Opinion: Using the Tax System to Create New Resources Out of Thin Air

ETHOS Issue 08, Aug 2010

Economists are fond of saying "there is no free lunch" — by which we mean that having more of one good thing requires making do with less of something else. An apparent exception occurs when existing arrangements are wasteful. In that case, we can have more of everything by eliminating waste.

A cursory review of historical attempts to eliminate waste in the public sector offers little encouragement. For decades, conservative political leaders across the globe have been cutting taxes on the promise to eliminate wasteful public programmes, but wasteful programmes remain. The problem is that government programmes tend to have constituencies. When pressure to cut government spending grows too strong to resist, the programmes that get cut are not the most wasteful ones, but those with the least powerful constituents. History cautions against expecting more than token victories from such efforts.

Private waste is a different matter. Although conventional wisdom holds that far more waste occurs in government than in the private sector, the truth is actually the reverse. More importantly, private waste is far easier to eliminate than public waste.

One important form of private waste is caused by garden-variety market failures such as congestion and pollution. This type of waste yields easily to simple instruments such as gasoline taxes, effluent charges and congestion fees, as many of Singapore's economic policies already demonstrate. A less widely recognised but far larger form of private waste stems from "positional arms races", which are well illustrated by the familiar stadium metaphor: all stand to get a better view, yet no one sees any better than before. It is the same with many forms of consumption. Hedge fund managers need huge houses and Gulfstream jets only because their peers have them. Evidence suggests that if top earners all spent less on such things, their lives would be no less fulfilling than before. Like the waste that stems from pollution and congestion, the waste caused by positional arms races can be curtailed sharply by a relatively simple change in tax policy.

SLOWING THE POSITIONAL ARMS RACE

As the economist Richard Layard has written, "In a poor society, a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses."¹ For the last three decades, virtually all income gains in the United States have gone to top earners. In most other countries, the growth in inequality began somewhat later, but virtually no country has escaped this global trend. In Singapore, as in most other nations, inequality is growing because most income and wealth growth has been accrued to those who were already near the top of the economic pyramid.

Top earners have spent much of their extra income on positional goods — things whose value depends heavily on how they compare with similar things bought by others. Like mutually offsetting weapons in a military arms race, consumption of this sort is largely wasteful. Such wasteful competition occurs because people take too little account of the costs that certain types of consumption impose on others. When one job applicant spends more on an interview suit, for example, others must spend more as well, or else accept lower odds of getting a call back. Yet when all spend more, no one's odds of landing the job are any higher than before.

Evidence suggests that satisfaction depends more on relative consumption than absolute consumption.

Although there is little evidence that middle-income families resent the spending of top earners, they are nonetheless affected by it in tangible ways. Additional spending by the rich shifts the frame of reference that defines what the near-rich consider necessary or desirable, so they too spend more. In turn, this shifts the frame of reference for those just below the near-rich, and so on, all the way down the income ladder. Such expenditure cascades help explain why the median new house built in the US is now about 50% larger than its counterpart from 30 years ago, even though the median real wage has risen little since then. In Singapore as well, expenditures on housing have been growing at rapid rates, even among people who have experienced little income growth.

Higher spending by middle-income families is driven less by a desire to keep up with the Joneses, than by the simple fact that the ability to achieve important goals often depends on relative spending. In almost every society, for example, the best schools tend to be located in the most expensive neighbourhoods, which means that if the median family failed to match the spending of its peers on housing, it may have to send its children to below average schools. Instead, middle-income families in most countries have opted to save less, borrow more, work longer hours and commute longer distances than ever before, all in an effort to keep pace with escalating consumption standards. While additional outlays for positional consumption goods — such as houses beyond a certain size — do not accomplish much, the same dollars could be spent in other ways that would produce real improvements in the quality of life, such as freeing up more time and resources to spend with friends and family, or on a healthier lifestyle or continuing education.

Such waste can be easily curtailed by existing policy instruments. In a world of perfect information, the ideal remedy would be to tax different goods in proportion to the extent to which their use generates negative side effects. In practice, we lack the detailed information necessary to implement this remedy. But a steeply progressive tax on each family's total annual consumption would serve almost as well.

If a progressive consumption tax were phased in gradually, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster.

First, a brief word about how this tax would work. The amount a family consumes each year is simply the difference between what it earns and what it saves. People would report their income to the tax authorities as they do now, and also their annual savings, much as how people in the United States currently document their annual contributions to tax-sheltered retirement accounts. The difference between these two amounts, less a large standard deduction — say, US$30,000 for a family of four — would be the family's taxable consumption. Rates would start low, perhaps only 10%. In this illustration, a family that earned US$50,000 and saved US$5,000 would have taxable consumption of US$15,000 and pay only US$1,500 in tax.

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise too far without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives. Even more striking gains would result from the tax's indirect effect on the expenditure cascades that have made life more difficult for middle-income families. If the rich spent less on housing, gifts and other things, the near-rich would spend less as well, and so on, all the way down.

Some may worry that tax incentives for reduced consumption might create or prolong an economic downturn. But it is total spending, not just consumption, that determines output and employment. If a progressive consumption tax were phased in gradually, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster.

