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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.