants made a great show as he gave 2,000 ducats. Eventually, the plate made its way to the back row, to a poor widow, dressed in rags and carrying a moth-eaten cloth handbag. She dug around in the bag for a while and eventually extracted two coins—two “mites,” worth about a penny each—and placed them in the collection plate.
At which point, Jesus Christ told his disciples, “Verily I say unto you, that poor widow gave more than anyone else.”
This story is known as “the widow’s mite”; it’s told in two of the New Testament Gospels.1 Christ’s statement can today be recognized as a central principle of tax policy around the world: The funding of community programs, whether through donations to the synagogue or taxes paid to the government, should be carried out in a way that is proportionate to wealth. If the rich man pays $10,000, but still has a million left in the bank, his tax burden is actually lighter than that of a widow who pays $10 but has no savings to back it up. The crucial point is not how much somebody pays in taxes but rather how much she has left after paying. This biblical lesson has been invoked time and again to justify a tax code that calls on the rich to pay higher rates than the poor.
When taxes work that way, people tend to perceive them as “fair.” And that perception is crucial to a successful tax regime: no system of taxes can be successful unless the taxpayers believe that the system is essentially fair. Nobody likes to pay tax, but people will pay if they sense that the regime is treating everyone justly. Opinion polls in every country show that people think the rich are undertaxed and should pay more. You might say that this is evidence of envy or resentment. Or you might conclude that these surveys reflect a basic human sense of fairness, an innate appreciation for the proportionate system of payment that Christ demonstrated so vividly in the temple. The American sage Will Rogers captured this concept precisely. Of course people like low taxes, Rogers said, but there’s something even more important: “People want JUST taxes, more than they want lower taxes. They want to know that every man is paying his proportionate share according to his wealth.”
This, then, is one of the basic reasons for taxes; they can make a population feel that its government is treating everybody fairly. That, in turn, enhances the political legitimacy of the state; it gives people a stake in good government and makes them better citizens. Some economists have argued, in fact, that this is the main reason to have a proportionate tax system in the first place.2
Which is something of a stretch. The main reason for taxes is to pay for the activities of government, for the goods and services we have decided to provide collectively rather than leave every man for himself. Highways, parks, playgrounds, schools, courts, Coast Guard cutters, air traffic control, auto safety, the patent office, the Food and Drug Administration, old-age pensions, seniors’ health insurance, student loans, spies, libraries, collecting the trash, clearing the snow, putting out forest fires, printing money, issuing passports, battling ISIS, catching crooks—the list of public functions, even in a nation like the United States that is relatively hostile toward government, could easily fill this whole page. We do these things through government—although the choice is often controversial—after concluding that there are certain areas where a public endeavor is preferable to the private sector.
The fire department, for example, was not always a government function. In the first century B.C., the richest man in Rome was an entrepreneur named Marcus Licinius Crassus, a figure so grandiose and so enamored of ostentatious display that his name became an English adjective. The crass Mr. Crassus had business interests ranging from silver mines to the slave trade, but perhaps his most lucrative operation was his private fire department, the biggest of several commercial firefighting firms in Rome. When a house caught fire, his chariot carrying a big water tank would clatter through the stone streets. At the site, Crassus would start negotiating with the frantic homeowner to set a price for his services, while the hapless customer watched the flames spread. A common result was that Crassus acquired the property, with the former owner obliged to pay him rent for life. The homeowners of Rome began clamoring for a public fire department, to free themselves from capitalists like Crassus.
Crassus, who became the biggest real estate magnate in Rome, began investing his money in carefully selected politicians, lobbying against any Roman senator who proposed to make firefighting a government function. One of his fiscal beneficiaries was a popular general named Julius Caesar. In return, Caesar stood up for Crassus’s business interests and gave him various prestigious positions, including the command of an army fighting the treacherous Parthians in what is now Syria. This did not end well for poor Crassus, however. He was defeated at the Battle of Carrhae in 53 B.C. When the Parthians realized they had captured the richest man in Rome, the ancient histories say, they poured molten gold down Crassus’s throat, on the theory that his lifelong thirst for gold should be quenched in death.
