Professor Ben Ho, Vassar College
JK Rowling created headlines recently by asserting that unlike other wealthy individuals, she will not try to avoid paying taxes because she believes it is her duty to pay her fair share. She, like many celebrities who endorse higher taxes on the rich, seek to admonish wealthy CEOs and corporations like Apple who hide their wealth overseas to avoid paying taxes. Answering the question of what is someone’s fair share of taxes has been central to recent budget negotiations. The top 0.1% pay more income taxes each year than the bottom 80%. Whether this is fair has been a substantial source of controversy.
Defining fairness will always be controversial, a topic that has vexed philosophers from Plato to Rawls. Economics offers a coherent and perhaps surprisingly compelling answer on what constitutes fair amount of taxes that may not be apparent to the outsider. I am not arguing the economic view of fairness is the ultimate view, but it is certainly a useful one.
The central tension economists recognize is the balance between the two competing desiderata, equity and efficiency. We want society to utilizes its resources as efficiently as possible but we also want the output of society to be distributed equitably. Sometimes we can implement policy changes that improve both (a pareto improvement in economics jargon), but often as is the case for the most interesting policy questions, policy choices involve trade-offs.
The desire for equity vs. efficiency can be traced back to the first principles of utilitarianism most associated with 18th century philosopher Jeremy Bentham. The goal of society is to maximize the sum of everyone’s collective well-being or utility. Because a poor person values say a hundred dollars more than a rich person—for example I would get far more excited at finding a $100 bill than Bill Gates—it makes sense to want to redistribute wealth from the rich to the poor. However, the efficiency consideration comes into play because the higher the tax rate, the smaller the incentive there is to work, to produce, to innovate, to create jobs.
Using these principles, the Nobel Prize winning mathematical models of economists like Mirrlees defines the question as a trade-off between redistributing as much as possible balanced against the desire to distort incentives as little as possible.
One implication is that taxes should be higher on activities that don’t respond as much to monetary incentives (i.e. low elasticity activities for those who like the jargon). For example, if people like artists and athletes pursue their craft out of love rather than out of a desire for money, they should be taxed higher than those who work for money. More generally we should avoid taxing earnings that incentivize people to work and tax instead earnings that were incidental to their efforts. This idea also suggests we should tax more highly earnings that come from luck, rather than earnings that come from effort.
People intuitively seem to understand this. In laboratory experiments, people who are randomly given a windfall amount of money are more keen to share it than people who had to earn the money after performing simple tasks. Similarly, people will demand more money from someone else who “won” the money than from someone who “earned” it. This perspective also offers insight into popular perception of CEO salaries versus NBA salaries. While the 500 CEOs of the Fortune 500 companies make about as much money as the 420 or so players in the NBA, people generally begrudge the salaries of NBA players less than the salaries of CEOs.
Such logic has traditionally led economics to advocate lower taxes on the rich, for fear of reducing the incentives of the most productive workers. However, in recent decades, economists and other social scientists have found that despite the protestations of the rich, people may be less motivated by money than previously thought, and that most who are rich probably got there more out of luck than effort (see pop-writer Malcolm Gladwell’s book Outliers for a nice survey). Both findings suggest that taxes could be raised with less damage to the economy than previously thought. However, the fundamental logic that higher taxes come at the expense of efficiency still holds true.