Tax on income is easy to levy but fundamentally unsound

The latest Mitt Romney “gaffe” is getting much attention. But I was a little surprised to find that while what he said may well be a gaffe in electoral terms – and he may even have lost the Presidential election here – his statement was actually quite correct. I had not appreciated that almost half of all US households paid no federal income tax at all. In the US, federal income tax is a major source of tax revenues and contributes about half of all tax revenues (tax revenues about 15.4% of gdp in 2011 with federal income tax providing 7.3% of gdp). Romney in his leaked video said:

“There are 47 percent of the people who will vote for the president no matter what,” Mr. Romney said. “There are 47 percent who are with him, who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them, who believe that they are entitled to health care, to food, to housing, to you-name-it, that that’s an entitlement. And the government should give it to them. And they will vote for this president no matter what. These are people who pay no income tax.”

As Annie Lowrey in the NYT points out, this is essentially true:

Mr. Romney is absolutely correct that about half of American households do not pay federal income tax. (He is also tapping into a now long-running vein of conservative anger at those households.) But he is missing some crucial context on why they do not pay federal income tax.

The nonpartisan and highly respected Tax Policy Center derived the 47 percent number – it is actually 46 percent, as of 2011 – and published an excellent analysis of it last summer. It found that about half of the households that do not pay federal income tax do not pay it because they are simply too poor. …… 

My perception of the US though – as a place where most people were “producers” and creators of wealth – has been somewhat shaken. It does not seem sustainable to have a situation where half of any population are “takers” and the other half are “givers”.  Eighty percent “givers” with twenty percent “takers” would seem to be a much healthier ratio (the ubiquitous 80/20 rule again). I would not have expected that such a large proportion of households in the US paid no federal income tax at all.

But leaving Romney’s electoral gaffes and what seems to be a losing campaign aside, the story only reinforces my view that applying taxes (and therefore disincentives) at the point of wealth generation rather than at the point of resource consumption (whether as goods or services) is fundamentally unsound. I take income generation to be a representative proxy for wealth generation. In any growth-society wealth creation  needs to be encouraged and it is the consumption of goods and services which needs to be “paid for”. Of course the problem with sales-based or consumption-based  taxes is the difficulties associated with applying  and collecting variable rates of taxes (on necessary items as opposed to luxury items for example). Moreover a sales based tax can encourage the emergence of a black economy where the full sales value is not declared – but so can income tax where the service provider does not wish to declare his full income. Nevertheless taxation at the point of consumption of goods or services seems to me to be not only sounder but also more just than anything which discourages or acts as a disincentive to the generation of wealth.

It is unfortunate that income tax often leads to a class-debate where the possession of great wealth is seen by some – usually those without – as being immoral. The possession of wealth should not however be confused with the creation of wealth. (Even if mere possession of wealth leads to large income it is only a measure of wealth being put to sound use. Distribution of that wealth does not necessarily mean that it will be put to better use.) Taxation as a means of getting resources for helping the poor is one thing  but taxing and discouraging wealth creation at its source is counter-productive and unsound.

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