With Crassus out of the picture, the Romans fairly soon decided that the fire department was a function not well suited to the private sector. Almost all governments everywhere have reached the same conclusion. Around the world, firefighters proudly ride their long red trucks down the street during each city’s annual municipal parade. In Japan, city fire departments hold exhibitions on January 6 every year, the national Firefighters’ Day, where kids get to try on fireproof suits and sit at the wheel of a huge hook and ladder. When I went to the Tokyo event one chilly January, there was a sign at the entrance: “Honorable Tokyoites, we respectfully thank you! Your tax payments supplied our equipment.” After all, fire departments aren’t free; like the other activities of government, they must be paid for. And that’s why the only things certain, as Benjamin Franklin famously observed, are death and taxes. (And some people get hit with both at once, as we’ll see when we discuss the inheritance tax.)
This aspect of taxation was crystallized in the famous dictum of the Supreme Court justice Oliver Wendell Holmes Jr.: “Taxes are what we pay for civilized society.” That slogan today is engraved over the main door of the Internal Revenue Service on Constitution Avenue in Washington, D.C. Of course, the IRS doesn’t choose to remind us that Justice Holmes made that comment in a dissent against a decision of the court majority; it came in an otherwise forgotten legal dispute known as the Philippine Cigar Case.
The case of Compañía General de Tabacos de Filipinas v. Collector of Internal Revenue3 was decided in 1927, but the international maneuvers the tobacco company employed would be familiar today to the corporate finance executives who dream up complex cross-border deals to avoid paying taxes. The Compañía General de Tabacos owned a warehouse in Manila; it needed fire insurance on the building and the cigars stored inside. The Philippine government imposed a tax of 1% on insurance premiums. The company did not want to pay. So the tobacco company in the Philippines arranged for its sister company in Barcelona to buy the insurance policy; the Barcelona office hired a broker in Paris, who bought insurance from one company in France and another in Britain. The Compañía General then argued it didn’t have to pay the tax, because the policy wasn’t purchased in the Philippines. This dispute wound its way up to the Philippine Supreme Court, which ruled unanimously that the tax had to be paid.
Because it lost its lawsuit in the nation’s highest court, you might think the cigar company would just shell out the 1% tax. But in those days, the losing party in a case before the Supreme Court of the Philippines had one more avenue of appeal.
In 1927, the United States was a colonial power; its scattered empire included the Philippine Islands. A legal case decided in the colonies could be appealed to the U.S. Supreme Court. The U.S. chief justice then was William Howard Taft, a former president and a man who never met a tax he didn’t hate. So Compañía General de Tabacos took its case to Washington—and won.
Chief Justice Taft’s opinion for the court majority is about as convoluted as the mechanism the tobacco company used to buy insurance. After several pages of impenetrable prose—“The collection of this tax involves an exaction upon a company of Spain lawfully doing business in the Philippine Islands effected by reason of a contract made by that company with a company in Paris on merchandise shipped from the Philippine Islands for delivery”—Taft concluded that the company didn’t have to pay the 1% tax. Six other justices concurred, so the Compañía won by a vote of 7–2.
The two who sided with the Philippine tax authority were Oliver Wendell Holmes Jr. and Louis Brandeis, a pair of justices who became known as the Great Dissenters because so many of their dissenting opinions turned into majority holdings in succeeding decades. In the Philippine Cigar Case, Holmes quickly brushes aside the tax-avoidance scheme, concluding that an insurance policy on a warehouse in the Philippines should be liable for the Philippine insurance tax. He goes on to explain that nobody likes paying taxes but it’s important to look beyond one company’s tax bill and see “its organic connection with the whole.” Seeing the whole picture, according to Holmes, reminds us that individuals and corporations get a lot of benefit out of the taxes they pay. “Taxes are what we pay for civilized society,” he explains, “including the chance to insure.”
Taxes, though, are not the only way to pay for civilized society. Governments have other ways to get by. At the simplest, most brutal level, a government that has a police force and an army can simply commandeer goods and services; countries like China, Venezuela, and Russia have occasionally decided to “nationalize” oil wells or gold mines or factories and then sell the output to earn government revenues. The previous owner of the well or factory might bring a lawsuit, but these actions tend to get snarled in the courts for years or decades. Even modern democracies like the United States sometimes use this approach; our government commandeered services from me and millions of others through the military draft during the Vietnam War. The problem with just seizing stuff, though, is that the citizenry hates it, so the commandeer approach tends to produce revolutions.
