Taxation and Society Jude Wanniski February 8, 2002

Many of the lectures from the early years of SSU, which began in November 1996 with one student, do not read as well as they might. But this third lesson of that semester, which is more philosophical than technical, holds up very well and I will run it here with some additional comments at its conclusion. The student was Kevin Isbister, who e-mailed asking how he could learn supply-side economics. That's how SSU began.

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Kevin conjured a most interesting question on the correct level of taxation in a society. He also asked how to pronounce "Keynesian," which refers to the famous demand model developed by Lord John Maynard Keynes in the 1930s. "Keynes" is like "Canes."

Kevin's Q: Taking the assumption that there is a point when high taxation will eliminate the incentive to invest and produce, and thus begin reducing the revenues produced by the government taxes...what would you consider to be the other guarding limit on the system? That is, is there a point where taxation could become too low and hence begin harming our economic-society? And, related to that, what would the ideal tax burden be for a given economy?

A. The question involves political philosophy as much as it does economics. This is why we should understand you cannot really separate "politics" and "economics" when discussing "society" or "the nation state." For that reason Lord Keynes considered himself a political economist. The December 2 [1996] issue of The New Yorker contains a long essay entitled "The Decline of Economics," which is worth taking a look at in this connection. The writer, John Cassidy, a British economist who writes for the magazine, notes that the private marketplace for trained economists is shrinking. The reason is that economics does not really work as a mathematical science, which is what the academic economists have been teaching for the past half century -- after Keynes died in 1946.

In my 1978 book, The Way the World Works, I pointed out that the level of taxation that a people are willing to submit to changes from peacetime to wartime. The specter of imminent defeat in war is enough to persuade people to work at high levels of effort, with the state taxing away 100% of their production, giving back only enough to keep the workers alive. The Chinese experiment in Communism after WWII was the most extreme example of taxation in recorded peacetime history. The Chinese state essentially taxed 100% of all the production of its people and then redistributed that production back to the people according to Maoist principles and the needs of the state. ("From each according to his ability, to each according to his need.") Soviet Communism was also a system that approached total taxation, but there was always a bit more untaxed free market -- small farmer's markets and private farm plots. Even so, the Chinese seemed better able to feed themselves, because of a tax system that was regressive as it applied to communes and collectives. That is, a collective of 20,000 people would be required to surrender to the state a smaller percentage of its output as the output increased. People could thus be persuaded to work harder because the marginal tax rate fell on the higher collective income. In the Soviet Union, the tax system was progressive on the farms, which discouraged greater collective effort. The Chinese system broke down in latter stages of the Cultural Revolution when the central government attempted to raise taxes on the most productive communes in order to make everyone equally poor.

In the first part of your question, you ask if there is a point at which taxation is so low that it hurts society. Here, the limiting case would be zero. At a perpetual zero tax rate, of course, there is no government, no civilized society. It is theoretically possible to design an economy with a zero tax rate for a relatively short period. The government's expenses would have to be borne by borrowing resources from the productive elements of the society -- promising to redeem the bonds issued at some future point, through taxes levied on future production or through the sale of assets owned by the state. In 1989, the USSR government invited me to Moscow to discuss a transition to a market economy from a command economy ("command" meaning the taxing of all resources by a central authority which would then redistribute them according to some formula). My advice at the time -- and it would be similar today -- is that the government should try to get by without any taxation for a period of years. It could borrow what it needed from the population, using as collateral the vast resources owned by the state. It could also begin to sell off those assets as a further source of immediate revenue. This would give enterprise the fastest possible start, without any tax burden to be shared by the state. Instead, the state put the tax rates so high -- on the advice of the Ph.D. economists of the International Monetary Fund -- that businesses would perish if they paid the taxes. Only the evasion of taxes by the corruption of tax collectors enables the private market to exist. Starved for revenue, the government has to resort to borrowing and is finding it is possible to do so as long as it maintains the value of its currency relative to the dollar, which has been stable relative to gold.

If you see by these examples of limiting cases on either end of the tax scale, you should be able to reason your way toward the center -- at least for a general answer to your question. Which is that there is no good answer to your question. We can only approach an answer to the economic question if we first answer the political question: What kind of society do we wish to have? There are any number of things society requires of the state, things that the state can do more efficiently than private markets. If this were not true, there would never have been a need for government and we could have remained in a state of nature. Most of these things involve what the people need collectively to secure themselves against threats foreign and domestic. After the armed forces are maintained and most of the required domestic law enforcement system is sustained with tax revenues, the question is posed to the populace on a variety of services that can be provided by the state or by the private markets. We know the old folks have to be taken care of; how much should be done in the private sector and how much by the state? We want a society where the hungry are fed. How do we decide who are the deserving hungry and who the able-bodied freeloaders? How do we decide which of the hungry should be fed by private charities and which by government care packages or food stamps? We know children have to be educated. The degree to which we decide that free public education should be as good as the best private education is critical to answering your question about taxation.

