Tax principles in plain language

In the AFR recently there was a rallying call for “tax boffins” to stop hiding behind terms and communicate with the public - with the call from none other than Ken Henry.

I have a bit more sympathy for boffins - as the purpose of terminology is often to be “precise” about complex concepts. The attempts to simplify these ideas can easily turn into an inaccurate description of trade-offs that misinforms those we are trying to inform, or that becomes subject to manipulation by advocates and rent seekers of varying persuasions.

This does not mean attempts to make the impenetrable, well, penetrable are in vain. They just are not easy. So let's attempt to do so with a few concepts here - and I’ll likely give an example of how misleading someone can end up being trying to simplify these things!

tl;dr We can try, but I’m worried we end up with oversimplified examples of concepts without understanding - which leads us to pursue tax reform with an unwarranted confidence, based on illusory certainty about measures of these terms mean. After all, if you are reading the tl;dr instead of the post you were hoping not to read long definitions of technical terms to start with ;)

Efficiency

The big word that gets thrown around a lot by economists and their detractors is efficiency.

You'll hear it used to explain why such a tax policy is “obvious”. You'll hear it used to critique the cold-hearted, impractical, thinking of economists. And in almost every circumstance the person using it would struggle to articulate what the term actually means.

However, a key advantage I have in these debates is that I'm not very smart - so I struggle to understand unless someone is quite specific with me. Due to two decades of this I have some idea of what “should” be meant when we talk about efficiency with respect to a policy choice:

1. Limited Distortions: It does not change someone's choice between various options - what is called a distortion of their choice.

2. Corrections/theory of the second best: If someone's choice is already distorted (due to poor information, market power, biases, or other policies) it corrects for this - subject to other potentially better policies not being used.

Now there are simplifications here that matter (i.e. these are not changes due to the person having less income, just the relative attractiveness of varying options - as a result behaviour may not change but there may be a big distortion). And it is not also clear why we care.

The answer is that allowing individuals to trade freely without imposing a wedge between the values they would be willing to buy or sell for allows all trades to occur where the buyer values to product more than the seller. What an economist calls maximising surplus.

Efficiency is the principle of removing impediments to individuals trading with each other - such that as many situations where buyers and sellers would gain from trade occur as is practicable.

Some forms of taxes are distortionay/inefficient due to pushing individuals towards the untaxed choice (i.e. chasing capital gains, focusing on home production rather than labour income) - they are then inefficient relative to a tax that raised revenue without such distortions.

And before you say it market power is a distortion because a firm with market power realises that selling at a price “spills over” onto the price they can sell to other customers - leading to them not trading with people that they would otherwise want to. It is inefficient - and this is not due to greed, but instead due to the same efficiency arguments we would levy at a tax.

This is also not necessarily technical efficiency - if individuals enjoy a process more that uses more inputs, or happen to have gotten stuck in their ways in terms of how they serve coffees in their cafe, then this outcome can still be economically efficient even if the engineer in all of us would demand it was not technically efficient with reference to some notion of optimal production. Economists don’t really help themselves on this one with how we teach efficiency using a productive frontier - myself included!

A core thing that I’d like to say is about efficiency is that it represents the idea of letting people live free from all social chains that restrict their ability to make choices - efficiency isn’t about cold hearted technicality, it is about allowing buyers and sellers who have a double-coincidence of wants meet and satisfy this. It is a social process with all the strange and wonderful thoughts and feelings that different individuals have in life.

And the threats to this come from all sorts of directions - it could be in government regulation, monopoly, institutional discrimination. And it could also be solved by government regulation, social pressure, and institutional change.

Side note: If you need a term, we’re just talking about allocative efficiency here.

The ups and downs of equity

Equity itself often gets called “fairness” and by itself it is just as vague. So we want to be a bit more specific - and to do that we split equity into two types: horizontal and vertical.

OK so horizontal equity is the first term discussed, and nicely follows from efficiency above.

Horizontal equity is about treating individuals in the same circumstances the same way - or relatedly treating decisions individuals could take equally.

A tax system that taxes all forms of income the same way - at the same rate, with the same timing, allowing the same expenses - would be said to satisfy horizontal equity. Having tax rates that are similar for people with a similar level of income may also be seen as satisfying horizontal equity.

But is income really what we mean by equals? What about if someone is in a circumstance where they have higher living expenses, how do we consider this?

If I was to say it simply - horizontal equity is the rule that we try to treat people the same way. It is a rule that we should be a bit firmer about.

Vertical equity is another important - but even vaguer - element. You will find a lot of people saying they can measure this and that their measure tells us what is fair. This isn’t that helpful.

The Verticle equity principle here is that individuals who earn more pay proportionally more than those who earn less.

Not just that they pay more, but that they pay a greater share of their income - or however we define their “capacity to pay” or ability to contribute to pay for government spending.

How much more is fair? How the hell would I know. Saying that we measure vertical equity and we want it to “go up” is just saying that high income earners should pay a higher share of income tax - at some point most individuals would probably say there is a limit to that.

There is a concept called “modern horizontal equity” that states that the rich person giving up funds until they are poorer than the poor person (reranking) is probably unintended - and so that shouldn’t really be counted.

But more broadly, our willingness to say that some differences are admissible isn’t the end of the world. In fact, extreme purity testing of equality demeans the difference between true injustice and slight unfairness - so instead of looking at one fairness measure to rule them all it is important to understand who would win and who would lose.

A typical economist would say that this takes us straight back to talk about efficiency with redistribution through taxes and transfers to people. Allow people to trade with each other, but make sure individuals are endowed at birth with the opportunities to live a good life - and a safety net when things go wrong.

And you don’t need to be an economist to discuss what you think those choices are, and what trade-offs you think we as a group should be willing to accept. Instead you just need to be human. And the decision about which way to go with these systems is determined at every election - so what economists can do is to try to communicate what those trade-offs genuinely are.

Summing up

There were a lot of words here. But the words were necessary to not mislead about what we meant.

Efficiency often gets confused with “firms making more sales”, equity is often confused with “what is fair”.

I’ve even heard other economists talk about tax policies that increase vertical equity as being clearly and objectively preferable, and that principles of efficiency are overrated. And I agree with Henry that using actual words here would improve the clarity and transparency of what is being said!

But these individual terms are part of a clear discussion of what tax is and what trade-offs exist from tax system choices. We use these terms to express an entire paragraph of text and examples of how they work - because they have a particular meaning.

I’m surprised there isn’t a desire to instead help the public, and those who communicate directly to them (politicians and journalists) to understand what these terms mean so that they can engage with them - as a form of civic literacy. To quote Joan Robinson:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

Our three terms can be paraphrased as:

1. Efficiency: A tax that influences the choices of buyers and sellers less than alternative ways of raising the same revenue (including cutting spending).

2. Horizontal equity: A tax that treats similar people in a similar way.

3. Vertical equity: A tax that takes proportionally more from someone with a greater capacity to pay.

But do we really think instead using these descriptions would clarify what we should measure, and where our views may differ on tax issues? Or without getting people to truly engage with the complexity do these summaries because rhetorical word games that people can play to simply persuade others to give them a tax subsidy?

Does an oversimplification of these concepts lead people to believe we are measuring them with more certainty than we are and that we can target them? In my view, it does - and if you are the type of person who rails against the oversimplification of GDP and CPI, I hope this gives you similar pause.