When is Taxation Fair?

I had a long conversation with my brother while in Europe, and it sparked a lot of thinking inside me. We were talking about the Obama Administration’s concessions during last year’s budget negotiations and the resulting extension of tax cuts for the rich. From that instance we moved on to a more general topic: what is fair taxation?

We noted at first that since the beginning of the idea, taxation was driven by ease of implementation more than by the idea of fairness. It’s not just about who can afford to pay taxes, it’s also how you assess taxes in a way that a government bureaucracy can successfully monitor and demand. Additionally, it’s pointless to demand money where there is none, so a lot of governments focus on taxes to be paid while money changes hands – in that case, you know there is money somewhere.

I noted, on the other hand, how the treatment of corporations (including incorporated individuals) and employees is radically and vastly different: corporations have income and expenses, and taxes are (largely) paid on the difference between the two. Employees have income and expenses, but the taxes are (largely) paid on the income alone. That is, if a company needs an office, it doesn’t pay taxes on the office rent; if an employee needs an apartment to live in, that employee pays taxes on the apartment rent.

The logic, of course, is that everybody should be treated like corporations. Taxes should be paid only on the part of the income that you are saving. The problem with that is that nobody saves – and so there would be no taxes paid. But in the end, that’s exactly how rich people manage not to pay money: they funnel it into corporations that need to buy precisely the things the rich need to buy, and hence the corporation doesn’t pay taxes on the thing, while the rich person keeps that very thing. Nothing illegal happening, not even immoral – because the immoral thing, if at all, is that people have to pay taxes on things they need (like the roof over their head).

But why do we pay taxes at all? The answer, because we need to fund different things that are necessary, doesn’t satisfy. After all, nobody is asking you whether you need those things, and if you don’t need or want those things that others believe necessary, why should you pay for them? Let those that are so fond of them pay!

I’ll give you an example: my beautiful house in Hawai`i costs me a small fortune in county property taxes. Now, the county takes my money and pays for schools, roads, power lines, sewers, water, gas, police, fire stations. I have no kids that go to school, I haven’t gone to school in Hawaii, there is no road the leads to my house, I have no power coming to the house, the sewer line doesn’t make it as doesn’t the gas line, when the house was burglarized and my truck stolen, police did absolutely nothing, and let’s not even talk about fire trucks coming up the hill. Why am I paying taxes, then?

I think the answer is simple in general: we make money, establish wealth, and part of the wealth we have is due to the presence of society and government. The most basic example is the existence of property law and law enforcement. If there was no law enforcement, we wouldn’t really own anything, because the next guy could take it from us. So we need to pay for police and courts and prisons and even congresspeople because otherwise we wouldn’t own anything – or couldn’t keep what we own.

Aside from that, the holding on to property, even the generation of new wealth depends on infrastructure. The Chinese are reaping the benefits of having understood that logic, since they are now fueling their gigantic growth with the infrastructure (roads, railways, power, education) they have built over the past three decades. India, a country that could (thanks to lower language barriers) be much more apt at doing the things that China does is stuck behind, largely because it is close to impossible to count on manufacturing things on time there for the moment.

So, to me the logic is simple: we increase our wealth in part thanks to the infrastructure provided by government. As a result, it’s only equitable that the government get a cut of the wealth increase (income) we have. The only point of contention is how large that part should be, and on what kind of parameters it should be based.

If we wanted a very simple way of dealing with this, we could propose the following deal: rank all people by wealth; see how much wealth the same people have the following year; determine the average increase in wealth for each wealth group; take a certain amount from this average wealth.

For instance, assume that people owning $100,000 will own in average $120,000 a year later. They made a profit of $20,000. Let’s say the government takes half of it – then the government takes $10,000 in taxes.

Wait, wait! That means that you have to pay $10,000 in taxes regardless of whether you actually made $20,000! It also means that you would pay $10,000 in taxes even if you made $100,000 that year! Well, yes, that’s right: the government is not really interested in how well you did, only in how well the average person did. If you manage to increase your wealth by nothing in a year, then someone else should have taken that money and done something better with it. After all, that’s what we do with mutual funds: if the return on investment is not as good as the next fund, we ditch them.

So, assume you own land worth $10,000,000. Let’s assume that people with $10,000,000 have in average $12,000,000 a year later. Then they would have to pay $1,000,000 in taxes (50% of the increase in wealth). What if they don’t have that kind of money? Well, then the government owns 10% of their land. Why? Because while they weren’t able to make any money off the land, the average person would have, and it would be better for everybody if that other person actually had.

What’s the point of all of this? The point is that you should be punished for not doing anything, while you should be rewarded for doing well. Also, you shouldn’t keep things that you don’t actually use, because society is better off if you actually use them.

Take the example of the rich land owner that lets his/her land lie fallow. Maybe he or she just has too much land to farm, maybe he or she is speculating. In any case, that land owner will end up with a resource (land) that generates no income. Someone else could have taken that resource and made income with it (which he or she could have shared via rent or lease to the land owner), which is in the interest of society at large. As a result, the land owner should have to pay for the land unused.

But doesn’t this system encourage debt? Isn’t this system such that it becomes a burden to own anything? The answer, of course, is that it becomes a burden to own anything unproductive. So much so that in this system, you end up automatically losing (at the tune of 10% a year) the things that you don’t use. But what’s wrong with that? You lose the thing you don’t use.

Of course the is the not insignificant problem that the “stuff” you own isn’t shared with people that have a use for it: it simply passes to the government as taxes. What’s with that? Well, the answer to that is twofold: first, the government can function as a broker, taking the unused property and passing it on (selling it) to someone willing to pay for it, because that someone has an idea of what to do with it; second, the taxes paid by unused property are taxes not paid by used property.

What does this mean? If you go an look at current charts of wealth and income distribution, you notice that an astonishing amount of the wealth is owned by a small fraction of the country. Notice that income distribution is much less uneven, making it clear that wealth is not produced by hard work (since the most successful workers are not as rich as the richest individuals).

I started this post thinking about how corporations and employees are taxed differently: the former are taxed on profit (income minus expenses), while the latter are taxed on income alone. The average employee will have to carry average expenses taxed, while the corporation will not. If the average employee spends, say, $35,000 a year on rent, leases, food, etc., that’s in average $10,000 that the employee has to leave on the table because of this difference.

In other words, the average poor and middle class person is subsidizing the rich. Why, nobody knows.