Tuesday, July 12, 2011

Increasing Taxes on the Wealthy Not A Panacea (Part I)

Public opinion is often in favor of increasing taxes on the wealthiest in society in order to, among other reasons, reduce government budget deficits, finance subsidies and transfer payments to the poor, and fund various public works programs.  Economists who oppose such increases are often painted in a harsh light and characterized as friends of special interests (Wall Street, particular industries, and perhaps even Republicans).  But, there are some fundamental economic principles at work that cause most economists to remain wary of looking to tax increases on the rich as a panacea for debt, reducing inequality, and public works funding.

A simple, often used, example of a justifiable tax on the rich is the imposition of a luxury tax on the purchase of yachts.  The justification is simple: if you can afford to buy a yacht, you can afford a 10% luxury tax.  The proceeds of the tax will then go to help the poor who can barely afford basic food staples, let alone a yacht.  Who would oppose such a tax?  Well, perhaps no one, not even the rich.  The problem: wealthy people do not have to purchase yachts.  Luxury items are easily foregone.  The wealthy, when faced with a 10% increase in the price of their luxury item, can easily forego the purchase of a yacht and instead will purchase some other luxurious item such as expensive vacations, more days off of work, nicer vehicles, jewelry, etc.  If the wealthy do this, substitute away from yachts in favor of some other luxury good, what will be the effect on the amount of revenue the government raises from the luxury tax on yachts?  The simple answer is that they will earn less than forecast.  Should this bother policymakers?  There is still some revenue coming in from individuals that could not live without a yacht, so why worry about it?  We should worry about it because of the amount of deadweight loss this causes in an economy. 

Deadweight loss is the amount of economic activity wiped out of an economy due to the imposition of a tax.  It is a measure of the inefficiency of a tax when compared to that most efficient of taxes, the lump-sum tax (a topic for later).  We know that the more easily someone can substitute away from the taxed item, the greater is the deadweight loss to society (the more inefficient the tax).  The wealthy are particularly good at finding the greatest use of their dollars (there are some exceptions of course, like some heirs and heiresses) and they also have the opportunity to substitute away from the taxed item due to the level of resources at their command.  Thus, luxury taxes often result in less revenue generation than predicted, result in relatively large deadweight losses (great inefficiency), and end up hurting the companies and labor involved in providing the good or service that is taxed.

What should be taxed instead?  There are still plenty of questions to ask, and answer, regarding this topic, which I will post on soon.

1 comment:

Joe said...

When I use the example of the yacht market I usually indicate also that other variables might have an impact on the yacht purchasing decision. If the US and the EU place a high tax on yachts, I can go to China which produces very fine vessels nowadays and still get my yacht with no added luxury tax.
This still keeps the example simple, because it builds on a previous point you made, that the wealthy are particulary good at finding alternative means to spend their dollars. I used to play with this example in class all the time, but law students aren't any fun when it comes to issues of economics...