A good political economist should be able to design a tax system to fit the needs of any choices made by a given society. In Moscow in 1989, I told my hosts I could assemble a team that could design a much better command economy than the one that broke down underneath them. Systems can be designed that involve a great deal of collective activity that would be far superior to many countries that today have much smaller interventions by government. Generally speaking, history does tell us that government is only efficient at doing things that are standardized. It can build highways far more efficiently than it can build information superhighways. This means each society has to design a political system equipped to sort out things government can do efficiently and things it cannot do. A society that is culturally homogenous can have simpler mechanisms than societies that are culturally diverse. You can design a political system that is almost perfect, with low taxes, as the Athenians did, but see it fall to the Spartans, who had higher taxes and a stronger military.

In the current state of affairs, it's my guess that the tax systems in the United States and in most countries of the world are not facing the problem of rates that are too low. This is because we have just come through the most serious and concentrated global monetary inflation in recorded history. The inflation happened at a time when almost every country in the world has had a progressive income tax system, which caused rates to climb inadvertently, not by the considered judgment of the people and/or their elected representative. Your question, about a society being damaged by rates that are too low, would come about if the world experienced a monetary deflation at a time when tax systems were regressive. Taxpayers would come off the tax rolls in droves, leaving a smaller number of people to support all government services. The deflation would wreck the debtor class which would be unable to pay its creditors. The economy would contract just as the social needs of society expanded with tax revenues plunging. Such a combination of problems is nowhere in sight.

Your question of the ideal tax burden for a given economy thus is one that cannot be answered with a specific number. There are economies with more than half of all annual production flowing through the hands of government that are much nicer places to live than other economies where less than 10% of the national output is represented by the national budget. Germany is among the former. India and Bangladesh are among the latter. This only proves that in countries where almost everyone is poor, only a small number of citizens can afford to pay any tax.

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February 8, 2002

What stands out from this essay is in the penultimate paragraph: "Such a combination of problems is nowhere in sight." Meaning a monetary deflation and a regressive tax system. That is a combination that still is nowhere in sight, thank goodness. The combination of a deflation in a tax system that pushes people into lower tax brackets, which is what is happening in the United States today, is much easier to bear than a deflation that pushes workers into higher tax brackets. That is the worst of all worlds, as debtors not only find their assets shrinking in nominal dollars because of the deflation, but it is harder for them to earn after-tax dollars because of the regressive tax structure. Bankruptcies would occur at geometric rates. If we look closely at the collapse of Argentina's economy in recent days, we find almost the worst possible combination. The government had linked the peso to the U.S. dollar, which was fine as long as the dollar was stable against commodities. But when U.S. tax rates were cut in 1997 and the Fed failed to respond to the needs of a growing economy for more "money supply," the dollar deflated as it became scarce relative to gold and commodities, and this dragged the peso into the same deflation. The IMF economists then offered to help with an infusion of cash, but insisted that Argentina RAISE taxes in order to get the aid. There are no economists at the IMF who have studied at Supply-Side University!!

One of my biggest surprises in broadcasting the good news of Supply-Side Economics was in finding that quite a few political conservatives did not like the idea of a system that would produce more tax revenues with less effort. To them it meant a bigger government and they actually preferred a smaller government if what it took was smaller revenues. The demand-side economists that had served the Republican Party for many years -- with disastrous political results -- supported the Reagan tax cuts thinking they would "starve the economy of revenues." The group included the conservative Keynesians who had served the Nixon administration and the Monetarists who served the Reagan administration. David Stockman, who became Reagan's budget director -- with my help and to my everlasting regret -- abandoned the supply-siders almost as soon as he took office and cut his deals with the Keynesians and Monetarists. He helped persuade Reagan to phase in his promised tax cuts and supported the deflationary monetary policies of the Monetarists.

When the economy went into a deep recession in 1981-82, Stockman gave an interview to William Greider of the Atlantic Monthly which essentially said he never believed the tax cuts would work. They were a “Trojan Horse,” he said, meant to shrink the size of the government. Stockman could say that because so many of the Reagan supporters believed that. They rejected the thought that economic growth could be so rapid it would produce a budget surplus, and the Democrats would use it to finance socialized medicine, for example. If there is a surplus to spend, Republicans always prefer to increase defense spending. It is in the nature of the two political parties to divide along these lines. It is rare for a Reagan to come along who genuinely believes in supply-side policies that will unleash the productive energies of ordinary people.