Left-wing populists and demagogues are promising massive transfers through taxation from the rich to the poor. But they will not succeed...
The American journalist H. L. Mencken once famously remarked that elections were advance auctions of stolen goods. His observation certainly seems to apply to the parliamentary elections in Iceland which are to take place on 25 September. The left-wing parties are all engaged in a fierce competition about which of them can promise the most generous transfers to special interest groups from the taxpayers. Of course they assure the general public that it will only be the rich who will feed the bill, the now-notorious one per cent. Others need not worry, they assert.
Perhaps this is the occasion to restate some of the reasons why such a strategy is bound to fail, not only today in Iceland, but always and everywhere. First, the very rich have ample resources to avoid or evade excessive taxation. Their property is frequently capital which is easily transferable across borders, and they can hire a whole army of accountants and lawyers to organise their tax affairs. In the second place, and consequently, the taxmen will never be right on target: they will have to tax a much larger group than the one per cent if they are to obtain the revenue necessary for all the additional transfers promised during the election campaign.
What is however crucial is the long-term effect of heavy taxation. It is that the tax base shrinks because productive individuals shift their efforts into untaxed or lightly-taxed channels. They work fewer hours and they try to receive some of their remuneration not in cash, but rather in various perquisites such as lavish offices, frequent trips to exotic places, share options and suchlike. The taxmen try of course to go after such perquisites, but they are usually a few steps behind in the hide-and-seek game. Occasionally, the well off also move into the underground economy, not only avoiding taxes, but also evading them.
The main explanation for the fact that Europeans work much less than Americans is, the American economist and Nobel Laureate Edward C. Prescott suggests, that they are taxed more aggressively on their income. Less work means a smaller tax base over time. This is an old insight but it was memorably articulated by American economist Arthur Laffer who once plotted tax revenues against the tax rate, showing that the revenues might reach a maximum point at a certain level of taxation and that it would then fall even if the tax rate would increase. This is no idle theory. For a while in the 1980s and early 1990s the tax revenue per person was roughly the same in two comparable European countries, Switzerland and Sweden, whereas the tax rate in Sweden was almost double the tax rate in Switzerland. It became clear to the Swedes that they were finding themselves on the wrong side of the Laffer Curve where an increase in the tax rate led to a decrease in tax revenue. Indeed, the only jobs that were being added were in the public sector. Since the 1990s, the Swedes have gradually retreated from the worst excesses of the nanny state, lowered taxes and facilitated wealth creation by entrepreneurs and innovators.
We observed a Laffer Effect in Iceland when we gradually lowered the corporate income tax from 50 per cent in 1985 to 15 per cent in 2003. In this period, the revenue from this tax actually rose considerably, in proportion to Gross Domestic Product, GDP. The reason was that the tax base grew with the growth of the private sector, while tax returns became more accurate and tax evasion less frequent. Another small but telling example of a Laffer Effect was about rental income. It had been taxed at the same rate as marginal personal income, close to 50 per cent. Then we changed the rules, upon which it was taxed as capital income, at the rate of 15 per cent. Initially, the revenue the government reaped from rental income decreased, but nevertheless in a period of a few years it reached its previous level. There were two main reasons for this. The supply of rental housing increased when owners of real estate saw that they would only have to pay 15 per cent on the income from their real estate instead of 50 per cent. And those who had rental income were more willing to declare it on their tax returns when it was taxed at the rate of 15 per cent than when it was taxed at the rate of 50 per cent.
The Laffer Curve is a heuristic device rather than an accurate description of the relationship between tax revenues and the tax rate. It shows to the left-wing populists, demagogues, bureaucrats and would-be recipients of government transfers that after taxation has reached a certain level, it becomes self-defeating. Then it becomes harmful not only to the taxpayers, but also to the taxmen themselves. This does not mean that the maximum point on the curve would be an optimum. The objective should not be to set taxation at a level which would maximise government revenues. Nor should it be to set taxation at a level which would maximise economic growth, although this would be a more reasonable objective. The objective should simply be to gather enough revenue to pay for the services which government should offer to the citizens. The American economist and Nobel Laureate James M. Buchanan was once asked what would be the optimum level of taxation. He replied that this was for the taxpayers to decide but that he would estimate the production of real public goods to require perhaps around 15 per cent of GDP.
Those who advocate massive redistribution of income through the tax system tend to overlook that the system is already now significantly redistributive. At present, in most countries the poor pay almost no taxes, whereas the rich pay almost all the taxes. For example, in the United States the notorious one per cent earned 21 per cent of total income in 2018, but it paid 40 per cent of all income taxes. The highest-income ten per cent paid 71 per cent of all income taxes. Moreover, as one of my colleagues at the University of Iceland, Economics Professor Ragnar Arnason, has shown, even a flat income tax (with only one tax bracket above a tax-free minimum) would be significantly progressive. His reasoning is simple and persuasive. We should distinguish between the gross and the net tax rate where the latter would be the outcome of weighing together benefits and burdens. It is plausible to assume that government produces more or less equal benefits for rich and poor, but it is a fact that almost all the burdens are borne by the better off. Thus, the net tax rate when benefits have been taken into account is much more progressive than the gross tax rate.
The very fact that the rich and the moderately well off pay almost all the taxes leads to a thought experiment vividly displayed in Ayn Rand’s novel Atlas Shrugged. What would happen to a society if its most productive part, the innovators and entrepreneurs, would tire of being exploited and decide to leave? It would be quite unlikely that others would smoothly take their place, especially because they would encounter all the hurdles and hindrances left behind by the emigrants. What would most likely happen is that the economy would stagnate, as it does in Rand’s novel. Yet again, this is not only a figment of her imagination. This happened in Cuba when the entire educated middle class fled, and it is now happening in Venezuela. This happened also in Spain in late fifteenth century when the Jews were expelled, in Algeria in the 1960s when the ‘pied noirs’, the French-speaking minority, were driven out, and it is now happening in Zimbabwe and South Africa, as the White minority feels embattled.
When you try to soak the rich, you will end up with soaking everybody, including the poor who will be deprived of their chances to escape poverty through the old-fashioned virtues of hard work and thriftiness. It is as true now as it was in the nineteenth century that you cannot make the poor richer by making the rich poorer (a saying often attributed to Abraham Lincoln, but not found in his works). Moreover, there are cogent additional arguments for the desirability of the rich, or rather for a class of people who are financially independent.
Thus, the rich are led as if by an invisible hand to serve the public interest, even if this may not have been their intention.