Friday, February 9, 2007

Taxation and productivity

I had a recent discussion with a friend of mine regarding taxation and he pointed out that Sweden had very high taxation but didn't seem to suffer so much. Well on closer examination not all is right in Sweden. Their low unemployment includes people who are working on Government work programs. If you remove these people then the unemployment in Sweden shoots up to 15 - 17% (
I wondered whether there might be some other impacts. But to start off, we must first think about what taxation does.
Most countries have two types of taxation - corporate and individual. I would argue that corporate taxation is morally and economically unsound and individual taxation is a necessary evil.
Let's start with corporate taxation. Most types of corporate taxation tax the profits of a corporation. This type of taxation is fundamentally wrong.

Firstly taxing the profits of a corporation means that there is less money being cycled into the company ie. through investment, research and development or profit sharing for the employees. Furthermore there is less money going to investors who are taking a risk in investing. This means that investors are either not getting a fair return on the risks that they are taking or the investors will only invest in firms that have a risk profile that match the size of their returns. In the long run, I believe that investors will wise up to the fact that they are not rewarded for risk taking and they will move to safer investments.
What does less risk taking mean? It means that that high risk, high return investments are less likely to occur, which typically means those investments that can potentially have tremendous benefit to the productivity and well being of society.

Secondly, taxing the profits of a corporation move resources from an entity that efficiently utilizes (the corporation) to an entity that is notoriously inefficient (the government). P J O'Rourke, once commented that there's nothing worse than someone spending someone else's money on someone else. Governments do just that. Bureaucrats and politicians have no initiative to spend the money wisely or efficiently and we see profligate spending.

Thirdly, corporate taxation is a form of double tax. The corporation as an entity is taxed and then each worker is taxed on top of that. This means that each worker loses in terms of investment (training, profit sharing, etc.) and loses in terms of his income (through individual tax). On top of that, investors are double taxed in many countries. Firstly by a cut in their dividends (through the corporate tax) and through a tax on capital gains.

So much for corporate tax. Individual tax is a necessary evil. Necessary because the state needs some form of funding even for it's minimal responsibilities (security and justice). However let us not have any illusions that individual tax is evil. The best sort of tax is a flat one as people are not penalized for being rich (or poor for that matter). "Progressive" taxation means that we have a positive marginal tax rate, which means that the rich are in some sense penalized for being rich. The rich tend to be the ones who are more likely to have the money to invest in risky projects (witness Jeff Bezos and his space tourism initiative). There is a well known corrolation between wealth and the amount of risk that an investor is willing to take. The average middle class investor is looking for a safe investment to ensure his/her retirment - there is very little money to put into things that may not pay off. The wealthy, on the other hand, have enough left over to put into riskier things like private equity funds and venture capital. High risk ventures very often are where we see the most impressive strides in productivity growth. Taxing the wealthier more, therefore, is essentially taxing risk taking.

In conclusion. Corporate taxation reduces productivity, double taxes individuals and impairs risk taking in a society. Individual taxation, though necessary, is an evil as well especially progressive tax regimes that penalize the wealthy. Progressive tax regimes put a marginal burden on risk taking, which works toward reducing the amount of risk a society is willing to take.

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