Date created: 28 November 1996
Last modified: 18 November 1997
Maintained by: John Quiggin
John Quiggin

Taxing ingenuity of economic thinkers

Australian Financial Review

J Dec 9 , 1994

Economists are famous for making convenient, but unrealistic, assumptions. An old joke has a physicist, a chemist and an economist stranded on a desert island with a stock of tinned baked bins. The scientists try all sorts of methods to open the tins, but fail. At last the economist says with a superior smile 'Assume we have a tin-opener.'

Of all the assumptions economists make the most convenient is that of the lump-sum tax. This is a tax which has no effect on any decisions anyone makes, no compliance costs and no costs of collection. Obviously no such tax exists in reality, but in the world of assumptions this is no problem.

Economic fundamentalists use the lump-sum tax assumption to wish away the income-distribution effects of the policies they advocate. They argue that policy should be concerned only with efficiency, and that any adverse 'equity' consequences should be dealt with by the tax and welfare system. This argument only makes sense if a lump-sum tax is assumed into existence. Otherwise the costs of coping with the equity consequences may exceed the gains generated by the policy in the first place. (For those who prefer their economics in algebra rather than in English, I have a forthcoming article in Economics Letters which proves this point in the approved academic fashion).

Advocates of an interventionist role for government have also exploited the lump-sum tax assumption. All sorts of interventions in the economy make sense if a lump-sum tax source is available. For example, most public utilities are characterised by scale economies which mean that the marginal cost of serving an additional customer is less than the average cost for the enterprise as a whole. Assuming a lump-sum tax is available, the optimal policy is for the utility to set its price equal to marginal cost. If marginal costs is sufficiently low, the service should be given away freely and the entire cost borne by consolidated revenue.

Once it is admitted that no lump-sum taxes are available, life becomes much more difficult for policy economists. For any policy that involves a net expansion in spending, it is necessary to weigh the benefits of the policy against the resource costs of raising the necessary revenue. To make life more difficult, there is very little agreement on how large these costs are. Estimates range from near zero to 50 cents per additional dollar of revenue raised, with most falling in the range of 10 to 20 per cent.

This point has been raised in response to a recent survey by the Economic Planning Advisory Council (EPAC) showing that most Australians would be prepared to pay higher taxes in return for improvements in community services such as health and education. It has been argued that the respondents were not made aware of the resource costs of raising taxation and would have answered differently if they were better informed.

On the whole this seems unlikely. The community is well aware of the costs of raising taxation. Indeed this awareness has dominated political debate ever since the 'Tax Revolt' of the late seventies. The problem, as we are now becoming aware, is that not raising taxation is also very costly. We could, for example, finance education entirely by student loans and health entirely by private insurance. But the resource costs of doing so are huge. The resource cost of loan financing is measured by the bank margin between deposit and lending rates, usually around 3 to 4 per cent for well-secured home mortgages and as much as 10 per cent for personal loans. For a 5-year personal loan, this can approach 50 per cent of the amount borrowed, as much as the upper bound estimates of the cost of tax financing. Although the costs of insurance mechanisms are harder to quantify, they may be comparably large, especially if there is any attempt to impose community rating on the system.

As the service sector increasingly comes to dominate economic activity, we will move further and further from the comfortable world of lump-sum taxes. We will be faced with difficult choices between funding these services with socially costly taxes and proposals for private financing that may prove even more costly. The result will be to break down assumptions that have dominated the political debate for many years.

On the one hand, as the competition for funds intensifies, the pressure to economise on existing areas of expenditure will grow. This will be particularly evident in European countries where the unsustainability of universal, income-based, systems of transfer payments is already becoming evident. On the other hand, the assumption, still embodied in the Forward Estimates, that the tax share of GDP can be steadily cut will be recognised for the nonsense it is. The future will be one of intense pressure for new sources of revenue. With the lump-sum assumption abandoned, the ingenuity of economists will be taxed to the limit in finding methods of levying higher taxes while minimising the associated resource costs.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

Read more articles from John Quiggin's home page

Go to John Quiggin's Weblog

Read more news articles from 1994 and earlier