In Defense of a Progressive Tax System

If you’ve been reading this blog for a while, and spend time in the comments to the post, what follows might be familiar to you. I remember posting bits and pieces of it in comments to posts by PGL and Angry Bear back before I wheedled my way into their midst.

I believe in a progressive tax system. I believe in a progressive tax system because I believe in capitalism. Capitalism is based on the idea that resources flow toward those who have the greatest marginal use for them, not through government edict, but through the Invisible Hand of the market. If I build a better mousetrap, under ideal circumstances, mouse-trap connoisseurs will flock to me, giving me money and hence encouraging me to build more of the same. It will also encourage others to innovate and build even better mouse-traps. The flip side of this is that those who benefit the most from something – in this example purchasers of fancy mouse-traps – will pay the most for that service.

Adam Smith went a step further – he pointed out that when it all works, capitalism is the ideal system because in allocating resources in this manner, the market is actually allocating resources in the manner that most benefits society as a whole.

(Of course, it doesn’t always work that way – information is not always perfect, externalities abound, crime is rampant, market power creates its own distortions, and of course, there is also fraud and other crime to wreak havoc in the market.)

And while the government operates outside the market in many ways, under ideal circumstances, government services should be provided and paid for as much as possible using the same approach as private services – those who benefit the most should pay the most. What are the services the government provides? Ideally, at a minimum, it sets rules and enforces them and protects the country from foreign invasion (e.g., the Canadian hordes). In plain English, the government is responsible for ensuring that society doesn’t break down. Oliver Wendell Holmes put it better: “Taxes are what we pay for a civilized society” If government goes away, you have Somalia.

So who benefits the most from the existence of government? At first glance, one might say the poor. After all, in many instances, they receive transfers from the government. Perhaps in a free-for-all, the rich would simply let them starve.

But a second glance gives you a different set of winners and losers. Consider a janitor who lives in downtown LA, and an investment banker who lives in Bel-Air. The government provides a lot of services to the investment banker that are not used by the janitor. For instance, it prevents the janitor from driving off in the banker’s vehicles. (It doesn’t need to prevent the banker from driving off in the janitor’s vehicles, if any.) In fact, the government is the first line of defense for most of the investment banker’s property, as most of it is held in intangible form; bank accounts, stock certificates, etc., only have value as long as society is maintained. Now you might say – well, even if the government disappears, Bank of America will maintain the value of its clients’ accounts. Sure, they’ll have an incentive to do so, but what ensures that every programmer who now works for Bank of America doesn’t simply steal from B of A clients is fear of jail, which means, the government.

The janitor has no shares of stock, and maybe a couple of hundred bucks in the bank. Most of his property is physical and sitting in his rented apartment; he (and a baseball bat) is the first line of defense for his own property.

Well, the stockbroker has physical property too. What about the boat he keeps at Marina del Rey, or the second home in Aspen? Again, those (or his ownership of those) are defended primarily by the government – he and his baseball bat are located too far away to keep out interlopers. Sure, he might pay private security to watch those items, but if government ceases to exist, the $10 an hour rent-a-cops (not the security companies, the employees) will be living in his second home and his yacht. Heck, they’d probably chuck him from his Bel-Air home while they’re at it. Nobody’s going to steal the janitor’s apartment; first, because it isn’t his (he rents it), and second, why steal from a poor man when you can steal from a rich one more easily?

And so far all I’ve written about is protection. This could be a really long post, and I could write point out other ways those at the top benefit more than those at the bottom. As an example – anyone think the janitor has more political power and access to elected officials than the investment banker, and anyone think power and access doesn’t buy you something?

In any case, the services one gets from the government increase with one’s assets. But these services increase more and more rapidly as one’s assets increase. (With protection – the more wealth you have, the more of that wealth is in intangible form or, if physical, not something to whose defense one can contribute.) In a fair and capitalist system, therefore, taxes should increase with wealth, and they should be progressive, increasing proportionally to the services provided by the government. Now, we don’t tax based on wealth, but rather on income that is a proxy (however poor) for wealth.

I note that the Bible of capitalism, Adam Smith’s Wealth of Nations, says the same thing: “It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.” In other words… Smith felt that the tax system should be progressive.

(As an aside: Its possible you clicked on the link, scratched your head, reached for your well-worn copy on the bookshelf, thumbed through it, and said to yourself – but how does this quote come from Book 5 of the Wealth of Nations when there are only three books? Well, it turns out that the copy you have, bought at the bookstore, is a bit short. See, the folks who love to quote Adam Smith, and who call themselves capitalist – the ones who work at Cato or Heritage – they only like what’s in the first three books. Booksellers cater to book buyers, so your copy only has the first three books. More on some of what Adam Smith was about courtesy of Mark Thoma.)

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