Wednesday, March 10, 2010

On taxation I.

As the elections in Hungary in April draw nearer and the result seems pretty sure - at least regarding the person of the next prime minister - more and more speculation appears on the probable economic policy of the next government. Some of these are driven by curiosity and goodwill, others rather by pure and badly veiled self-interest, but one thing is common these are speculations as long as no elaborate program is published. (However, I'm sure that no one will really have any idea until the government will take over its responsibilities and initiates the first measures, but it is not my point here to denounce any party's campaign strategy.) But the issue of taxes has a key role in almost every attempt, usually in the well-known form of the tax cuts = strong growth causality. 

The idea certainly has a popular appeal and precisely because it is so easy to assume that nothing else is needed for living better than cutting taxes. Hand over less to the greedy paws of the state and in return even your future prospects for higher income will be enhanced immediately, it is the perfect populist perpetuum mobile. But beyond this rather simplistic approach the issue of taxes is at the core of almost every attempt to revive economic growth and ensure its sustainabilty and not only in Hungary. Either in the form of tax cuts or at least as a restructuring of the system, placing higher emphasis on property and consumption taxes and relieving a part of the burden on labor as a means to raise the employment rate and improve the employment rate. (The underlying reasoning is quite simple: the only obstacle of employing more people is the high cost of labor and the high taxes as they are disincentives on working, especially when they are accompanied by generous social benefits. Therefore as soon as taxes will lower employers will hire people and those who were earlier reluctant to work due to high taxes will flock to the gates of factories. Everyone can judge this reasoning and think of possible supportive or counterarguments.) May point is not to challenge this idea - although I'm reserved at best towards this simple argumentation - rather I would like to focus on other aspects of the tax issue, like the real effect of tax cuts on personal income - as it is always assumed that it is positive for everyone - and the real nature of the restructuring, the so called "whitening effect" or the macroeconomic role of tax cuts or even tax hikes. All of these from the perspective of a layman, of course and without the pretence of being comprehensive.

Tax cut is a popular promise as it is too easy to assume that the lower the taxes are, the higher one's net income is. In a narrow sense it is usually true - and people even tend to assume the same for so-called restructuring as lower tax rates has an immediate and direct effect on net income level, while the offsetting measures are many times hidden, not to speak of the tendency of the individual to take into consideration the positive perspectives and perceive the negative ones as applying only to others - but taken into account a series of direct consequences this assumption is highly questionable and certainly would need closer scrutiny. (Apart from those idealistic views that postulate a self-financing tax cut, the result of which is a stronger economic activity bringing even more revenues than the earlier system. But it is one of the basics of science that perpetuum mobile is impossible, so let's not deal with this nonsense.)

It is easier to assess the effects of the tax restructuring, as its aim is not to lower the overall level of taxes. The basic proposals - always based on study how the different types of taxes affect economic activity - advises lower taxes on labour costs (in general, not only lower income taxes, but lower social contributions paid by employers and employees as well) and higher ones on consumption (usually VAT, but other taxes connected to retail too) as less distortionary and on property. The effect of higher income is certainly imaginary for a lot of affected people, as the higher VAT immediately offsets a part of the raise in net income. But the effect is different for the different income categories, depending on the consumption/income ratio and the savings rate of the individuals. Those whose consumption makes a higher proportion of their net income will suffer more. It is hard to tell how far this measure can offset the results of income tax cuts, it can be different in every individual case and depends on the reactions as well - scaling back consumption can offer some relief - but the usual assumption is that the lower income categories are hit harder as the weight of basic goods and services (foodstuffs, energy, transport) is usually higher in their personal consumption basket and these are the ones where the possibility for considerable savings is the most restricted.

