Tax incidence and legislation change

In a previous blog I set out my approach to taxation. What matters is the incidence of taxation and where possible this should fall on the most economically fortunate members of society. In this blog I wish to emphasise an important point about how changes to tax rules create windfalls for, or costs to, taxpayers. This means that the incidence of the tax system may not fall on the intended groups in the aftermath of such changes.

This point was emphasised in an address given over one hundred years ago by the economist Edwin Seligman. Much of this address is aimed at attacking the somewhat silly views of taxation from what he calls the perspective of the individual: taxation according to the benefit principle or ability to pay principle. Despite his warnings these views have remained popular with tax lawyers and economists through to this day. (Murphy and Nagel in The Myth of Ownership have in this century done a good job of attacking these views of taxation and we can but hope that writers on taxation will take notice at some point). Seligman wants to focus on the place of taxation within society as a whole, which is a much more satisfactory perspective. The tax system has to be justified to all, taxpayers and benefit recipients alike, and this needs to be done through a theory of justice. In the course of his address on this subject Seligman makes a very important point about the incidence of taxation, which I will describe here.

Seligman pointed out that we need to take account of the shifting and diffusion and capitalization and absorption of taxation. The rational price of an investment, or factor of production, or whatever, will take account of the expected tax which it will attract. This is the capitalization aspect. So if a new tax is levied on a particular kind of investment (in Seligman’s example a bond), or the rate of an existing tax is increased, then this will be passed on to the capitalized market value of the bond. So the person who is holding the bond when the change takes place will take an immediate hit on the value of the bond. It will be absorbed into the new price. Previous owners of the bond are unaffected, as are future owners. This is because past owners have already sold at the previous capitalization and future owners will buy it at the new capitalization rate.

The idea of shifting is that people will pass on some taxes to others, so that a special tax on housing will fall on housing owners. However, as a result of this people will stop investing in housing until rents or values rise to cover the cost of the tax. In the meantime, the tax will therefore fall primarily on people who build houses and provide goods and services to house builders (or the investors in and workers of these companies). The tax is therefore diffused onto many people instead of the owner of the primary item.

In both cases this leads to the disappearance or vanishing of the tax. The increase in tax is a heavy burden on some existing owners but does not create a permanent burden on such owners. The tax may fall on other, unintended groups and individuals, as well. When creating or increasing taxes, these changes should be borne in mind, since the increase may act as a kind of wealth tax, something I will write about in another blog.

Of course, this point goes the other way. Removing tax or lowering the rate on existing taxes can create windfalls to owners. If someone buys something at a market value where there is an expectation of a certain amount of taxation and the taxation is dropped, the owner immediately has something they can sell for a larger amount. The potential to create windfalls is something to which we all need to be aware.

Governments are therefore going to be constantly lobbied to allow special exemptions and for the dropping of taxes which will create an immediate windfall to whoever happens to own the item at that point in time. In states where corruption is relatively difficult lobbying of this kind will be one of the easiest ways to make a quick windfall. Governments may be enticed to bribe strategically important voter groups (more likely in the UK due its archaic democracy) and political parties may be able to offer corporations and the wealthy artificial windfalls in exchange for campaign donations (more likely in the US due to its ridiculous rules on political party funding).

Failures to collect tax also create windfalls. An example of this is the Vodafone Mannesmann deal, over which Vodafone could have expected to pay several billion pounds in tax. Through questionable accounting (via Switzerland and Luxembourg), Vodafone paid very little tax and for some unknown reason HMRC officials made a deal with Vodafone that enabled them to pay a fraction of the expected amount. This was a pure windfall to Vodafone shareholders and a pure loss to the rest of the UK who would benefit from the government spending (or debt alleviation) that would have followed from the tax revenues. Of course, other corporations will then ask that they can have the same favourable tax treatment. This bizarre decision, described in Richard Brooks’ book the Great Tax Robbery, was an absolute scandal.

Given these temptations, right-thinking citizens must remain vigilant that governments and their agents are not falling prey to the promotion of the interests of the few at the expense of the many. Tax windfalls of this kind will usually benefit people who are among the least deserving of state help. Tax reductions may sometimes be advisable, but they should always be undertaken with the utmost caution.