Plain Sense Economics

As a followup to my earlier note on Oregon’s Measures 66 & 67, we need to take a quick look at some of the theories and rationale behind government taxes. This isn’t and can’t be an exhaustive discussion, but hopefully it is a start for our considerations. For SOU students I commend to you my colleague, Kip Sigetich’s class, Public Finance EC 319.

Here’s a quick list of reasons to tax. Each have a bit longer explanation down below.

We tax to…

1. pay for public services that are easier or more efficient to provide as a community than to pay for individually.  (AKA public goods)
2. correct for inequalities in individual wealth or income – to provide some basic level of food, shelter, medial care, etc. (AKA welfare and other social services)
3. correct for externalities.
4. Change behavior – encourage or discourage through incentives

1. Public Services/Public Goods:  There are services that many people want, but individually we could not afford to buy them. While it is possible for groups of individuals to come together privately to pool their funds and provide the service, they often run into the free rider problem. So we give government the ability to build roads, provide police and fire protection, and many other worthwhile goods and services. Often times voters have to approve the tax to pay for these. Here are some other posts on the topic.

2. Income Redistribution / Social Services: In some economies there is an explicit goal for a Robin Hood policy (take from the rich and give to the poor) – purely to even out income or wealth. In the United States and many other countries there is a social ethic or value that says that the poorest members of society should be able to live in at least some minimum level. This ethic or value is controversial, of course. Some voters support strong government efforts to improve the lives of our poorer members – along the lines of European social democracies. Other voters prefer a self-determination, self-reliance model, where citizens have opportunities but are left to their own to survive or advance in the world. And many voters are somewhere in between. In a later post we’ll show how many tax strategies focus on extracting more tax revenue from the wealthy than from the poor.

3. Correcting Externalities: In economics we call the presence of externalities a market failure. When someone outside of a market transaction is either harmed by or benefits from that transaction, we have an externality. If there is an externality then the market will produce either too much or too little of that good, and will not reach a social optimum. The most common example is factory pollution. When the factory produces a good and pollutes while doing that, others outside the factory are affected. See more on externalities here.

4. Incentives to Change Behavior: Some times we enact taxes to discourage behavior. “Sin taxes” are one such example. Tobacco taxes can be used to defray state health care costs. Generally this is a pretty inefficient mechanism since many of the “sins” are addictive and demand for them price inelastic. More often a tax on tobacco or alcohol is just a convenient way to raise revenue, and voters are more likely to support those taxes over more general income or sales taxes. A more modern application of this category is called a Pigovian tax, and the prime example being discussed is a carbon tax. Taxing activities and products that release carbon into the atmosphere should discourage and reduce those activities.  We also give tax credits for behavior we want to encourage.