from 1.5 percent of gross national product in 1960 to 18 percent by the mid-1990s. Cheating the tax man can be a vicious circle. As more individuals and firms slip into the underground economy, tax rates must go up for everyone else in order to provide the same level of government revenue. Higher taxes in turn cause more flight to the underground economy—and so on. 17
The challenge of transferring money from rich to poor is not just on the taxation side. Government benefits create perverse incentives, too. Generous unemployment benefits diminish the incentive to find work. Welfare policy, prior to reform in 1996, offered cash payments only to unemployed single women with children, which implicitly punished poor women who were married or employed—two things that the government generally does not try to discourage.
This is not to suggest that all government benefits go to poor people. They don’t. The largest federal entitlement programs are Social Security and Medicare, which go to all Americans, even the very rich. By providing guaranteed benefits in old age, both programs may discourage personal savings. Indeed, this is the subject of a longsimmering debate. Some economists argue that government old-age benefits cause us to save less (thereby lowering the national savings rate) because we need to set aside less money for retirement. Others argue that Social Security and Medicare do not reduce our personal savings; they merely allow us to pass along more money to our children and grandchildren. Empirical studies have not found a clear answer one way or the other. This is not merely an esoteric squabble among academics. As we shall explore later in the book, a low savings rate can limit the pool of capital available to make the kinds of investments that allow us to improve our standard of living.
None of this should be interpreted as a blanket argument against taxes or government programs. Rather, economists spend much more time than politicians thinking about what kind of taxes we should collect and how we should structure government benefits. For example, both a gasoline tax and an income tax generate revenue. Yet they create profoundly different incentives. The income tax will discourage some people from working, which is a bad thing. The gasoline tax will discourage some people from driving, which can be a good thing. Indeed, “green taxes” collect revenue by taxing activities that are detrimental to the environment and “sin taxes” do the same thing for the likes of cigarettes, alcohol, and gambling.
In general, economists tend to favor taxes that are broad, simple, and fair. A simple tax is easily understood and collected; a fair tax implies only that two similar individuals, such as two people with the same income, will pay similar taxes; a broad tax means that revenue is raised by imposing a small tax on a very large group rather than imposing a large tax on a very small group. A broad tax is harder to evade because fewer activities are exempted, and, since the tax rate is lower, there is less incentive to evade it anyway. We should not, for example, impose a large tax on the sale of red sports cars. The tax could be avoided, easily and legally, by buying another color— in which case everybody is made worse off. The government collects no revenue and sports car enthusiasts do not get to drive their favorite color car. This phenomenon, whereby taxes make individuals worse off without making anyone else better off, is referred to as “deadweight loss.”
It would be preferable to tax all sports cars, or even all cars, because more revenue could be raised with a much smaller tax. Then again, a gasoline tax collects revenue from drivers, just as a tax on new cars does, but it also provides an incentive to conserve fuel. Those who drive more pay more. So now we’re raising a great deal of revenue with a tiny tax and doing a little something for the environment, too. Many economists would go yet one step
The challenge of transferring money from rich to poor is not just on the taxation side. Government benefits create perverse incentives, too. Generous unemployment benefits diminish the incentive to find work. Welfare policy, prior to reform in 1996, offered cash payments only to unemployed single women with children, which implicitly punished poor women who were married or employed—two things that the government generally does not try to discourage.
This is not to suggest that all government benefits go to poor people. They don’t. The largest federal entitlement programs are Social Security and Medicare, which go to all Americans, even the very rich. By providing guaranteed benefits in old age, both programs may discourage personal savings. Indeed, this is the subject of a longsimmering debate. Some economists argue that government old-age benefits cause us to save less (thereby lowering the national savings rate) because we need to set aside less money for retirement. Others argue that Social Security and Medicare do not reduce our personal savings; they merely allow us to pass along more money to our children and grandchildren. Empirical studies have not found a clear answer one way or the other. This is not merely an esoteric squabble among academics. As we shall explore later in the book, a low savings rate can limit the pool of capital available to make the kinds of investments that allow us to improve our standard of living.
None of this should be interpreted as a blanket argument against taxes or government programs. Rather, economists spend much more time than politicians thinking about what kind of taxes we should collect and how we should structure government benefits. For example, both a gasoline tax and an income tax generate revenue. Yet they create profoundly different incentives. The income tax will discourage some people from working, which is a bad thing. The gasoline tax will discourage some people from driving, which can be a good thing. Indeed, “green taxes” collect revenue by taxing activities that are detrimental to the environment and “sin taxes” do the same thing for the likes of cigarettes, alcohol, and gambling.
In general, economists tend to favor taxes that are broad, simple, and fair. A simple tax is easily understood and collected; a fair tax implies only that two similar individuals, such as two people with the same income, will pay similar taxes; a broad tax means that revenue is raised by imposing a small tax on a very large group rather than imposing a large tax on a very small group. A broad tax is harder to evade because fewer activities are exempted, and, since the tax rate is lower, there is less incentive to evade it anyway. We should not, for example, impose a large tax on the sale of red sports cars. The tax could be avoided, easily and legally, by buying another color— in which case everybody is made worse off. The government collects no revenue and sports car enthusiasts do not get to drive their favorite color car. This phenomenon, whereby taxes make individuals worse off without making anyone else better off, is referred to as “deadweight loss.”
It would be preferable to tax all sports cars, or even all cars, because more revenue could be raised with a much smaller tax. Then again, a gasoline tax collects revenue from drivers, just as a tax on new cars does, but it also provides an incentive to conserve fuel. Those who drive more pay more. So now we’re raising a great deal of revenue with a tiny tax and doing a little something for the environment, too. Many economists would go yet one step
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