Note, besides, that it is no more immoral to directly rob citizens than to slip indirect taxes into the price of goods that they cannot do without.[323]
Albert Camus
Chapter 2 identified two instinctually rational drivers of economic behavior, self-interest and societal-interest, with the first driving markets and, ideally, the second driving public policy, but frequently otherwise. Self-interest is satisfied by maximizing profit and surviving the slings and arrows of the marketplace. Societal-interest is satisfied by the fair and efficient provision of public goods and their associated taxes. The choice of public goods and taxation requires a valid democratic process as the ultimate arbiter of the validity and fairness of public choice. Hence, anything that interferes with an efficient democracy degrades public choice and economic efficiency and vice versa.
The unified theory of macroeconomic failure identified several groups of chronic negative externalities that confront Western economies and, therefore, require public sector intervention. The discussion so far concerning the efficiency of public expenditure and taxation has been limited; a broader examination is now in order to permit a critical review. This chapter discusses public sector expenditure, taxation generally, and indirect taxes specifically. The three chapters to follow will examine corporate and personal taxation.
Before going any further, a word of caution is necessary about the unhappy state of affairs in the field of public finance, particularly to the students of public finance. If the previous discussions, especially concerning the role of academia, have illustrated that politics has corrupted macroeconomics, then we should emphasize that public finance has been a prime target of this perversion. For example, most public finance books and scholars are guilty of singing the praises of a “progressive” personal income tax instead of factually explaining that the present tax regime is regressive because it uses the wrong tax bases like taxing income from capital instead of capital proper. At the same time, the abundance of personal income tax loopholes, shelters, and exceptions has rendered any talk of progressivity misleading. Like macroeconomic theory, public finance has been a stagnant pond for too long and badly needs an overhaul. It is up to the students of public finance to bring their field into the 21st century.
Public goods are fundamentally different from private goods; hence, a market framework cannot provide them efficiently, if at all. The full benefits of pure public goods cannot be internalized through the market price because they are lumpy, it is not possible to exclude anyone, and their consumption does not diminish their availability to the rest of society. Examples of pure public goods include defense, police protection, the courts, the protection and enforcement of property rights, environmental protection, international relations, and democracy—a process for authorizing, funding, and administering a public-goods program. On the other hand, quasi-public goods like public health and education have characteristics of public goods, such as the spillover of benefits, as well as private goods, such as divisibility and lack of lumpiness, which permit the wealthy to treat them as private goods.
The following are some of the reasons that make the provision of public goods by the state necessary, as follows:
• Lumpiness, indivisibility, and huge cost make the public provision of pure public goods, like national defense, a necessity.
• Resolving conflicts and protecting property rights require an effective court system to ensure fairness and dispense justice, and a police force to enforce such decisions as well as to provide security.
• The production of negative externalities, such as pollution, requires public intervention through laws, taxes, and penalties to restrict their harmful effects on society.
• Improving income distribution helps alleviate poverty and chronic underconsumption to drive the economy closer to its production possibility frontier, thereby improving the performance and efficiency of the economy. Market forces cannot resolve such problems, requiring public intervention by replacing regressive taxes with progressive ones, providing more and better job opportunities to lessen unemployment, a higher minimum wage, training, education, transfer payments, public health, and other welfare programs.
• Maintaining competitive markets requires public intervention and regulation to prevent monopolies and curb oligopolies.
• The presence of natural monopolies, such as central banks and utilities, requires their public ownership or, at a minimum, satisfactory public regulation and oversight of their pricing, production, and operations.
• Improving the economic efficiency of decision-making requires the availability of reliable information about products, services, capital markets, and government statistics.
• Protecting the public against harmful products and practices in the marketplace requires product licensing and supervision by specialist agencies, such as the Food and Drug Administration (FDA).
• The production of positive externalities associated with quasi-public goods, such as public health and education, requires public intervention to encourage their consumption to capture their public benefits more fully.
In recent decades, some economists have argued that improving economic efficiency and the rate of growth require reducing the size of the public sector. For example, Richard Rahn, originator of the Rahn curve, called for reducing the ratio of the public sector to GDP to the levels prevailing in the 1920s and in the 19th century.[324] This suggestion overlooks the history of US economic cycles summarized in Chapter 11, particularly the section titled “United States Cyclical Contractions (1785-2009).” A prime reason why economic contractions have become shallower and shorter since 1942 is the increase in the size of the government relative to GDP, following the growth of the welfare state. In addition, a satisfactory level of welfare is essential while a large segment of the population needs it, a requirement under a democratic system. Repudiation of essential welfare in the midst of poverty is tantamount to an abandonment of democracy. Moreover, improper privatization of certain government functions, such as the Federal Reserve and prisons, proved prohibitively costly to the government and taxpayers as well as detrimental to democracy itself.