Should a recession occur, a temporary cut in consumption taxes would actually provide a much more powerful stimulus than the traditional temporary cut in income taxes. People would benefit from a temporary consumption tax cut only if they spent more right away. In contrast, consumers who fear that they might lose their jobs in a recession are often reluctant to spend a temporary income tax cut.

When large pollution or congestion tax increases have been proposed in the past, critics have objected that they will impose unacceptable hardships on the poor. If a progressive consumption tax had a large standard deduction, that would largely insulate the poor from additional economic hardship. But if policymakers wanted to do more to promote the economic well-being of low-income families, they could use some of the revenue from a progressive consumption tax to finance a simultaneous reduction in the payroll tax.

Free-market enthusiasts often complain that higher taxes make the economic pie smaller, but taxes on harmful activities have precisely the opposite effect. When the economic pie grows larger, it is always possible for everyone to have a larger slice than before. By eliminating waste, these taxes free up resources for things we actually value.

How A Progressive Consumption Tax Would Work

Consider a wealthy family that currently spends US$10 million a year and is debating whether to add a US$2-million wing to its mansion.

If the top marginal tax rate on consumption were 100%, the project's cost (including tax) would be US$4 million.

Alternatively, the family could scale back, building only a US$1-million addition. Then it would pay US$1 million in additional tax and could deposit US$2 million more than before in savings. Government revenue would rise by US$1 million, and the additional savings would stimulate investment, promoting growth.

Either way, society would come out ahead with no real sacrifice required of the wealthy family. Because the tax would induce most other wealthy families to scale back their mansion additions, it would lower the bar that defines an acceptable mansion for families in their circle. In effect, it would create real resources out of thin air.

TAX MORE TOMORROW

With much of the world economy still in the midst of a deep downturn, no additional taxes should be levied on low- and middle-income households in the short run. Under the circumstances, however, there would be considerable advantage in a gradual phase-in of a progressive consumption tax, to begin once unemployment has again fallen to a suitably low threshold. At first, we could collect income taxes as before and levy a progressive surtax only on consumption in excess of some high threshold — say, $500,000 annually. The threshold could then be lowered gradually until the consumption tax completely replaced the income tax.

By eliminating waste, these taxes free up resources for things we actually value.

Alternatively, the current income tax could be retained permanently and be supplemented with a progressive surtax levied only on extremely high levels of consumption, as the economist Larry Seidman has proposed.² Since this surtax would apply to fewer than 1% of households, Seidman's approach would be administratively far simpler and hence likely to provoke less political resistance.

One compelling advantage of a gradual phase-in is that it would provide an immediate and powerful demand stimulus. With a steeply progressive consumption tax looming on the horizon, top earners would accelerate any major purchases they had been planning to avoid paying the additional tax.

Intelligent policy design requires realistic models of human behaviour. Contrary to the assumption that underlies traditional economic models, evidence suggests that satisfaction depends more on relative consumption than absolute consumption. This finding is confirmed by experience. Most people, for example, recall being happy during their student days despite living at a much lower material standard. If we take the relevant evidence at face value, there is nothing controversial about the claim that by slowing the rate of growth in spending on positional consumption and cutting back on activities that pollute the planet, we can free up resources to spend in more effective ways. Nor is there any controversy about the policy instruments needed to bring about this change. Pollution taxes have proven their effectiveness in the environmental domain. Precisely the same type of market failure that leads economists to favour those taxes is present as well in the case of positional consumption expenditures.

Progressive consumption taxation has long been proposed by both economists from all parts of the political spectrum. It is a policy move that would create valuable new resources out of thin air.

ABOUT THE AUTHOR

Robert H. Frank is the Henrietta Johnson Louis Professor Management and Professor of Economics at Cornell University. Until 2001, he was the Goldwin Smith Professor of Economics, Ethics, and Public Policy in Cornell's College of Arts and Sciences. He has also served as a Peace Corps volunteer in rural Nepal, chief economist for the Civil Aeronautics Board, fellow at the Center for Advanced Study in the Behavioral Sciences, and was Professor of American Civilization at l'Ecole des Hautes Etudes en Sciences Sociales in Paris. His books include Choosing the Right Pond, Passions within Reason, Microeconomics and Behavior, Luxury Fever, and What Price the Moral High Ground? The Winner-Take-All Society, co-authored with Philip Cook, was named a Notable Book of the Year by The New York Times, and was included in Business Week´s list of the ten best books for 1995. Professor Frank holds a BS in mathematics from the Georgia Institute of Technology, an MA in statistics and a PhD in economics, both from UC Berkeley. Professor Frank visited Singapore in November 2009 at the invitation of the Centre for Public Economics, Civil Service College, to speak on "The Economic Naturalist: In Search of Solutions to Everyday Enigmas" and "Falling Behind: Income Inequality and Middle Class Disaffection".

NOTES

1. Layard, Richard, "The secrets of happiness", New Statesmen, 3 March 2003, http://www.newstatesman.com/200303030016

2. Seidman, Laurence S., Pouring Liberal Wine Into Conservative Bottles: Strategy and Policies (University Press of America, 2006).

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