Cases in which income taxation is preferable to lump sum taxation with the same ex post net transfers.
The main reason for progressive taxation is that the welfare cost of taking money from wealthy people is lower, because they have a lower marginal utility of consumption. I would like to discuss other advantages of income taxation, that is cases in which it can cause an increase in money metric welfare, or, in other words cases in which a distortionary tax and transfer policy is desirable even if, in the end (in the Nash equilibrium) everyone gets a transfer equal to taxes paid.
The incentive effects of taxation can be desirable for many reasons. I will try to list them in a series of posts. One very simple reason is that lower income is typically obtained by providing a goods and services to poorer people. This means that the signal from the market is not ideal – even if people obtain income by providing useful goods and services, the income depends on the usefulness divided by the consumers marginal utility of consumption.
For example, lawyers income depends on the wealth of their clients separately from the validity of their clients cases. For another doctors income depends on insurance coverage of their patients as well as the effectiveness of therapy and the need of the patience. I will address these issues in the second post in the series. In this post, I will assume that agents sell goods not services and that they sell them for the same price to all customers. Even in this case, there is a difference between the income maximizing choice and the most socially useful choice. Some people obtain more income selling luxuries that no one needs, but for which high income people are willing to pay a lot rather than selling necessities which poor people really want, but for which they can pay little.
People often perceive a difference between maximizing income and contributing as much as they can to society. There is nothing odd about this – it follows from absolutely standard assumptions about market prices and simple utilitarianism – economists most standard approach to welfare economics ( which is an approach to social welfare often considered to underestimate the importance of equality).
So far, there is no hint of any reason why the incentive effects of income taxation might be useful. The novel assumption is that people are not perfectly completely selfish. If you would rather see well fed than starving children, then standard economic theory does not apply to you. It is very important to avoid the false dichotomy between the assumption that people are perfectly selfish and that they are perfectly altruistic. I have often read read proofs that people are not perfectly selfish presented as an argument against the assumption that people are partially altruistic. Before going on, the assumption I need can be that people care 100% as much about their own interests as about anyone else’s. Such people would strike us as extraordinarily selfish, but they are not selfish enough for standard theory.
No one argues that people are selfish. Selfishness is almost always assumed in economic models. I can think of a number of justifications. One is that we should hope for the best but plan for the worst – hope that people are altruistic, but design a system which will work if they are perfectly selfish. I see no merit in this argument. In particular, we don’t have to guess, we know people are partially altruistic. Another is that a system designed on the assumption that people are partially altruistic also works if they are selfish – it just isn’t true that if one fears something might be true, then one should assume that it is. Another argument for assuming selfishness is that economists focus on arms length interaction, and altruism is important in interactions other than buying and selling. This post aims to demonstrate that that argument is invalid. A third argument for assuming selfishness is that altruism has benefits which are separate from the benefits of good policy. The main point of this post is that policies which are optimal if people are selfish and Pareto inefficient if people are partially altruistic.
The key paper in the literature on this topic is “” by Lester Thurow. Thurow’s point is that if people are slightly altruistic, then redistribution from the rich to the poor can make everyone happier, can be a Pareto improvement. Rich person A likes the fact that money is taken from rich person B and given to a poor person. The small loss for person B bothers him a tiny amount, the large gain for person C pleases him a small amount. Person A does not want his money to go to the poor, but in a large society the huge amount of benefit to the poor from transfers from all the other rich people can make up for his (not totally) selfish desire to keep what he has. This means that rich people who support progressive taxation and welfare but don’t give all of their money away are not necessarily hypocrites.
Thurow points out that even partial altruism is an externality and if people are partially altruistic, then equality is a public good. Standard arguments combined with the clearly true assumption that people are not completely 100% selfish imply that redistribution from the rich to the poor can be Pareto improving.
These posts are not simply a reiteration of Thurow’s point. I will assume no net redistribution. The tax and transfers will not help the poor directly, however, their incentive effects may help the poor.
This post will assume that people produce goods and can choose whether to produce a necessity or a luxury good. Caring about the benefit of their product for the consumer, they will prefer, other things equal, to produce the necessity. In equilibrium, other things won’t be equal because they can make more money producing the luxury. By reducing that incentive, income taxation can shift production from luxuries to necessities. This can increase welfare. This, in turn, can please everyone because people are partially altruistic (the last point is exactly Thurow’s point).
A tiny simple model after the jump