The present anemic growth rate in the United States is the result of multiple causes, all invariably traceable to deteriorating democratic standards. The causes include a regressive tax system, tax discrimination against economic efficiency, tax subsidization of debt resulting in amplified cyclicality, falling competition, an overvalued dollar, and wasteful expenditures on wars of aggression and zombie banks. Thus, rationalizing public expenditure and improving the efficiency of taxation can dramatically reduce waste, increase public benefits, and raise efficiency, resulting in faster growth. In other words, the priority is increasing public sector efficiency by improving the public-expenditure tax mix rather than a blanket reduction in the size of government, as vividly demonstrated since 2009 by the disastrous austerity programs in Southern Europe.
Improving the efficiency of public sector expenditure requires resolving a variety of potential and actual issues, of which the list below is but a sample:
• High democratic standards are required to ensure the validity and legitimacy of public choice in formulating public expenditure and tax policies. For example, it is a contradiction of terms to speak of rich democracies having widespread poverty, homelessness, hunger, and depravation of their citizens; if such societies are rich, then they are not democratic.
• Which public goods and in what quantities does the public demand and need?
• Is the government provision of public goods cost-effective? For example, lack of serious competition in the United States has made the cost of US medical care much higher than in Japan, while the quality is materially inferior.[325] Reducing the inflated cost of public goods requires the breakup of monopolies and oligopolies and intensifying competition between public sector suppliers.[326]
• Is the government distributing the benefits and costs of public goods fairly and efficiently?
• Eliminating the structural conflict between fiscal and monetary policies is a necessary condition for an effective economic policy.
• Fiscal stabilization during contractions through the timely implementation of infrastructure projects maximizes the benefits per dollar expended, whereas tax cuts and quantitative easing are not cost-effective.
• Improving US competitiveness and growth requires the rejuvenation of the industrial sector, which in turn requires the end of chronic dollar overvaluation and trade deficits, because an overvalued currency is tantamount to a tax on exports and a subsidy for imports.
• Improving US international standing by pursing international peace, coexistence, and goodwill is infinitely cheaper than the prohibitively costly and futile wars of aggression.
• Public welfare would improve by reducing economic inequality and improving job opportunities, public education, health care, housing, and social services.
• Improving quality of life requires reducing crime and its associate costs through the elimination of poverty, better job training and job opportunities, and shorter and fairer sentencing.[327]
Tax Objectives, Efficiency, and Types
Taxes are the price of public goods and they are borne by people whether as consumers, workers, or capital owners. Taxes entail an excess burden when they misallocate resources, pervert a fair distribution of income, encourage the wrong activities, increase economic instability, entail waste, or promote economic inefficiency. Hence, it is the responsibility of economists to point out the flaws of the tax system, improve its efficiency, and lessen its burden.
As with public expenditure, there are several issues regarding the objectives, appropriateness, and efficiency of taxes, such as:
• Is a valid democratic process providing the constitutional and legal basis for taxation?
• Are taxes providing sufficient revenue to cover the cost of the required public goods?
• Are the benefits of the wealthy and high-income groups from the public expenditure commensurate with their level of taxation?
• Is taxation improving income distribution?
• Do tax loopholes and shelters make taxes unfair, undemocratic, and lacking in transparency?
• Is the tax code simple enough for taxpayers to understand and comply with it?
• Do taxes improve or detract from the efficient allocation of economic resources, with implications for economic growth?
• Do taxes amplify or dampen economic fluctuations?
• Are taxes reducing or increasing negative externalities?
• Is it possible to improve the efficiency of tax collection (diminish the cost of tax collection as a percentage of the revenue generated)?
There are two broad categories of taxes: direct and indirect. Direct personal taxes include personal income, capital gains, inheritance, transfer, and, in some jurisdictions, wealth taxes. The principal direct corporate tax is on corporate income.
On the other hand, indirect taxes, our focus in this chapter, are transactions based and levied on products and services. They are indirect because they are not specific to any individual or corporation and, in principle, avoidable by not consuming a good or service that is subject to tax.
The Case for a Pigovian Tax on Financial Pollution
Taxes can improve as well as detract from economic efficiency. The best example of the former is in curbing negative externalities. When the social cost of a good exceeds its private cost, the market is unable to internalize all the costs associated with its production or consumption, or both, indicating a market failure and a negative externality.[328] Correcting this market failure requires public intervention to curb the activity in question, typically by raising its private cost to match its social cost through taxation. Thus, taxes on petrol and diesel serve to curtail consumption of those goods to cut the incidental production of air pollution associated with their consumption. Such taxes are exceptional in that they simultaneously increase welfare and raise revenue; they are referred to as Pigovian taxes, after Arthur Pigou (1877-1959), the eminent English economist. Remarkably, Professor Pigou was also the first to consider welfare from the perspective of an externality.