Governments have a convenient monopoly on the printing of currency (or legal currency, at least). In theory, a government that didn’t want to tax its citizens could just print the money it needs to provide common services. The problem here is inflation, which increases sharply as more and more money floods into the marketplace, with severe repercussions. A less damaging way to make money from printing money is the concept of “seigniorage,” which is the difference between the face value of a bill and the cost of printing it. The U.S. government spends about six cents for the paper and ink used to make a $10 bill, which means a seigniorage gain of $9.94 when a new $10 bill is put into circulation. The U.S. Mint says it earns something over $100 million each year this way. As long as a government doesn’t print so much money that it triggers inflation, seigniorage can be a small but steady contributor to revenues.
Governments can also bring in money by borrowing. When the U.S. government spends more than it takes in—in fiscal 2016, we ran a deficit of $590 billion—it borrows money from banks, investors, and foreign governments to make up the difference. For all the breast-beating in our political debates about “unsustainable deficits,” the U.S. government is a relatively conservative borrower compared with other rich countries. Among the thirty-four richest countries, government deficits averaged 111% of GDP in fiscal year 2014; the U.S. deficit was actually below average, at 106% of GDP.4 Countries like Italy (147%), Portugal (141%), and Ireland (133%) had significantly bigger debts, as a share of their total wealth, than the United States. Not surprisingly, Greece ranks near the top of debtor nations, with outstanding loans that total 188% of its GDP. The world champion at borrowing money, though, is the government of Japan, which has been running annual deficits for years greater than 225% of its GDP. This is less of a burden for Japan than it would be for most other countries because Japanese people have traditionally been prodigious savers, and their bank deposits provide most of the money the government needs to borrow. So Japan has huge debts, but it is indebted mainly to itself.
Borrowing money can be less painful than taxes, but here, too, there’s a limit. At some point, the interest charges become a significant part of the national budget, which means either reduced government services or higher taxes just to pay the interest. And if a government gets so deep in debt it can’t borrow any more—as happened to Greece after the Great Recession of 2008–9—the result can be severe austerity. Dozens of the planet’s two hundred or so countries are too poor to get a loan; for many of them, foreign aid from the United States, other rich nations, and UN agencies is an important source of revenue.
Finally, governments can sell goods and services to bring in cash. The U.S. government charges entry fees at national parks and sells timber from the national forests. It collects royalty payments when somebody mines coal or drills for oil on public land. It collects fees from banks to finance the Federal Deposit Insurance Corporation (FDIC) and from pharmaceutical companies to pay for testing new drugs. For a few lucky countries, government sales bring in all the revenue needed; some of the oil kingdoms in the Middle East collect no taxes from their citizens.
In ancient times, the king taxed what he could see. The Romans would measure the crop from a farmer’s field, or count the number of cows in the stable, and take 10% in tax; thus the tax collectors, or “publicans,” were derisively called tax farmers. In the 1790s, France imposed the “contribution des portes et fenêtres,” a tax on doors and windows, on the theory that only well-off people could afford such luxury; naturally, some homeowners bricked in their windows when they suspected the tax collector was coming around. Using the same tax-the-rich logic, European governments in the eighteenth century collected a duty on the elaborate wigs that the gentry wore and the powder they used to keep their wigs white.
As the nation-state concept developed and countries began to have discernible borders, the easiest way to collect taxes was export and import duties. There were only so many ports of entry, so this didn’t require a large number of tax offices. And this tax was not easy to evade; after all, it’s hard to conceal a clipper ship sailing into harbor with a cargo of tea from India. Custom duties brought in 90% of federal revenues for the newborn United States in its first decades; our government nearly went broke during the War of 1812, when the British navy blockaded all American ports.5 In the young United States, the U.S. Customs House was the most imposing building in all port towns; these old structures can be seen today at the edge of Boston and Baltimore harbors. The handsome redbrick Customs House in Salem, Massachusetts, where Nathaniel Hawthorne worked while writing The Scarlet Letter, still stands as a reminder of the nation’s first revenue service.
Over time, though, as a nation’s domestic economy builds up, “internal revenue” becomes more important than taxes at the ports. State and local governments create their own tax systems; the property tax has always been an important source of revenue for local government, because you can’t pick up your house or farm and move it to the next state.
