Yesterday I wrote and posted an essay about why the economics of bulk discounts provides some justification for progressive income tax rates, and a friend asked about how this seems to be the very opposite of the traditional justification cited, namely that it's less of a burden for a rich person to pay a 10% tax than it is for a poor person to pay 10%. The traditional argument is that a dollar is worth less to a rich person than to a poor person, and so we should prefer our government to take more of its tax dollars out of the pockets of rich people than the poor. So how can my argument, which is that marginal dollars are worth more to the rich, be consistent with this?
It is confusing, to be sure, so confusing that I felt it necessary to write a whole new blog post to answer it, instead of simply replying to the original comment.
The source of the confusion, though, is this: Although we naturally treat money and wealth as essentially interchangeable (because, hey, that's what money is for: to exchange for wealth), they are fundamentally different things. Money is ultimately a fiction, or to put it less subversively, a convention. It stands for value, but isn't itself intrinsically valuable; when you get a dollar in exchange for something, what you're really accepting is a promise to be able to exchange that dollar for something else of value later on. And that something of value, whatever it is, is what actual wealth is all about. To put it another way, money is potential wealth, not actual wealth.
Now, let's look at the traditional argument for progressive income tax my friend was talking about. You can see that it is really about wealth, because it works just as well if we substitute, say, bread for money. For someone with a loaf of bread to give up half a loaf is much more of a burden than for someone with ten loaves to give up five loaves, because of the condition they're in afterwards. The first person will be pretty hungry with only half a loaf to eat, while the guy with five loaves will suffer only for a lack of variety.
The argument still works pretty well if we talk about dollars instead of bread, because on an every day scale, we tend to think of prices as constant: 1 dollar buys one loaf, 5 dollars buys five loaves. And so on a practical level, this has been a pretty good argument for why progressive income tax is fairer than a flat tax. The error of equating money with wealth here does not create any immediate confusion, and so it goes unnoticed. But it is still an error, and it leads us into trouble when we move too far beyond the everyday scale, to consider the workings of the economy as a whole, which is what we have to do when we talk about tax policy.
Remember what I said about money being a fiction? That becomes clearer when you look at the bigger picture. Money is a placeholder for credit/debt, a hydraulic fluid for trade. You trade your labour for food, clothing, shelter, entertainment, etc., but money lets you do it indirectly. So what's really happening in an economy is people making stuff (wealth) and trading it with each other. The wonderful thing about the free market is that, by allowing people to make their own decisions about what to buy and sell based on the prices that emerge from voluntary negotiations, we can collectively come up with extremely efficient allocations of resources, much more efficient than we could produce with some super-smart person deciding and directing everyone's efforts. If there isn't enough of some good being produced, the price will rise, and more people will start producing it. If there's too much, the price will drop.
In theory, you don't need money for a free market. In a barter economy, people would still be able to see that there's lots of demand for this and very little demand for that, and so people who chose to make something valuable would accumulate more wealth than those who didn't. Money just speeds up the process and makes it much easier to see where the demand lies. But it does something else, too: it introduces some dangerous distortions to the process.
Thought experiment time. Imagine you have two identical workers, equally skilled and equally productive, and both commanding the same hourly rate for their work. The only difference is that one has worked very little this year, and the other has already earned a hundred thousand dollars. You need to hire one for an hour's work, and since you'll pay the same rate and get the same result whichever one you choose, you should be indifferent as to whom you hire. And that's sensible. Except remember my previous post on the economy of scale and bulk discounts. If you happen to hire the guy who's already earned a lot of money, you won't be paying any more, but he'll be getting a lot more buying power out of the dollars you give him. So, from a society-wide view, all of us collectively will be allocating more chocolate bars, more piano lessons, more whatever, to the already-rich guy than we would be if you gave the same money for the same work to the other guy. In other words, they may be getting the same amount of money, but the richer worker will receive more wealth.
Think about that for a moment. I mean, there's only so much wealth to go around at any given time, and as a society, we do want to make sure it's used efficiently. That's why we have a free market system, because it generally encourages people to invest resources in things that create more wealth rather than less. But here, in the thought experiment, the two workers are exactly equal in the amount of wealth they produce for the money they are paid, and yet they receive unequal distributions of wealth when they go to spend that money. That's inefficient, and it's an inefficiency that results entirely from our mistakenly equating money with wealth.
Now, you as an employer cannot be expected to distinguish between the two workers here, and it's not your responsibility to decide what's best for society; you just need someone to do the work, and you'll pay whatever you are willing to pay whoever is willing to accept that price. You're in no position to figure out what real wealth that pay will buy for each of your prospective job applicants. And yet society does have a legitimate concern here; we want an efficient allocation of resources.
A properly calibrated progressive income tax, however, can fix this. If we impose a tax that keeps the buying power of each earned dollar constant, then the dollars earned by rich and poor alike will be a more accurate reflection of the wealth that the market should allocate them for whatever it is they contribute.
In other words, I'm proposing that free market capitalism can be made more efficient at producing wealth if we use taxes to correct for the distortions that money introduces into the system.