Not surprisingly a similar effect is detectable in the case of the property tax - in most cases a real estate tax - a favorite choice for many experts. The supporting arguments are usually practical ones - it is impossible to hide a house while it is easy to do it with income (so everyone is guilty of tax fraud, isn't it?), it is easy to tax them and it is in line with social justice as richer people tend to own more valuable properties. Albeit these arguments do not seem to be quite solid ones - for the market value of a real estate depends only in part, sometimes even marginally, on ones own activity - but my aim is to highlight its effect on the reality of income tax cuts. For most people their house is the only or the far most valuable piece of real estate their own and only a very few has capital return on them. (Beyond the advantage of not paying rent for their homes.) Therefore they can only service this tax from their income from work or labour (or in some cases from other incomes, however in case of many countries the wage is the dominant form of personal income for the bulk of the population.) As soon as the real estate is not used for some aim to yield return the property tax becomes in effect a hidden income tax. (Or even not so hidden if someone presume that it is a tax on the indirect income of being free of rental costs for housing.) But in both cases it is a tax levied on earnings and not on capital returns. Nevertheless it could have merits, for eyample a redistribution of wealth, bringing back capital to the economy etc., but it offsets income tax cuts and in a very arbitrary way. Due to the low influence on the market value of one's home, due to soaring real estate prices during boom years and protracted, many times incomplete correction in worse years. And due to the fact that in several ECE countries the ratio of real estate value to net income is probably higher than in many Western countries. It also means that the offsetting effects are different for everyone and only general assumptions and hypothesises can be put forward without a thorough analysis, but one can safely assume that a property tax can easily hit not only the lower income categories, but the middle-class, depending on the home value/income ratio. (The much advised solution to make a property tax deductible from the income taxes could eliminate the effect on the middle class, but wouldn't resolve the problem for lower middle class people and for those in the lower income categories. And selling one's home is also not necessarily a solution, because it would only capitalize a hidden income - the lack of home rental costs - in the form of a financial saving and the loss of income would only be avoided if the newly emerging rental costs would be covered by the return on this capital entirely.)

But these are almost explicit implications of the tax restructuring approach, although not necessarily recognized by those who would be affected. (And the problem of the effect on different social categories still persists, it can easily turn out to bring advantages only to those in the higher income categories.) However, the income tax cuts has a very similar offsetting effect, as long as they are not self-financing (and I would dismiss this assumptions, at least in the short term, because I try to assess the immediate effect on income) or not financed from new sovereign debt issuance. So, one can assume that tax cuts are accompanied by spending cuts. If these are not confined to the laying off of unnecessary public administration personnel (a phenomenon certainly existing, but the extent of which - and conversely the extent of the savings offered by this usually popular move - is hard to guess)  the implications will be higher implicit or explicit costs for public services. (People will either be charged with a higher sum for these or will be obliged to buy them from private entrepreneurs instead receiving them from the state on a lower price etc.*) The first aspect of this offsetting effect is the inflationary one, higher explicit prices for public services will drive the CPI upwards and they will remain at that level even after their statistical effect faded in the next year. (However, some savings can be achieved at the personal level by not buying these services, because earlier everyone paid for them a usually lower individual price in the form of taxes, while from this moment only those would be charged with a higher one-time price than the tax was who effectively would use them. But again it is not easy to make estimates regarding this effect and apart from the case of significant cost savings due to higher efficiency - or because of a more depressed demand due to visible an higher prices - the aggregate sum spent on these services would remain equal, only its distribution would be different. But its analysis is far beyond the means and possibilities of this blog post.) However, beyond inflation one can assume another offsetting effect, the effect of almost compulsory saving. Scaling back the state (spending cuts) usually implies the emergence and reconfiguration of systems like pensions or health insurance on the basis of self-provision. Even if it won't be obligatory legally it would be hard to avoid paying these contributions, because the cost sparing accessibility of public services would depend on them in case of necessity (classic health insurance) or they could mean the difference between a pension barely higher than subsistence level and a decent sum. However it is not necessarily a meaningful investment in the future, as it is rather a forced consumption and obligatory saving. (A kind of "békekölcsön" or "hadikölcsön".) And it has very similar effects and probably would have the perception as paying taxes. At this point the negative effect is more probable on the lower income categories, as for the higher earners, who even vefore the tax cuts had enough income to save a considerable amount, it is a meaningful choice between different risk-reducing strategies and investment forms. In general I would hypothesize that the effect of tax cuts - due to almost compulsory savings - would be only really positive in higher income categories and could even mean a decline of freely disposable income in the lower categories. And certainly surprise many from the middle class.