In the twenty-first century, the United States and other established countries have come to rely on income and consumption taxes as their main sources of revenue. But newer nations are replicating the history of taxation we saw in the United States. Achilles Amawhe, a senior director in Nigeria’s Federal Inland Revenue Service, told me that he has watched his country’s tax bureau grow throughout his career. “I was just a boy when Nigeria won her independence,” he said. “And as soon as I got out of school, I went to work for the nation, in the tax bureau. I have devoted my life to giving my country an honest, efficient, and respected tax service.” Achilles gave me a baseball cap bearing his agency’s logo, FIRS, and told me that the whole history of Nigerian tax was in that hat. “We started with custom duties; then we began taxing inland enterprises; then the provinces opened their own tax offices, and we became the ‘federal’ service. So FIRS—the Federal Inland Revenue Service—captures the development of taxes in our new nation.”
But maintaining a civilized society is not the only reason for taxation. Governments use taxes for numerous other purposes beyond the basic task of raising revenue to pay for public programs. “Virtually everything governments attempt to do with direct expenditure programs they also attempt (for better or worse) to do with taxation policy,” notes the economist Sven Steinmo. “Indeed, no other public policy issue has been used so widely for so many purposes. . . . Raising revenue, redistributing income, encouraging savings, stimulating growth, penalizing consumption, directing investment, and rewarding certain values while penalizing others are just some of the hundreds of goals that any modern government tries to promote with its tax system.”6 Tax has become a multipurpose government tool that performs many missions.
For example, taxes turn out to be a powerful instrument for getting people to do what government would like them to do. The U.S. government wants to encourage you to contribute to charity, to buy an electric car, to get a college degree, to support your dependent children, to buy health insurance, to insulate your attic, to invest in oil wells, to fund a retirement account, and to take out a mortgage to purchase a home; accordingly, all those desirable practices provide a deduction, an exemption, or a credit that will lower your federal income tax bill. Inducing desirable behavior can also help to build “civilized society,” although that aspect of taxation does not appear to be what Justice Holmes had in mind. But governments everywhere use the tax code to promote good citizenship.
When the government of South Korea wanted corporations to use more of their profit for wage increases and less of it for dividends, the corporate tax code was amended to reward companies that raised their workers’ pay. To encourage people to leave their cars at home, Germany gives a tax break for commuting expenses, but only for those who commute by bus or train. Canada and Australia think it’s beneficial for individuals to support political parties and candidates, so they offer a tax credit for political contributions. Unlike the United States, though, Canada has a strict limit on contributions—nobody can give more than $4,800, total, in one year—so the maximum tax credit is $650.
In the same way, taxes are often an effective tool to discourage people from doing things perceived to undermine the common good. This kind of levy is sometimes called a “sin tax.” A sin tax is the exception to the consensus view among economists that taxes should be “neutral”—that is, designed so that people base their decisions on business or personal grounds, not on tax considerations. But taxes imposed on what we don’t want people to do are specifically designed to influence our decisions and conduct. The father of modern economics, Adam Smith, strongly endorsed this kind of tax in his famous study The Wealth of Nations: “Sugar, rum, and tobacco, are commodities which are nowhere necessaries of life, which are become objects of almost universal consumption, and which are therefore extremely proper subjects of taxation.” For Smith, taxes on sugar, rum, and tobacco had a double benefit: they discourage consumption of unhealthy products, thus reducing the cost of health care over time; they also bring in a steady flow of revenues, because those who smoke, drink, and eat candy generally do so even when the national economy is in a slump.
The great success story in the realm of taxing bad behavior is the cigarette tax. In the mid-1960s—the period depicted in the smoke-filled TV serial Mad Men—more than 40% of Americans smoked daily; they paid less than thirty cents per pack, including sales tax. After the surgeon general first warned, in 1966, that “smoking may be hazardous to your health,” the federal and state governments started taxing tobacco products heavily, to discourage the habit and to help offset the health-care cost governments were facing because of illness due to smoking. The taxes have consistently gone up since then—Americans today pay twenty times the 1965 price for a pack of cigarettes—and the number of smokers has consistently gone down. Today less than 16% of Americans smoke regularly. The experts attribute this partly to improved education efforts but largely to that huge increase in the sin tax on smokers. When cigarette taxes go up, smoking goes down.
