The Best Theory of Taxation for the Economy

Introduction

This paper argues in line with Smith that high taxes coupled with increased government services and falling within the four taxation criteria that Adam Smith raised is more than just the best approach. It also gives citizens the power to demand service delivery from the government, leading to a dignified life. For a long period, tax experts have differed regarding raising revenues towards funding various government functions and units. Some have questioned whether taxes should be for revenue only, a tool of social control, or both. Others have contemplated whether tax levies should be applied selectively based on the “ability to pay” or whether all citizens should equally be part of the tax system. Other contentions have suggested that the “benefit principle” should be central in determining taxation and its rates. In raising the “benefit principle” discussion, they question the possibility of the government making those who benefit directly from the services or projects charged for the same.

Rostow points out that Smith, in his book, The Wealth of Nations (1776), argued that it is of general public benefit to do such things as defending the country and maintaining the institutions of good government.¹ Consequently, Smith’s point was that it is reasonable for the entire population to be part of the tax system, helping the government raise revenues for running its functions and implementing its projects. In so doing, it also gives the citizen legitimacy in demanding certain other things of the tax system, including amounts of tax accruing some relationship to the citizen’s abilities to pay. Thus, there must be some criteria for determining whether taxes are good for the public or are punitive. The four main characteristics that good taxes must have include they must be certain and not arbitrary, they must be cheap in administering and collection, they must be proportionate to the income and abilities of the citizens to pay, and they must be payable at times and ways convenient to the taxpayers.² A major tax conundrum hit the 20^th and 21^st centuries, contemplating whether higher taxes with many social services or low taxes with few government services is the best approach.

Analysis

One of the main factors characterizing the 20^th and 21^st centuries is the increasing growth of multinational companies. However, this change has come along with one of the most concerning taxation problems, where multinational corporations engage in tax avoidance theatrics. As a result, many governments have been limited in addressing challenges regarding international policies, global pandemics, forced migration, climate change, and increasing inequality.³ Further, Faccio and Ghosh posit that this action by the multinational corporations has played a key role in taking away a tool that could contribute to achieving equality and justice distribution, causing citizens to have increased distrust in the social contract. Faccio and Ghosh estimate that multinationals deprive governments of at least $240 billion annually in fiscal revenues.⁴ This deprivation action disproportionately affects the global south due to its limited revenue sources. While tax evasion cannot be directly linked to lower taxes, it causes the government to collect below its targets, affecting their service delivery, which can be linked to lower tax policy. This practice is akin to multinationals shifting their profits to jurisdictions with low or zero tax rates, as many established companies from the United States and Europe moved their operations to China in the 1980s.⁵ Among the inducements that motivated increased foreign direct investment in China was the tax holidays, even though many multinationals were unsuccessful initially.⁶ While this practice can lead to increased employment levels, it undermines the tax base of countries where they carry out their activities. In the long run, these practices exploit resources in the countries they operate while leaving them in a worse position.

High taxes are critical in motivating demand and consumption if the governments can show proof of their value to the public. Tax issues and their impact on market prices have always formed one of the fundamental factors surrounding the discussion of pricing theory. Komleh argued that besides governments using taxes to cover their expenditures within the budget, taxes also are critical in controlling the market and eliminating defects.⁷ This argument is also supported by Kolmar, who argued that increasing taxes affects demand negatively, eventually hurting a given country’s economy in general. He also argued that the reverse is true, associating tax cuts with a positive impact on demand and the economy.⁸ However, learning from President Reagan, it may be only partially true. When Ronald Reagan was running for president in 1980, he argued that the economic ills of America were connected to oppressive taxes and big government. Consequently, upon clinching the seat, he implemented a policy cutting taxes by 25% in 1981.⁹ However, this policy did not bear fruit for a while, leading the country into inflation and a recession that lasted for about two years. Thus, it is only partially true that reducing taxes impacts the economy positively. On the contrary, Boulianne points out that constantly engaging citizens in policy-making through civic education and following through to implement these policies can help increase citizens’ trust in the government.¹⁰ Trust is a vital component in any level of human relationship. Thus, a situation where the government adequately engages the public in increasing taxes coupled with increased delivery of quality services would result in increased motivation for consumption by the citizens.

High taxes are key in reducing economic inequalities existing in different countries and various parts of the globe, in general. Over the last half a century, there has been a dramatic decrease in taxes on the rich across the global north countries. At the same time, the world has witnessed a sharp increase in income inequality over the same period. While there is an ongoing debate in academic and political spheres over the economic soundness of these changes in tax policy, Hope and Limberg found out from their study that cutting taxes on the rich contributes to increasing income inequality.¹¹ Thus, it implies that the rich will continue holding on to their high incomes while the poor are charged higher taxes proportionate to their income. Consequently, it put the government in a precarious position to overburden the poor with punitive taxes that disobey the Smith taxation rules or go slow in delivering social services. Either of the decisions disadvantages the less fortunate in society, which then ends up exacerbating the inequality crisis in a given country. The soundest tax policy that can help reduce income inequalities is charging higher taxes on high-income households than low-income households.