Inexcusably, economists have invariably ignored the huge divergence between the public and private costs of interest-bearing debt, a divergence that requires classifying interest as a financial pollutant and, these days, the foremost negative externality. Bank lobbying for interest favoritism through the insertion of a multitude of clauses in the tax code, to permit interest deductibility from corporate and personal taxes, has made matters worse by encouraging indebtedness. This huge divergence between public and private costs explains the economic rationale for its ban by Jesus Christ, an affirmation of the consistency between morality and economic efficiency. Hence, banning usury was a mercy to the world from its belated economic, social, and political consequences, which too few fathomed at the time or since.
Why is the social cost of interest-bearing debt much higher than its nominal interest or private cost? Part III of this book provided a wealth of evidence of the huge consequential cost of interest-bearing debt, including prohibitively costly financial crises. For example, when a mortgage borrower defaults and the lending bank takes possession of his (her) house, the borrower loses the house equity he (she) accumulated over many years, an incremental cost that is over and above the nominal interest cost but it is not explicitly recognized as a large additional cost of debt. In addition, the personal traumas associated with debt are real costs that are not included in the interest on debt. Moreover, when mass defaults occur, triggering a financial meltdown as the sub-prime crisis demonstrated in 2008, the social cost of the interest negative externality becomes incalculable. Thus, whether the debt is for consumption or investment or whether the borrower is an individual, corporation, or government its nominal interest greatly understates its full social cost.
Worse still, the social cost of debt increases exponentially, as the pervasiveness of debt in an economy increases because it artificially amplifies cyclicality and its associated negative externality too. Thus, the sale of numerous repossessed houses crashes the housing market and halts housing construction, causing vast job losses, followed by further rounds of defaults. Comparable concerns apply to all types of borrowing. Recent experience in the United States and Western Europe has demonstrated yet again that these consequential public costs, including the amplified contractions, are in the trillions of dollars, a phenomenally high cost that is not included in the nominal interest.
Furthermore, the social cost of mass misery exacted by interest-bearing debt is impossible to estimate using current statistical tools. How deep is the pain of homelessness and broken families, following mortgage defaults? What are the economic as well as the emotional costs of losing a family business to a bank? The desperation of Indian farmers driven to suicide because they cannot withstand losing their lands and livelihoods for failing to meet a bank mortgage payment is unimaginable.[329] Suicides also increase with the rise of poverty, which parasitic economics spread. What is the dollar equivalent of making tens of millions of people desperate and miserable? Those public costs are enormous and real but unaccounted for because the presently available statistical and accounting methods are inadequate and primitive, preventing us from assessing the full cost of usury. It is testimony to the power of banks that most goods and services are subject to tax but not interest, despite its huge negative externality.
Pollution of the natural environment is physical while financial pollution is conceptual; nevertheless, the negative externality of financial pollution is far more extensive and economically more damaging than environmental pollution. Both require taxation to curb their respective negative externalities and improve economic efficiency and social welfare.
What is the appropriate rate for taxing financial pollutants? The social cost of interest-bearing debt runs into the trillions of dollars, making any tax on the nominal interest, however huge, too small. Hence, banning interest is economically logical. However, given the present pervasiveness of debt, weaning the economy from interest needs to be gradual to avoid jolting the economy. A very high tax on interest would eliminate all new lending instantly instead of gradually, whereas economies need time to adjust and adapt.
Hence, an initial financial-pollution excise tax of say 4 percent per annum applied to the face value of new debt is a small fraction of its social cost, but it is sufficient to discourage new borrowing without eliminating it outright. The rate ought to be raised in later years to discourage lending further. Moreover, for such a tax to achieve its objectives in the face of high interest rates, it would need to be the greater of 4 percent of the face value of the debt or 40 percent of its yield to maturity.
What should be the tax base of a financial-pollution excise tax? In addition to the face value of loans and bonds, the base should encompass all interest-bearing transactions such as deposits, inter-bank lending, and Federal Reserve transactions. Chapter 9 called for the prohibition of derivatives, warrants, and short selling, other than covered short selling for hedging production, exports, and the like. On the other hand, if naked short selling of securities and derivatives were to continue, it would be economically logical to impose a financial-pollution excise tax on these transactions. To discourage derivatives, the tax base would need to be the value of the potential assets that those contracts control at the time of their initiation, and not their negligible premiums.
Finally, preferred shares are a debt-equity hybrid instrument; if it resembles debt more than equity, then it ought to be subject to tax too because, like debt, it would entail an incremental risk to the economy.[330] The elimination of clauses concerning cumulative dividends, renegotiation of terms, and priority in net assets of a company could result in somewhat higher preferred dividend yields for some companies, but that is preferable because it makes the true cost of financing explicit instead of partially implicit.