Governments also try to prevent the excessive use of beer, wine, and liquor. As the United States proved between 1920 and 1933, outright prohibition doesn’t work in a free society. So different countries have tried different approaches; Germany, for example, has an “apple-juice law,” requiring that bars and restaurants include nonalcoholic drinks on the menu at a price lower than the cheapest beer or whiskey. Several provinces in Canada set a minimum price for alcoholic beverages so the bartender can’t lure people in with free or cheap drinks. But here, too, taxation has proven most effective. When the journal Addiction studied changes in alcohol taxes around the world, it concluded that a 10% increase in the tax on a drink reduces alcohol consumption by about 5%, which is enough to avoid tens of thousands of deaths and accidents each year.7 After British Columbia raised liquor taxes in 2002, deaths attributed to alcohol dropped by 32% over the next six years; the Canadian government attributes this to the higher price of booze.
As obesity has become a bulging health problem in many wealthy countries, the so-called sugar tax has begun to spread as a way to cut the consumption of high-calorie cola, candy, and junk food. Adam Smith would presumably approve. France, Denmark, and Belgium have all imposed various versions of the “fat tax.” Mexico, where the problem of obesity is even greater than in the United States, imposed new taxes in 2014 on sugared soda pop and junk foods like potato chips, cookies, and cheese curls. The sugar tax makes a regular Coke cost about 25% more than a Diet Coke; it makes a candy bar significantly more expensive than an apple. To complete the symmetry, the government promised to use some of the money from the sugar tax—initial revenue estimates were $1 billion annually—to improve the purity of the country’s water supply, because a lack of clean water is one of the reasons Mexicans consume so much soda pop in the first place.
Some countries, eager to enhance civic participation, charge a tax penalty for people who fail to vote. Mandatory voting is particularly popular in Latin America; among the nations that penalize nonvoters are Argentina, Brazil, Costa Rica, Ecuador, Peru, and Uruguay. The mechanism is pretty simple. You get a certificate at the polling place that says you voted; you attach that to the tax return. If the tax agency doesn’t receive proof that you voted, you pay more tax. President Barack Obama proposed a similar penalty for American nonvoters; so far, this idea has gone nowhere.
Taxes designed to curtail certain actions or purchases don’t always work. Following the oil shocks of the early 1970s, the U.S. Congress was eager to reduce Americans’ consumption of petroleum and thus reduce the nation’s dependence on foreign oil. One proposal called for a minimum level of fuel efficiency in all cars, so that it would be illegal to sell or buy a car that used too much gasoline per mile. But that was considered too draconian for the automobile-dependent United States, where the chance to buy a muscle car is considered a basic American birthright. So Congress instead passed the “gas-guzzler” tax in 1978, imposing a hefty tax on any car that gets less than 22.5 miles per gallon. The point was to discourage the purchase of these profligate vehicles. You can still exercise your God-given right to buy a gas-guzzler, but you have to pay extra for the privilege. (Nobody thought of minivans or SUVs back then as family cars, so they weren’t included on the taxable roster in 1978.)
There’s a two-page addendum to IRS Form 1040—it’s Form 6197—that collects the tax for wasteful autos; the top rate is $7,700 for a car that gets less than 12.5 miles per gallon. In 2014, according to the Environmental Protection Agency, no car sold in the United States was that extravagant, but seventy-eight different models from twelve different makers were officially labeled “gas-guzzlers.” The thirstiest passenger car sold in the United States was the Bentley Mulsanne, rated at 15.9 miles per gallon; the ten-cylinder Lamborghini Gallardo Spyder was second worst (16.2 miles per gallon), followed closely by the twelve-cylinder Ferrari FF (16.4 miles per gallon). Did the tax discourage anybody from buying one of these notorious fuel gulpers? Sales figures don’t show it, which is not surprising. The gas-guzzler tax on that inefficient Bentley Mulsanne is $3,700 (in addition to the normal sales and registration taxes); it doesn’t seem likely that somebody who wants to ride around town in a $279,000 Bentley would choose a Ford hybrid instead just to save $3,700 of tax.
