Thursday, May 14, 2009

Uspide down - Tax cuts, free market and distorting subsidies

Recently I was pondering the idea that the practice of tux cuts (more precisely cuts in the contribution to social security payable after the salaries) represent - at least in the context of the European Union - a kind of - reversed - state subsidy for companies and that way not only being distortive in the free market but implicitly contrary to the basic ideas of the Union. Of course one should presume as a starting point that the tax-free economy never existed and therefore we could and have to compare the effects of such moves to the existing conditions in Europe and not to the highly idealistic concept of the tax free economy as the less distorted and less regulated , as a consequence the real free market economy. But this premise is the easier to accept because it would be not only ahistorical to make this comparison with a theoretical concept never ever realized, but it even would violate such ideas as the theory of comparative advantages, not really foreign from the theory of free market.
If one takes the EU not as a conceptual phenomenon but as a historical entity integrating earlier separated markets than in every given moment the integration is nothing else than a single market in which different - national - regulations can be considered as inherent elements of its architecture and therefore being a factor in determining comparative advantages. This approach - and the acceptance of the idea and ideal of the EU itself, the concept that it is a market where every single actor competes with everyone else - allows us to consider taxes and other contributions as factors of individual choices regarding decisions of production (what, where, with what kind of factors of production etc.) . If we can rely on the idea that every actor is rational, than the differences of the taxation systems will be part of those choices and therefore the distribution of companies and production throughout Europe will be the optimal one considering every factor. (Well one weakness of the argumentation that it is not quite clear from which date can the EU be treated as such market, or is it possible at all at the moment. But let's assume that since the Maastricht Treaty it is in fact a really dominantly common market where every actor has a horizon beyond the national economy and the differences in national regulations constitute elements of this common and single architecture causing comparative advantages.)
The key is whether we accept the idea of an existing common market, because in this case every change - achieved not at the European but on a lower level - affecting the architecture of the market distorts it, because it modifies the equilibrium. Every tax cut distorts the market, disfavor companies whose earlier decision was quite rational and in line with the common market's characteristics, while favors companies whose earlier decisions were poorer. (Once again one can assume that the different tax systems in themselves signal the non-existence of a single market, but at least equally feasible is the perception that the lack of customs and harmonized regulation frames a market and not taxes.)
But the phenomenon is even more interesting in the special case of Hungary, where the main idea at the moment is to lower labor costs in order to make hiring new workforce more attractive for SME-s. The peculiarity of the idea lies in the fact that these companies - while contributing to the GDP with a forth of it or so -, uses at about 20% of the allocated capital and employs almost 70% of the workforce. Anyway it is rather the lack of capital that restricts their expansion and not the lack of workforce. (One can imagine the productivity figures with these factors.) It is quite possible that the new employees will have a zero or negative marginal product, what means that the tax cuts will effectively subsidize production otherwise bringing not profit but losses. That's the textbook example of distortive subsidy, I would say...
Well, I know that thing are not so simple as I presented above. Moreover my definition of a single market is not incontestable. But otherwise I would hypothesize that even in other concepts of the single market tax rates and systems would converge to each other in a similar situation - because of the competition for investment etc. - and not to zero, as it is the case in today's Europe. Or is it not a strange process?

(I know that once again there is nothing revolutionary in this post, but it was a self-pleasing activity to provide the argument and I'm a sinner in this regard.)

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