However, toothpaste advertisers will certainly drew our attention to a possible source of higher revenues, the "whitening effect". It is usually assumed that lower taxes will inspire people to legalize their earlier grey or black incomes, because - as this reasoning assumes - their incentive to hide it was only the horrifying nominal or marginal tax rate. (The implicit assumption of the "whitening effect" is the existence of a highly effective tax administration that can detect tax evasion with a high certainty making this practice risky enough to convince earlier evaders to accept the lower tax rate.) Nothwithstanding the sorrowful fact that the highest estimates of grey economies in the EU are usually produced for low tax level countries (Hungary is of course overtaken in this sense by Romania, Slovakia, Estonia, Latvia, Bulgaria, one can imagine the mood of our experts etc.) the assumption is not in compliance with the basic assumptions of the idea that lower taxes generate more work and with higher labour input higher growth. The main argument behind the reasoning that low taxes = higher employment (more work and more employed) refers to the willingness to work more if the income is taxed more benevolently. The favorite tool of measuring the effects of the tax system is marginal tax rate, i.e. how much can someone retain from one unit of additional income. However, if one considers black economy properly, it means that a significant part of one's income is taxed with a zero rate, therefore the marginal tax of grey and black incomes is zero. So the advocates of the "whitening effect" (while relying on psychological arguments, usually abhorred from if they are used to doubt their economic models) at the end state that people - contrary to their basic premises - will be ready to do the same work with the same intensity if their marginal tax rate will be raised. (And not insignificantly, as any natural number is infinitely more than zero ;) ) Therefore it is highly improbable that people will legalize their untaxed income, or if they do then labour input will decline in the economy, generating less output as the marked raise of the marginal tax rate  is a strong disincentive for work. 

Even if one dismisses this conclusion as absurd (I wouldn't be sure, people are usually not flocking to legalize their incomes even with lower tax rates as long as they are not really deterred by the high risk of being punished for tax evasion, but in this case - as it recently happened in Germany when someone offered for sale a CD with the alleged data of alleged tax-evaders - they usually do it on very unfavorable terms - i.e. high tax rates - as well) the extent of the cut in the income tax rates to unearth hidden incomes is not easy to estimate and certainly depends on the total income/grey income ratio. Because the higher one's illegal income as a ration of the total income is the lower his/her effective tax rate calculated on this total income is. Therefore only a more pronounced cut can bring enough incentive to legalize income. One can hypothesize that people with only occasional grey earnings will more readily pay some tax with a smaller cut (although it is not entirely consistent with the marginal tax incentive idea), while those who are in fact employed as grey workers - either entirely paid under the table or having officially a lower salary than they are receiving - will be convinced only by a very marked step on this route. This is not entirely hypothetic, as the main aim of these cuts is usually to convince the latter category- who are also conceived as the potential source of significant additional budget revenues. (Besides these rather automatic considerations one can also refer to the problem of labour costs beyond the income tax, social contributions and especially those that are paid for by the employer. Even in case of a significant tax cut these elements of labour cost can easily deter employers to offer a legal full salary, they can instead offer a splitting of the gains from the tax cuts - higher official salary with the same or slightly higher net income -, what would also be in fact a higher taxation of these grey incomes.) 

Anyway, one can safely conclude that tax cuts in themselves won't bring more freely disposable income for everyone. (It is important to note that one's income can nominally be higher, but with inflation, higher personal spending and almost compulsory savings the freely disposable income, the part of one's earnings that can be distributed freely into different consumption goods or directed into investment etc. can be even lower than before and ultimately this is what counts in assessing whether one is better or worse off after the tax cuts.) The effect of tax cuts can hardly be assessed in general, it should rather be done with the analysis focusing on different social groups, even though the macroeconomic effects are easier to grasp. But maybe for the individuals their personal fate has a precedence over macroeconomics, however shortsighted it be.

(So much for today, I will continue the analysis of the macroeconomic peculiarities in the next post.)

*There is always the possibility of magical savings due to higher efficiency of private providers, but the empirical evidence for this is controversial at best, therefore I won't make an attempt to guess its extent.

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