The government could require lenders and brokers to collect the tax on its behalf in the same way that merchants collect sales tax and forward it to the government. Still, existing debt ought to enjoy a tax holiday for five to ten years to give the economy time to adjust. This tax holiday is necessary for a smooth transition to an equity-based economy that is free of debt.
Effect of Sales Taxes on Exports
Many countries, including all of Europe, have replaced their sales taxes with value added taxes (VAT). This is important for exports because under World Trade Organization rules, exporters are entitled to receive rebates of VAT, but not sales taxes. As a result, the exports of countries using sales taxes suffer a self-inflicted trade disadvantage corresponding to the rate of sales tax embedded in the goods they export.[331] In the case of the United States, this tax hurdle to exports compounds the competitive disadvantage of an overvalued dollar.
Repeal of Taxation of Essentials
High tax rates on luxuries such as Caspian Sea caviar, fine clothes, jewelry, expensive cars, private jets, and yachts is equitable because those who can afford opulent consumption can afford the higher taxes that it ought to attract. Similarly, the high rates of excise taxes on harmful, demerit, goods, such as alcohol and tobacco, have dual benefits; a fall in consumption lessens health and social problems, while an increase in tax revenue helps pay for the associated medical and social bills.
However, taxing the essential consumption of low-income groups—namely, taxing basic food, clothing, or heating—is unjustified because it is regressive and increases income inequality.[332] In recent decades, conservative political parties on both sides of the Atlantic have raised consumption taxes while reducing personal tax rates. For example, the VAT rate in many European countries is 20 percent or higher. This mode of taxation is regressive because it shifts more of the tax burden on consumers who cannot afford it.
Let us illustrate by using a hypothetical example of two consumers, Mr. Rich and Mr. Average, with annual net after-tax incomes of $1 million and $35,000 per year, respectively. To simplify the analysis, assume further that the annual consumption of Mr. Rich is $200,000 and that of Mr. Average is $35,000 (zero savings). Finally, assume that indirect taxes, including sales taxes and import duties, average 15 percent of all sales.[333] Accordingly, Mr. Rich pays $26,087 in indirect taxes (15 percent of $173,913) while Mr. Average pays $4,565 (15 percent of $30,435).[334] Thus, the consumption taxes are equivalent to a tax of 2.61 percent on the after-tax income of Mr. Rich ($26,087/$1,000,000) and 13 percent in the case of Mr. Average ($4,565/$35,000). In other words, relative to their incomes, the indirect tax rate of Mr. Average is five times that of Mr. Rich, flagging an absurdly regressive indirect taxation atop regressive direct taxes such as the social security tax, making the overall taxation of low-income groups most regressive, unfair, and economically illogical.
The lowering of personal tax rates on high-income groups in several Western countries while raising indirect taxes has stealthily implemented a reverse Robin Hood tax policy, symptomatic of democratic erosion and rising plutocratic power.
Conformity with the ability-to-pay principle requires banning all taxation of essentials; the tax shortfall can be recovered through higher taxation of luxuries, demerit goods, and various pollutants like coal, petrol, and interest, as well as by increasing the personal taxation of those who can afford it.
Four centuries ago, Gresham’s Law implied that a morally lax environment promotes fraud.[335] The social cost of fraud, a negative externality, far exceeds the illegal gains of the fraudsters. The environment that has flourished under the banking plutocracy has been very harsh toward minor offenses but extraordinarily tolerant of serious fraud. Indeed, a hungry shoplifter stealing food to eat could face a jail term for a trivial sum while big institutions and their staffs who defraud their clients of billions of dollars only pay fines representing a fraction of their loot, without jail sentences and without admitting any wrongdoing. As with usurious capitalism, the banking plutocracy has hatched a dual sentencing standard: harsh punishment for minor offenses and no sentencing for serious fraud.
Mending this system requires reinstating public morality. It also requires removing the incentive for committing fraud by reducing its expected payoff to a negative value. Thus, if the regulators only detect 10 percent of fraud incidents, a fraud tax set at 1,000 percent of fraudulent gains would decrease the expected value from committing fraud to -10 percent.[336]
Furthermore, allocating part of the fraud tax to reward whistleblowers should improve fraud detection as well as increase public revenue, at least until the fraud subsides. Similarly, making corporate officers who participate in fraud, their seniors, and their corporate entities jointly and severally liable for the fraud tax would deter participation. Prison sentences would help too. Moreover, the staffs of the supervising authorities who offer fraudsters easy settlements without jail terms and fines representing a fraction of the looted sums, instead of enforcing the full powers of the law, deserve to be expelled and sued for gross negligence.