There’s a libertarian appeal to tax provisions that aim to nudge people to do the right thing. The taxpayer retains the liberty to make personal choices—to smoke cigarettes, to commute by car, to wash down a bag of Chili Cheese Fritos with a pitcher of beer. To pass a law prohibiting such behaviors smacks of the nanny state. It’s less intrusive to let people decide for themselves whether to engage in these behaviors. But government imposes a tax penalty to offset the social cost of those personal choices, and that penalty may have the added benefit of steering people away from undesirable choices. Similarly, offering a tax break for insulating a house is less invasive than passing a law requiring that every homeowner install insulation.
Even when they’re effective, though, there’s a clear downside to all these tax preferences and penalties: they increase the complexity of any country’s tax code. Each new tax break or surcharge requires adding one more line to the tax return—or maybe twenty more lines, or maybe a whole new schedule, like Form 6197 for the gas-guzzler tax. Each tax deduction forces taxpayers to gather and keep track of the necessary documentation. Each one forces the taxing agency to perform audits to make sure the taxpayer is really entitled to the deduction she’s claiming. In Britain, for example, anytime a taxpayer takes the deduction for a charitable contribution, both the donor and the charity have to provide a notarized piece of paper to substantiate it. An Australian can deduct the cost of uniforms for her job, but first she has to obtain a certificate from the Register of Approved Occupational Clothing.
Beyond that, tax breaks tend to last forever. Every new preference spurs an army of interest groups and lobbyists who will fight to keep it in the code long after the economic rationale for it has expired. And each eternal deduction, exemption, or credit reduces the government’s revenue, eternally.
Taxes consume a significant portion of the total national wealth in every wealthy country. So it seems entirely reasonable that a nation’s taxes would have a significant effect on the overall economy. Accordingly, politicians constantly try to design tax regimes that promote investment and job creation and thus prompt greater economic growth.
But different politicians have different theories about what kind of tax change will stimulate the economy. These differences were particularly sharp as the developed world responded to the Great Recession that spread around the globe beginning in 2008. In the United States, the initial idea was to cut taxes so that people and companies would have more money to spend; then consumer spending and business investment would haul us out of the economic swamp. The United States issued an income tax rebate and cut the employee’s share of Social Security by 2%, providing ready cash and increased take-home pay for all working Americans. Most of Europe went in the other direction, raising the VAT to offset government deficits. Britain, where the tax rate had been 17.5%, cut it for one year and then reversed course, raising it to 20%. Hungary, which already taxed purchases at 25%, raised it to 27%, giving it the distinction of charging the highest sales taxes on the planet; Ireland’s VAT went up in stages from 21% to 23%, Spain’s from 16% to 21%, Italy’s from 20% to 22%. This was a sort of stealth tax hike; most consumers who have to pay the VAT don’t realize that it has been increased.
At first glance, it would appear that America’s program of stimulus through tax cuts worked better than Europe’s austerity through tax hikes. The United States came out of the Great Recession much sooner than Europe, and American growth rates since then have been higher than those in most European countries. But it’s not clear that America’s economic growth was due to lower taxes. In fact, most of the post-Recession growth in the United States happened after taxes were raised. That 2% cut in the Social Security tax was repealed after two years, lowering every worker’s take-home pay. Congress and the president cut a deal to increase taxes on top-bracket earners in 2013. Yet the U.S. economy continued to grow at a moderate pace with the higher taxes; the unemployment rate fell from 8% at the time those tax increases took effect to 5% three years later.
Despite this ambiguity, politicians have no hesitation about claiming that any tax policy they champion will be a major stimulus. They say that when they raise taxes; they say that when they cut taxes. When Britain hiked the VAT rate to 20%, the chancellor of the exchequer explained that this tax increase would let government reduce its borrowing, which would increase private-sector capital and spark a major economic boom. When President George W. Bush proposed across-the-board tax cuts in 2003, the White House predicted that this tax reduction would create 2.1 million new jobs and spark a major economic boom. (In the event, both the British and the American predictions proved wrong.) In the United States, Republicans frequently predict that tax cuts will “pay for themselves,” because the resulting economic growth will lead to higher tax revenues. This something-for-nothing theory, first proposed by Arthur Laffer, sounds enticing in a campaign speech. Sadly, it has never worked in practice.
