NYU Tax Policy Colloquium, week 8: Matthew Weinzierl's "Revisiting the Classical View of Benefit-Based Taxation," part 1

Yesterday Matt Weinzierl of the Harvard Business School presented the above paper, as our colloquium crossed the halfway point for 2014.  It's useful to put this paper in the context of others that he has recently written, reflecting an ongoing project of engaging with some of the underlying philosophical issues in tax policy.  While the paper has a lot of math, along with shorthand references to economics ideas (e.g., Cobb-Douglas, Lindahl, and the Samuelson rule for public goods) that potentially make it tough sledding for a legal audience, in fact the set of underlying set of interests may well be a better fit in a law school environment such as ours than in many business schools.

A bit of background may be in order, and indeed is most of what I'll discuss in this post, with the aim of sketching out the underlying project for a broader audience.  Economists and some economist-fellow-traveling law profs, such as myself, regard optimal income taxation (OIT), derived from James Mirrlees' pioneering work in 1971, as a foundational approach for thinking about progressivity, redistribution, and tax rate  design.  OIT generally applies a utilitarian or other welfarist framework in which tax policy's aim is to increase social welfare, defined in terms of utility or subjective wellbeing.  Notions that people are "entitled" to the fruits of their own labor thus play no direct role, although one might view such notions as being transmuted into concern about the incentive effects of taxation.  OIT is all about trading off the adverse incentive effects against the redistributive benefits that are attributed to taking money from people to whom it is thought to have low marginal utility (e.g., because they are wealthy) and giving it those to whom we attribute high marginal utility (e.g., because they are poor).

OIT is thus potentially highly progressive and redistributive.  In practice, not necessarily - this depends on such factors as the elasticity of high-end taxable income, and indeed Mirrlees himself kept finding that a relatively flat rate structure was optimal in various specifications of his model.  But the underlying thought process is not one that, say, a U.S. presidential candidate would want to endorse too openly in the general election, at least judging from the Republicans' attacks and Obama's very cautious defenses of redistributive policy in the 2008 and 2012 presidential elections.

Weinzierl's work seeks to address this evident disconnect between academic and public discourse.  He wants to revive, and put coherent flesh on the bones of, traditional tax policy frameworks that might better capture people's underlying intuitions about tax policy.  The aim is to improve OIT as a positive theory, whether or not one actually finds these frameworks intellectually persuasive.

Perhaps his best-known paper in this vein is the height tax paper that he coauthored with Gregory Mankiw.  Here the argument is as follows.  From an OIT standpoint founded on utilitarianism, taxing tall people by reason of their height ought to be normatively appealing.  The reason is that height is a "tag," statistically correlated with high income and apparently high earning ability.  Insofar as it is fixed, however, one cannot respond to the height tax (unlike to a high rate of income taxation) through tax planning such as working less or sheltering more.  The fact that people might find this tax normatively unappealing, however, shows that they are not utilitarians, at least in a consistent and thoroughgoing sense.  Fair enough, although how one interprets this is open to further debate.  (E.g., what should be the impact on one's own assessment of the merits of utilitarianism?  Observing that we have conflicting normative instincts is just the start, not the end, of the analysis, since we need not view our own moral intuitions or otherwise as evidence of some underlying moral truth that we choose to embrace at the end of the day.

 In any event, Weinzierl's benefit tax paper for our session is more closely linked to a more recent paper of his tax discusses equal sacrifice theory.  Both the benefit tax paper and the equal sacrifice paper discuss normative theories of taxation that had their academic vogue in the past (e.g., Adam Smith advocated the former, and John Stuart Mill the latter), but that have largely been rejected academically despite arguably remaining important in how policymakers and the general public think about the distributional element in tax policy.

Mill’s equal sacrifice theory involves looking at the total utility loss that individuals suffer by reason of paying taxes, compared to a hypothetical counterfactual baseline in which all public goods from government spending could magically have been provided for free.  Against this background, suppose that it just happened to be the case that the total utility loss from one’s paying tax was constant as a percentage of income.  In other words, suppose there was an elasticity of 1 (or actually -1) for the utility loss per dollar of tax paid, as income rises.  Under this assumption taxpayers typically would experience the same loss of utility from paying (a) $2,500 of tax on $10,000 of income, (b) $25,000 of tax on $100,000 of income, and (c) $25 million of tax on $100 million of income.

Under this of course arbitrary assumption, equal sacrifice would call for adopting a flat rate tax, despite the fact that (under standard assumptions) the marginal utility of a dollar would remain far higher for poor than rich taxpayers.  Suppose that changing the above flat-rate system so that the rich would pay more while the poor would pay less would have negligible labor supply effects.  The change would cause poor individuals to gain more utility than rich individuals lost, indicating that a utilitarian ought to favor it. But equal sacrifice theory would say No: the point is to equalize sacrifice, not to maximize utility.

Equal sacrifice can, however, lead to a very progressive system - or for that matter, a very regressive one - depending on one's view as to how fast or slowly the marginal utility of a dollar declines as one's income rises.

Suppose we don’t worry about the motivation for favoring equal sacrifice as a normative theory.  (Weinzierl’s argument on this score is merely that it appears to have wide intuitive appeal, which I think is probably correct.)  It still faces a distinctive informational problem that utilitarianism does not face.  (Both face the problem of defining and measuring utility.)   Under utilitarianism, you merely need to look at the available policy choices, choosing whichever of them you deem to yield the highest level of social welfare.  Under equal sacrifice, you must evaluate all of these alternative choices relative to a counterfactual – a hypothetical state of affairs that cannot in fact exist.  This of course is the imaginary scenario in which public goods could magically have been provided for free.

Why have I spent so much time on this paper, before getting to the benefits tax paper that we actually discussed yesterday?  (I'll turn to that in my next post.)  Because - in common with Weinzierl - I regard the two topics as closely linked.  Indeed, he and I are not the only ones to think so.  Both equal sacrifice and benefit taxation look to some notion of treating distinct individuals in some sense comparably, as an alternative to the OIT / utilitarian approach in which tax policy seeks to improve general or collective welfare.  Mill, in proposing equal sacrifice theory as a replacement for Smith's benefit theory, not only reached a very similar conclusion (flat tax above an exemption for necessities), but cited Smith as an influence and precursor rather than as the dead past that he wanted to bury.  I'll return at the end of the next post to what I make of this Smith-Mill overlap alongside seeming theoretical distinctness.