While tax policy is a key element of every budget, certain underlying themes are present regardless of the party holding the reins of the Union government. One aspect is that it is taken as a matter of faith that the state has first claims to the earnings of citizens. This is based in part on a bias in favour of an aggregated perspective on the nature of taxation.
As such, economists wind up doing the work of spending agencies of governments by seeking the best way to fatten up taxpayers for slaughter. By focusing tax analysis upon aggregate outcomes, individuals become means to an end. As such, analysts neglect the preferences and behaviour of individuals as taxpayers and citizens. In turn, so-called democratic governments will often fail to serve the best, broad interests of their citizens.
The historical development of distinct approaches to tax policy is found in the work of two 19th century economists: Adolph Wagner of Germany and Knut Wicksell of Sweden.
Wagner influenced public finance through his belief in an expansive role for governments to mediate social conflicts arising from competition and markets. As the state facilitated economic development through conflict resolution, the public sector would grow more rapidly than the economy.
In Wagner’s view, a country with a high ratio of government expenditures to GDP (gross domestic product) would have a higher level of civility. His aggregated focus on taxes reflects what is known in German as “Staatstreue” (state devotion).
In contrast to Wagner’s theories, Wicksell thought a “just” system of taxes should focus on preferences and behaviour of individuals. This led him to propose that the provision and payment of publicly provided goods should approximate market transactions.
Wicksell had observed that tax policy in Europe of the 1880s and 1890s was “hijacked” by special interest groups. Ruling aristocrats used tax rules to impose high value-added taxes on items consumed by the working class.
He saw that democracy would devolve into competition to shift taxes to groups with the least capacity to lobby governments. Unless tax policy rules were changed, he believed that as the working class became dominant, it would (mis)behave like the aristocrats of the 1890s. Wicksell felt that a “just” tax policy must be kept from the short-term political arena and acquire the same universal legitimacy as basic democratic institutions, such as courts.
Wicksell worried about the tax consequences of candidates seeking support of different special interests by using new public expenditures to their benefit. This would lead to a “ratcheting-up” of public spending so that tax levels and structures do not actually reflect what most citizens want.
Wicksell envisioned constraining tax policy with a strong democratic filter so that no one would be forced to pay taxes for public causes that did not meet their approval. This means each individual should pay exactly the amount of tax corresponding to the amount of public service they consumed. Thus, taxes would approximate “user fees” instead of being forced payments for services or goods not consumed. This “Wicksell criterion” requires net contributors to be compensated for any new public spending proposal.
Wicksell also suggested that governments must inform citizens of the full tax consequences of all new expenditures in clear, simple language. Then, citizens could evaluate each new proposal and vote on it. Should even a small minority reject the proposal, it would not pass.
As it turns out, Finland implemented a super-majority requirement whereby two-thirds of parliament must approve changes in tax policy. Some local governments in US states also follow some variation of Wicksell’s proposal.
Another element is that each tax law would have a five-year limit before facing the scrutiny of citizens again. Such “sunset” requirements reflect the fact that circumstances change continuously and allow eliminating taxes imposed to solve problems that no longer exist.
It is important to note that Wicksell was not proposing to avoid all or even most taxes. He was looking for ways to provide long-term stability for financing a public sector within a democracy. As such, he was concerned with how individuals respond to government spending and tax rates when they are deemed to be too high.
Considering tax policy as a basic agreement whereby individuals prefer definite services from governments with a more-or-less constant “tax cost”, taxpayers want tax rates to fall as their income rises. Yet, income-tax rates have risen steeply and opened a “tax gap” between preferred and actual rates in most democracies.
Individuals should be expected to try to close the gap. Taxpayers lower their effective income-tax rate through avoidance or evasion or capital flight or brain-drain migration. Growing “informal” market activities in high tax countries indicates that taxpayers do close the tax gap to move towards Wicksell equilibrium that equates payment for and consumption of public services.
An important but widely neglected aspect of a tax policy is that legitimacy and acceptance depend upon citizens’ belief that they are served by them relative to their contribution. Wicksell saw this clearly and proposed that taxes be implemented to approximate market transactions whereby individuals seek to equate the value of a government-provided service relative to its (tax) price.
Economists should stop making life easy for politicians and bureaucrats by giving them the least-worst ways to raise taxes. Instead, public officials should be forced to justify all new expenditures or explain why current ones should be preserved. Then they would have less time to dream up endless schemes for spending more of the taxpayers’ money.
Kurt Wickman is professor of economics at Gefle University in Sweden and Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi. Comments are welcome at firstname.lastname@example.org