Economists, for the most part, are considerably less confident than politicians about the economic effects of raising or lowering taxes. Two experts at the University of Michigan, Joel Slemrod and Jon Bakija, surveyed the data and the academic literature on this point. “The first thing to note about recessions and recoveries is that they generally occur for reasons that have little or nothing to do with taxes,” they report. Does a tax cut increase job creation, as the Bush White House asserted? “In a word (okay, two words), not much. . . . [C]laims about the effects of tax cuts on the number of jobs are suspect,” Slemrod and Bakija conclude. Can a tax cut really increase revenues? “A reduction in tax rates does not cause the economy to expand enough to recoup the revenues . . . at least in recent U.S. history,” Slemrod and Bakija explain. Do lower taxes stimulate economic growth? The two economists point out that over the last half century several countries with much higher tax burdens than the United States have had better growth rates, and here at home “the strongest growth period was when the top tax rates were highest.”8
Nonetheless, in all the developed democracies, right-of-center parties (they’re called “Conservatives” or “Christian Democrats” or “Republicans”) consistently push for tax cuts as a way to improve economic growth. All the Republican candidates in the 2016 U.S. presidential race promoted this idea. “We’ve got to lower the tax burden,” candidate Jeb Bush said on the stump, “to get this economy moving again.” Meanwhile, the left-of-center parties (“Social Democrats” or “Labour” or “Liberals” or “Democrats”) often take the opposite stance, pushing for tax increases—on the rich, that is. That brings us to the next major mission of the tax code.
The president of the United States declared in 2013 that economic inequality has become “the defining challenge of our time,” one that poses “a fundamental threat to the American dream, our way of life, and what we stand for.” Barack Obama was referring to statistics showing a large and growing gap in wealth and income between the richest Americans—the so-called 1%—and the rest of us. The phenomenon that the president was talking about is not limited to the United States; income inequality has been increasing sharply in almost every industrialized democracy.
“Redistribution of wealth” has become a controversial concept in the United States in recent years. Obama got himself in hot water during his 2008 presidential campaign when he told a voter named Joe Wurzelbacher (aka “Joe the Plumber”) that “when you spread the wealth around, it’s good for everybody.” The political press declared this sound bite a blunder, and Republicans made it a key campaign issue for weeks. “This sounds a lot like European socialism,” said the GOP candidate, John McCain. In fact, though, the idea of spreading the wealth around through taxes is hardly limited to Europe. Tax codes almost everywhere have been designed to achieve this goal. “If income redistribution is considered a desirable social goal, then taxation is clearly an important means to this end—and moreover one that every country in fact utilizes,” notes the tax economist Richard M. Bird.9 Even countries experimenting with a single-rate flat tax have preserved some element of redistribution by exempting low-income workers from paying the tax.
The mechanics of redistribution are fairly simple: you raise taxes on the richest citizens and use the added revenue to provide education, health care, jobs, or straightforward cash payments to the poor. To do that, a country needs a tax structure that works the way Christ recommended to his disciples on the day they went to the temple—a system that taxes people in proportion to their ability to pay.
In America’s current political discourse, it is the conservatives who complain about progressive taxes that place the greatest burden on the rich. Traditionally, though, economic conservatives were strong defenders of this principle. None other than Adam Smith said that “it is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in proportion.” F. A. Hayek, the Austrian economist who has become an idol for many American conservatives, made the same point in his classic work The Constitution of Liberty. The rich should be expected to pay more, Hayek reasoned, because “a person who commands more of the resources of society will also gain proportionally more from what the government has contributed.”10
Edwin R. A. Seligman, a professor at Columbia who helped lead the charge in the United States for a progressive income tax at the start of the twentieth century, maintained that the course of history was moving all modern countries inexorably toward a tax code based on ability to pay—or “tax justice,” as he called it. In his 1914 text, The Income Tax: A Study of the History, Theory, and Practice of Income Taxation at Home and Abroad, Seligman set forth his argument in majestic prose:
Amid the clashing of divergent interests and the endeavor of each social class to roll off the burden of taxation on some other class, we discern the slow and laborious growth of standards of justice in taxation, and the attempt on the part of the community as a whole to realize this justice. The history of finance, in other words, shows the evolution of the principle of faculty or ability to pay—the principle that each individual should be held to help the state in proportion to his ability to help himself. . . . Even where actual fiscal institutions represent more or less thinly disguised efforts of the dominant economic class to roll the burdens on the shoulders of the weak,—even here it is rare to find a cynical disregard of all considerations of equity.11
