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Wednesday, June 11, 2008

The Accountant and the Ditch Digger

Who bears the costs of government spending?

This is an important question because there is a very widespread misconception that those who pay the taxes bear the costs. By very widespread I mean that I've recently discovered that virtually everybody except my co-blogger (Howard) and a few other economically savvy persons seem to have this misconception.

As a simplification, consider an economy with only two types of jobs: relatively lower income ditch diggers and relatively higher income accountants. Let's say that income tax rates are raised for the accountants but not the ditch diggers. The misconception is this change in the tax rates would have no adverse effect on the ditch diggers since only the accountants pay more. Unfortunately, that's not true.

One general rule of economics is that if you tax something, you get less of it. Yes, there are exceptions, but those exceptions aren't applicable here. In this case the tax is on accounting labor so there will be less accounting labor. The mechanisms for the reduction in accounting labor include accountants working less overtime (or working part-time) and accountants retiring earlier. In addition, fewer people will put in the effort to become accountants so over time there will be fewer accountants and more ditch diggers. Fewer accounting hours and more ditch digger hours means that accounting hours get more expensive relative to ditch digger hours (in other words, the price mechanism is used to allocate the remaining scarce accounting hours to those persons and business that need them). As a result, the ratio of the after tax incomes of accountants and ditch diggers doesn't change all that much when the tax rates are increased for accountants.

The following chart illustrates the concept fairly clearly. Changing the top tax rate on the rich has had remarkably little impact on overall tax revenues. I readily admit that there are some distortions that are amplified by the way the data for the chart has been chosen, but the underlying concept is still true: changing tax rates on the rich have remarkably little effect on total tax receipts.
In addition, the remaining accountants (those who haven't retired or left the profession) are now charging businesses more for their services (because they can). Those businesses pass on these costs in their goods and services to the consumer. So the ditch digger, who is now making less (since there are now more ditch diggers), is faced with higher prices for the goods and services he consumes. Sure, the accountant is also faced with these higher prices, but since accountants make many times what the ditch digger does, the higher prices have a smaller impact on the accountant's household budget.

The bottom line is that progressive earned income tax rates end up not really being all that progressive when you consider who ultimately bears the cost. The cost of government spending is borne by all and because they have less resources, the poor suffer from those costs more than the rich. No matter what.

Taxing the rich will get you fewer rich, but it won't make the poor better off.


Harry Eagar said...

I guess he's proven that tax laws written for the rich benefit the rich.

Big whoops.

You assume taxes are a 0 sum game.

This is not correct.

If I pay taxes (through, say, a gasoline consumption tax) and that money is used to build roads, then I benefit not only by the amount of pavement mulcting me can provide, but by all the pavement that the government can lay down by mulcting all drivers.

It's simple really. I get way more roads than I could ever build were I never so rich.


Bret said...


First please notice the qualifiers. I was specifically talking about "earned income tax rates". Gasoline consumption tax is specifically not that.

However, consumption taxes tend to be harder on the poor as well.

The point is that the pain of government spending is always borne more by the poor.

Bret said...


Now that I've slept on it, I think I now understand your somewhat cryptic comment.

Yes, I agree that the government can provide useful goods and services.

My point is only that some people think that the poor don't bear any of the costs of those services if only the rich pay taxes. What I'm pointing out is that the poor pay those taxes indirectly. The rich will always pass a significant share of their tax burden on to the poor - because they can!

Harry Eagar said...

That isn't Hauser's point, though.

As long as the rich craft the laws to benefit themselves, they will benefit. Duh.

Hauser says you cannot mulct the rich.

You can. It may take a capital levy to do it, but capital levies have been used in the past.

There is a move to use them in America right now (against college endowments), though it has not been part of our tradition.

Bret said...

I was only using the Hauser's Law graph as an example of the fact that the rich pass taxes on to the poor. I agree that Hauser's Law is really a different point, and, as I mentioned in my post, is at least somewhat overstated in my opinion.

I also agree that "capital lev(ies)" are about the only possibility to actually tax the rich without affecting the poor as much as other types of taxes. Unfortunately, capital also has a tendency to "disappear" when taxed, so other than taxes on real-estate (which can't "disappear") which are pretty successful, capital levies also have limited value.

Howard said...

Hey, if the mob wants to abuse capital and then winds up with less investment and fewer jobs I guess that's getting what they want good and hard!

It's simple really. I get way more roads than I could ever build were I never so rich.

Up to a point. The bridges to nowhere and ethanol subsidies are really terrific for the economy...

Harry Eagar said...

Right now, the economy is limited mostly by shortage of labor, so if the subsidies didn't exist, it's doubtful the economy would grow much.

Besides, economic growth is not the only social good.