An increase in the tax burden can indicate positive economic development. Rostow describes tax burden as the percentage of a country’s Gross Domestic Product (GDP) collected in tax.¹² For this increase to be viable and sustainable for the economy and hold the argument plausible, it must first ensure that it confines with the taxation criteria Adam Smith highlighted. As Piketty highlights, Sweden presents a convincing case of the extent of the positive impact of the increase in the tax burden. While the United States and Sweden have similar GDP per capita, the tax burden in the United States is almost half that of Sweden, standing at 25% and 45%, respectively.¹³ The higher tax burden in Sweden reflects Sweden’s well-organized and extensive welfare state, comprising free education and health care, as opposed to the United States. The stability of the welfare state in Sweden plays a significant role in reducing uncertainty and such problems as bankruptcy. Consequently, backing up the high tax burden and increasing taxation with the provision of quality services is motivation enough for citizens wanting to help the government deliver more services by becoming cheerful taxpayers.

Higher taxes can reduce the demand for leisure and increase the supply of taxed labor through income effects. According to Faccio and Gosh, the recent public economics literature entails an apparent consensus alleging that income effects reduce the costs of raising revenues.¹⁴ Consequently, the reduced costs of raising revenues increase the desirable public good provision level. However, it is critical to consider the income effects of taxes symmetrically with the provisions of public goods. Thus, the cases where the public can perceive the social impacts of their taxes paid, such as increased social amenities, and increased subsidies on the cost of starting a business, it is easier for the general public to want to be part of the contributors to the wellbeing of the country. Thus, most of the public will develop a desire to shun leisure and avail their talents for use in various areas that can help contribute to the tax revenues that a country can collect.

Increasing necessary funds for implementing its projects, the government should consider raising the personal income tax rates on the highest income as one of the most effective ways. Increasing high-income tax helps to generate substantial revenues for investment in people and communities that provide economic and social benefits over a long period.¹⁵ The increase in high-income tax would also help to prevent what Keynes referred to as the speculative bubble. Thus, Keynes suggested that preventing speculating a bubble which is critical in the effort to prevent depression, calls for preventing the accumulation of too much money in the hands of too few people.¹⁶ Thus, a high-income tax would ensure the continued circulation of money in the economy. In the United States, minimizing or preventing harmful budget cuts and investing in ambitious new projects have been among the major concerns of the majority of states. Such ambitious projects of great interest to the states and the people include expanding early education, strengthening “rainy day” funds that help prepare for the next recession, infrastructure improvement, and boosting college access.¹⁷ About 41 states adopted the policy to raise personal income tax rates to achieve these projects. This sustained support for the growth of the public building blocks through high personal tax rates goes a long way in helping the states improve the residents’ well-being, build sustainable, prosperous economies, and expand opportunities that cater to all races across the states. Thus, high personal income rates in such a scenario are not a punishment but an uncomfortable investment that contributes greatly to the societal good and lessens the pressure on the net income.

Charging citizens with high taxes gives them the power to demand increased government services. In his work, Prichard presents the fiscal contract arguing that an arrangement that includes citizens yielding their rights for the sake of the collective interest, they should expect the central governing authority to deliver protection and other public goods to society in return.¹⁸ Taxation provides the most practical form of fiscal contract where the citizens forfeit part of their personal assets to the government in return for services. Consequently, on the one hand, as the government charges higher taxes on the rich as a percentage of GDP, the rich should demand accountability from the government for more protection of property rights. On the other hand, the more the government taxes the poor, the more the poor are eligible to hold the government accountable by providing basic public services.¹⁹ With increased public service, the less advantaged citizens can have access to these basic services at a reduced or no cost, hence reducing the propensity to lead undignified life. Thus, the citizens are justified to demand accountability from the government to which they forfeit their personal assets in the form of high taxes in the hope that the government will be responsible and shrewd in using their taxes.

On the contrary, the proponents of low taxes with reduced government services argue that reducing taxes helps to increase the consumers’ spending power. Consequently, it increases aggregate demand and leads to high economic growth. On the flip side, they also suggest that reduced taxes can increase incentives to work that eventually lead to higher productivity and increased supply. This argument was strongly advanced by Shumpert, one of the leading proponents of tax cuts and a great critic of the high taxes, holding that the high-income tax reduces savings and hence is a disincentive to work.²⁰ However, Harvey argued in his work that the effect of tax cuts on the economy depends on the financing of the tax cuts, whether the reduced tax rates increase the willingness to work and productivity, and the state of the economy.²¹ The proponents of lower taxes and reduced government social services fail to consider this taxation policy’s drawbacks. Besides translating into higher economic growth due to increased consumer spending, tax cuts can lead to government borrowing. There is a high likelihood of tax cuts resulting in lower tax revenues, forcing the government to resort to higher borrowing, thus, bulging the public debt burden. With increased public debt, it reverts the pressure on the citizen, and the most disadvantaged are the less fortunate, who, besides not having the opportunity of accessing government social services, they have to deal with the fact that their generations may continue in perpetual poverty due to paying off their income to offset the public debt.