Those considerations lay at the heart of the first tax law ever written in the United States. In 1634, the elders of the Massachusetts Bay Colony decreed that each man was to be assessed “according to his estate and with consideration of all other his abilityes whatsoever.”12 But that principle was forgotten in nineteenth-century America, where “the dominant economic class” successfully fought back efforts to institute progressive taxation. When Congress enacted a graduated income tax in 1894, the Supreme Court quickly voided the statute. The justices were almost apoplectic at the idea of asking the rich to pay more. “If the Court sanctions the power of discriminating taxation,” Justice Stephen J. Field wrote for the majority, “. . . it will mark the hour when the sure decadence of our government will commence.”13
The hour of sure decadence commenced sooner than Justice Field probably expected. By 1913, the United States had changed the Constitution (via the Sixteenth Amendment) to get around the Supreme Court, and the income tax became law. From its first day, the whole point of the U.S. income tax was to redistribute the tax burden from farmers and small landowners to the new class of tycoons and robber barons who had sprung up during the Gilded Age. The first income tax had a progressive rate scale, with the top rate at 7%. It was so carefully aimed at the richest Americans that less than 4% of households had to pay at all.14 Recently, there has been considerable public concern about the fact that 47% of Americans pay no income tax; the presidential candidate Mitt Romney opined that these are people “who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them. . . . These are people who pay no income tax.” In fact, though, the U.S. income tax was initially designed to apply only to those in the top income brackets; its primary purpose from the start was to offset inequality.
It may be difficult for Americans to understand that a tax system can be an important tool for building citizenship. A regime of taxes considered fair and reasonable, and an honest, efficient agency to collect them, can give people confidence in their own government. Because taxes hit just about every citizen in one way or another, everybody has a stake in effective taxation. This is particularly true in young nations or in countries where corrupt government has traditionally been a fact of life. Achilles Amawhe, the man who gave me that baseball cap from Nigeria’s revenue service, is acutely aware of this tax function. “When we won our independence, we had to prove to ourselves, and to the world, that we could carry out self-government,” he told me. “I always knew that an honest tax agency would be a symbol of that.”
In fact, a promise of rigorous universal tax collection can be a winning political strategy. When Alexis Tsipras and his Syriza Party challenged the longtime incumbent government of Greece in 2015, he ran on a pledge to “fight the oligarchy that is evading taxes,” and he won, in a country where ducking the tax man had long been considered standard operating procedure. As prime minister, Tsipras appointed an “anticorruption czar” with a mission to make all Greeks, rich or poor, pay the taxes they owed. The czar himself, Panagiotis Nikoloudis, saw his role as something considerably bigger than just bringing in revenues. Rather, it was his duty to convince the people of Greece that government can work. “If people see that I’m clean, and the prime minister is clean,” Mr. Nikoloudis said, “and that those who are not clean will eventually go to jail, I like to hope it will inspire a change in Greek society.”15
The theory that good taxes make good citizens (who then demand good government) has spawned a considerable academic literature in the field of political science. In a 2014 study, Lucy Martin of Yale University set up experiments to test the proposition that people insist on better government—and get it—if they have to pay for it through taxes. In a series of field tests in Uganda, Martin set forth a situation where both taxpaying and untaxed citizens were told that a public official was corrupt. Those paying taxes proved to be far more indignant about this and were more inclined to punish a guilty leader. In poor countries that depend primarily on foreign aid for their revenues, Martin found, citizens tend to tolerate poor government and official corruption. But that attitude changes when taxes become due. “Taxation generates a significant increase in the level of accountability citizens demand from leaders,” she concluded.16
In modern society, taxes go far beyond the basic mission of paying for government programs. This may be one reason why the U.S. tax code has become so ridiculously complicated; for each new mission, there’s a new privilege or penalty or preference written into the law. This complexity is exacerbated by the enormous impact of money on American politics. Each year, hundreds of different contributors, each with his own pet cause, manage to persuade Congress to insert a particular loophole or exclusion into the Internal Revenue Code. America’s tax system is like an old inner tube that has been patched a dozen times—and still leaks.
And this is exactly the wrong way to design a tax system. It violates the most important rule of good taxation—a principle the economists call “BBLR.”