Cut the right taxes

Taxing incomes is no panacea for improving social equity.

By JONATHAN LIPOW
June 18, 2006 21:01
4 minute read.
shekels coins 88

shekels good 88. (photo credit: )

 
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Finance Minister Avraham Hirchson is reportedly considering a reduction in VAT rates from 16.5% to 15%. Is this a good idea? In one sense, the answer is unambiguously yes. Israel's tax levels appear to be far higher than those required to fund all projected future spending needs. This means that if Israel does not reduce taxes by a little today, it will end up reducing taxes by a lot tomorrow. That would be a mistake.

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It is more efficient to set a single tax rate that will meet projected spending needs than to constantly fiddle with tax rates over time. The theory behind this, known as "tax smoothing," was originally articulated by conservative scholars like Robert Barro, Nancy Stokey and Nobel Laureate Robert Lucas, but the ideas behind it enjoy universal acceptance among economists. Underpinning tax smoothing is the entirely reasonable proposition that the damage caused by taxation goes up exponentially with increases in tax rates. This means that faced with the choice of having a 20% tax today and zero taxes tomorrow, or alternatively having a 10% tax both today and tomorrow, the latter option will do less damage to the economy. But does it make sense to reduce VAT as opposed to other taxes such as income tax? Here, the analysis becomes more complicated and the issues more subtle. In my view, however, the only logical conclusion is that rather than reducing VAT, taxes on capital gains, dividends and income should be lowered. HOW DO income tax and VAT differ? Put simply, VAT is a tax on consumption, while income tax is, not surprisingly, a tax on income. For two reasons, consumption taxes are inherently superior to taxes on income. The first is that income taxes discourage investment while consumption taxes do not. To understand why, consider Sara, a woman who must decide how much to consume now and how much to invest in order to consume more during retirement. Faced with a tax on consumption both in the present and future, Sara will choose some reasonable level of investment. An income tax, however, is another story. If Sara invests in order to consume more in the future, she will have to pay taxes on the earnings of her investments. If she consumes more now, she can avoid paying additional taxes. Faced with an income tax, Sara will likely reduce future consumption and increase consumption now. Across the economy, such behavior translates into lower investment and economic growth. While readers may understandably be skeptical that people actually make decisions based on these complicated considerations, study after study confirms that real-life Saras - whether consciously or not - actually make decisions that are remarkably consistent with this pattern. THE SECOND argument in favor of consumption taxes is that consumption varies much less than income. A temporary 5% rise or fall in income usually results in only a 1% change in consumption. This means that the revenue stream produced by taxes on consumption is far more stable than the revenue stream produced by income taxes. Why is a stable revenue stream an advantage? To put it bluntly, during economic booms, governments invariably squander the resultant fiscal windfall. Faced, however, with the revenue shortages triggered by slowdowns, governments are forced to cut back even essential spending. This is the public policy equivalent of "sugar highs" and "insulin lows." Just as swings in blood glucose levels can endanger your health, fiscal boom/bust cycles endanger public welfare. But if VAT is so obviously superior to income taxes, why is the Finance Ministry thinking about reducing VAT? The answer is social equity. Hirchson seems to be trying to show that he regards narrowing Israel's dangerous socioeconomic gaps as his highest priority - as it should be. Since it is widely believed that the income tax system redistributes income to the poor, while VAT does not, his thinking seems understandable. The problem is that, in practice, income taxes do not prove to be more "progressive" than VAT. While income tax systems can appear to redistribute income on paper, there is a huge gap between official tax policies and what people actually pay. Why? Consider Israel's veritable army of tax lawyers and accountants. What do you think these people do to make a living? In addition and as discussed, tax systems that are dependent on income taxes produce lower levels of investment. This means that capital is scarce relative to labor, which in turn makes wages lower and profits (per unit of capital) higher. Given that the rich are dependent on capital income while the poor are entirely dependent on wage income, it becomes clear that income taxes are not nearly as progressive as they may seem. The bottom line is that Hirchson should cut taxes - but he should focus on reducing taxes on income, dividends, and capital gains. The writer is a senior lecturer in economics at the Academic College of Judea and Samaria and is the portfolio manager of the Forum International Equity Fund.

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