Conclusion

In the 20^th and 21^st centuries, high taxes coupled with many social services are more sensible than low taxes with few government services. While high taxes bear the risk of destabilizing the economy and entrenching further income inequality among the people, the criteria of Adam Smith can help the government to avert such risks. It can then turn around high taxes to help provide high-quality social services such as free health care and education, address income inequalities, and motivate demand among the people. The argument of the proponents of lower taxes coupled with fewer government social services is enticing but dangerous. It can accrue positives, but it is not sustainable. It risks causing many generations to be in perpetual poverty due to the high cost of living resulting from unavailable relatively cheaper government social services such as healthcare facilities and schools. It can also lead to increased public debt due to high government borrowings that can overburden citizens, especially the less fortunate. Thus, increasing tax rates within the conditions that Adam Smith highlighted and ensuring that government provides the necessary social services is economically and socially appealing as opposed to reducing tax rates and taking away government social services.

Works Cited

Boulianne, Shelley. “Building faith in democracy: Deliberative events, political trust and efficacy.” Political Studies 67.1 (2019): 4-30.

Faccio, Tommaso, and Gosh, Jayati. “Taxing Multinationals: A Fundamental Shift Is Under Way.” Intereconomics 56 (2021).

Harvey, David. A brief history of neoliberalism. Oxford University Press, USA, 2007.

Hope, David, and Julian Limberg. “The economic consequences of major tax cuts for the rich.” Socio-Economic Review (2022).

Kolmar, Martin. Principles of microeconomics. Springer International Publishing AG, 2017.

Komleh, Ramin Abolghasemi. “The influence of taxation on supply, demand and market price.” The University of Milan. (2018).

Piketty, Thomas. “Capital in the twenty-first century.” Capital in the twenty-first century. Harvard University Press, 2014.

Prichard, Wilson. “Tax, politics, and the social contract in Africa.” Oxford research encyclopedia of politics. 2019.

Rostow, Walt Whitman. “The stages of economic growth.” The economic history review 12.1 (1959): 1-16.

Schumpeter, Joseph A. “The fundamental phenomenon of economic development.” The theory of economic development. Routledge, 2017. 57-82.

Skidelsky, Robert. John Maynard Keynes: Economist, Philosopher, Statesman. Macmillan, 2003.

Tharpe, Wesley. “Raising State Income Tax Rates at the Top a Sensible Way to Fund Key Investments.” Washington, DC. Web.

Footnotes

1. Rostow, Walt Whitman. “The stages of economic growth.” The economic history review 12.1 (1959): 1-16.
2. Faccio, Tommaso, and Gosh, Jayati. “Taxing Multinationals: A Fundamental Shift Is Under Way.” Intereconomics 56 (2021).
3. Faccio, Tommaso, and Gosh, Jayati. Intereconomics 56 (2021).
4. Faccio, Tommaso, and Gosh, Jayati. Intereconomics 56 (2021).
5. Harvey, David. A brief history of neoliberalism. Oxford University Press, USA, 2007.
6. Harvey, David. Oxford University Press, USA, 2007.
7. Komleh, Ramin Abolghasemi. “The influence of taxation on supply, demand and market price.” The University of Milan. (2018).
8. Kolmar, Martin. Principles of microeconomics. Springer International Publishing AG, 2017.
9. Hope, David, and Julian Limberg. “The economic consequences of major tax cuts for the rich.” Socio-Economic Review (2022).
10. Boulianne, Shelley. “Building faith in democracy: Deliberative events, political trust and efficacy.” Political Studies 67.1 (2019): 4-30.
11. Hope, David, and Julian Limberg. “The economic consequences of major tax cuts for the rich.” Socio-Economic Review (2022).
12. Rostow, Walt Whitman. The economic history review 12.1 (1959): 1-16.
13. Piketty, Thomas. “Capital in the twenty-first century.” Capital in the twenty-first century. Harvard University Press, 2014.
14. Faccio, Tommaso, and Gosh, Jayati. Intereconomics 56 (2021).
15. Tharpe, Wesley. “Raising State Income Tax Rates at the Top a Sensible Way to Fund Key Investments.” Washington, DC. Web.
16. Skidelsky, Robert. John Maynard Keynes: Economist, Philosopher, Statesman. Macmillan, 2003.
17. Komleh, Ramin Abolghasemi. The University of Milan. (2018).
18. Prichard, Wilson. “Tax, politics, and the social contract in Africa.” Oxford research encyclopedia of politics. 2019.
19. Prichard, Wilson. Oxford research encyclopedia of politics. 2019.
20. Schumpeter, Joseph A. “The fundamental phenomenon of economic development.” The theory of economic development. Routledge, 2017. 57-82.
21. Harvey, David. A brief history of neoliberalism. Oxford University Press, USA, 2007.