And on the third hand, if businesses paid the true cost of their leavings, instead of bucking it off to the public (Superfund, anybody?), then the brakes on growth would be (very likely) greater than from a progressive tax system, with the added benefit of a nicer country to live in, with the additional added benefit of a closer approximation to democratic ideals.

But if all you care about is growth, none of that counts? And that's all markets care about.

Which is why market worship is a bad thing.

joe shropshire said...

It may take a capital levy to do it...

Repeat after me: thou shalt not steal.

Bret said...

harry eagar wrote: "Which is why market worship is a bad thing."

Nobody here worships markets. Nobody here claims that there is no role for government in addressing negative externalities.

What we do look at is where government excels and where markets excel. Government is not the solution to everything and markets are not the solution to everything.

That being said, what's wrong with growth?

Harry Eagar said...

Interestingly enough, growth as growth has never been very high on people's to-do list.

Here are two books I have read this month that go into that pretty deeply, especially the first:

"Chants Democratic" by Sean Wilentz

"The Origins of Backwardness in Eastern Europe: Economics and Politics from the Middle Ages until the Early Twentieth Century," edited by Daniel Chirot

Howard said...

For some people maintaining the existing social order is most important. For others radical egalitarianism ranks highest. These people will always be in conflict with people who place great importance upon liberty although most people are willing to partake of the benefits of economic progress.

Howard said...

Bret offered an example of how attempts to sharply alter the relative after tax rewards of differing activities might trigger adjustments that countered such attempts and further that this might also run up against limits to how much tax would be collected. The point of the graph in the original post was to demonstrate that with almost 100 years of having an income tax, sometimes with extremely high marginal tax rates, the tax take still didn't exceed more than approximately 20% of reported economic activity as measured by GDP within the 60 years shown. At high rates the base was more limited and at lower rates the tax base was expanded thus keeping the tax take within a fairly narrow range.

Harry offered that this was a result of the rich effecting the tax laws. I think he is correct but he sees this as a bug and I view it as a feature. Remember the comment on some earlier post mentioning that things changed when peasants grew potatoes. This provided some protection from abuse by roaming marauders who could just load up and carry away other crops. Think of loopholes and special tax treatment as limiting the abuse of the "stationary bandits." I don't know who deserves the attribution, but "the economy breathes through its' (tax) loopholes." Give the progressives those super high statutory tax rates but keep the tax take reasonable. The progressives get the appearance of soaking the rich, the government gets some revenue and the rich get to keep enough money to keep investing in the economy and creating economic opportunity for themselves and for others. What a deal! Everyone can be happy. Politicians like it too!

The inflation of the 1970s blew this game as people got pushed into higher and higher tax brackets without a greater increase in real wages. The jig was up and we a got lower marginal rates and the Reagan Revolution.

As for Harrys' comment about taxes not being zero sum - of course not. Initially an even marginally competent government can use the revenue to provide public goods worth more the lost output thereby expanding future output even more and also improving the quality of life for most people in a variety of ways. Eventually a rising tax take relative to the economy runs up against the limits of conflicting values of the populace and the omniscience of the people in charge. That very matter was at the heart of the workable balance post. When I try to engage statists in a discussion of this matter I rarely get a coherent response.

As for preferring a progressive tax structure to get more infrastructure or other public good than most people could otherwise afford, that is easily accommodated. A flat tax which gets progressiveness through a generous personal exemption allows for the desired outcome without the distortions and disincentive of very high marginal rates. It also has the benefit of allowing the average earner to pay a lower average rate but the same marginal rate as most other tax payers. Nobody can abuse anyone else because we are all in it together. You want more taxes - we all chip in at the margin.

Bret said...

Howard wrote: "You want more taxes - we all chip in at the margin."

Which happens anyway, even if taxes are progressive. (That's the point of my post). The flat tax just happens to be more transparent and more efficient. But then politicians rarely like transparency.

Howard said...

The flat tax just happens to be more transparent and more efficient. But then politicians rarely like transparency.

Yes. It makes it less likely that people will pretended that they don't pay the embedded cost.

Harry Eagar said...

I don't recall that the free-marketeers rushed to embrace Forbes.

Probably they realized that it would have violated Hauser's Law.

Anonymous said...

I remember Forbes being very popular with free marketers. From where else does the flat tax draw support?

Howard said...

I remember Forbes being very popular with free marketers.


Certainly the message was popular. Harry likes to lump in pro-business types with free marketers even though they are very different groups. That way when they ask favors of government like any other special interest he can speak poorly of them. Paying attention to that important distinction and further implications would pose too great a challenge to his beliefs and worldview. We would then be accused of being mean.

Harry Eagar said...

I don't recall the flat tax being popular with anybody.

As far as I could tell, except for Forbes's paid claque, it had almost no constituency.