Fantasy Stories About Tax

Here we have another characteristically dodgy article from Duncan Weldon in The Guardian, who foolishly believes that the way to sort out the public sector crises of unaffordability is to throw more and more money at them (I argued here that that is the precise opposite of what we need). Like giving more chips and ice cream to a morbidly obese child, pouring more money into crisis-ridden services is only going to conceal the deeper rooted problems, and will consequently make things worse in the end. This is a point that has been made on here repeatedly in recent times.

What I haven't mentioned quite so recently is the other big problem seen throughout articles like the one above - a misunderstanding of who tax actually affects and in what way. Take, for example, the call for higher corporation tax on the basis that by taxing big corporations more there will be more to redistribute to struggling families. It's a simple idea, but like many simple ideas, it is simply wrong.

The main problem is that the definition is factually inaccurate, because corporations don't actually pay tax - only individuals pay tax. The cost of corporation tax is primarily borne by customers (with increased prices of goods or services) or employees (with decreased wages) to avoid being borne by shareholders (through lower dividends). Corporations pay tax only in the sense that the cheque or debit is written in the name of the company. If the cost of taxes ultimately falls on individuals in the form of higher prices of consumption and lower wages (or in some cases increased unemployment) then a tax policy that tries to hurt corporations is simply a tax policy that harms the people the lefties are trying to help.

Abolishing corporation tax and taxing at the level of shareholder dividends and high-end consumption at an increased rate, coupled with a reduction in the top rate of income tax, would do more to boost the UK economy than any of the flimsy policies most MPs proffer. But because the abolition of corporation tax and top rate reductions are about as attractive as a fart in a space suit to most of the electorate, no political party is brave enough to implement them.

Another thing not often realised is that the cost of tax to an individual is greater than the sum of money paid to the IRS in 1s and 0s. To see why, suppose that the demand for highly skilled workers like doctors, surgeons, IT directors and financial advisers is very inelastic. If taxes on high skilled jobs are high, it will reduce numbers of doctors, surgeons, IT directors and financial advisers, which will mean that consumers pay the price through higher fees for those services.

Where the demand is inelastic, high taxes on such workers reduce the number of suitable people willing to train for those jobs, with the result being that customers in need of their services bid up their wages at a cost to their own pocket. In other words, the cost of the tax is a transfer from those that pay the tax to those that consume the services of those in the high skilled industry.

A similar issue arises with the minimum wage, where the state-enforced increased cost to employers is a cost that is passed on to consumers with higher prices or fewer jobs. Further, PAYE taxes (that's income tax and national insurance) are a tax on labour, which of course means that you get less than the optimum amount of it. Whether PAYE taxes are paid by the employer (before he pays wages) or by the employee (when he receives wages) doesn't matter much - they are essentially the same tax on labour.

The place where the ultimate burden of tax falls is largely contingent on supply and demand's elasticity. If the supply of labour is elastic then that means prospective employees won't be particularly sensitive to wage levels, thereby placing the burden on employees. If on the other hand employers have to increase wages to hire good workers then the tax burden falls on the consumers of what those workers produce.

Income taxes interfere in the market of trade by diminishing value in society too. This happens because income tax means there are fewer transactions, as exchanges that would otherwise benefit both parties now do not take place. Suppose I am willing to pay no more than £11 per hour to have some work done, and I have some workmen who are willing to do the work for £10 per hour. That being the case the transaction should take place and both buyer and seller will be happy with a £10 an hour hourly rate.

But once the government imposes 20% income tax, things change, because now the most the workmen can earn from me in net pay is £8 per hour, which means they'd be unwilling to do the job for me. In order to satisfy the workmen's earning needs, the 20% income tax means that the workmen have to charge me £12.50 an hour to clear £10 an hour. What then transpires is that either the work doesn't get done because I'd rather not spend that much money, or else I end up doing it myself and making a much less good job of it.

The upshot of all this is that tax is not some kind of magic money tree that can be obtained without negative consequences. People who wish to tax us out of crises usually miss three vitally important things:

1) Tax something and you usually get less of that thing, which in many cases means the nation is worse off by the reduction.

2) Tax something to bestow benefits to one group of people and you usually find that what you give to them in one hand you take it out of their other hand a short time after.

3) Tax something and you also end up hurting other groups you have usually totally forgotten about.