First, let us look at something more basic. The unarguable truths about taxation.

Taxation cannot create any wealth, it simply takes wealth from an individual. That wealth my come from an intermediary such as a corporation or trust, but, in the end, that money would have eventually gone to an individual but for taxation. Taxes are nothing more than a means of transferring money from an individual to the state¹.

Taxation can be used to encourage specific behaviors, but only at the expense of other behaviors. The tax system encourages behavior X by making it less costly than behaviors A through W. That is done by making the tax burden higher on those alternatives than on option X. This will have one of two effects. Either it will do nothing, as individuals were inclined to do X anyway, or it will turn individuals from an option they prefers (say A) to an option they like less (X). Whether or not this is beneficial is a question that must be answered in each specific case. All I want to make clear is that using the tax system to encourage, for example, home ownership, is by making other options, such as renting, less appealing.

With regard to capital formation and investment, taxation can be used to encourage greater savings, but only by discouraging spending. History shows that relatively small tax breaks for savings are not enough to discourage spending, it takes a much more drastic action. Whether done through government mandated austerity programs, punitive luxury taxes, or an overall crippling sales tax, it takes a pretty severe penalty to discourage people from spending. However, it can be done. The question remains, however, whether the level of penalty required to dissuade spending will harm the economy more than increased capital formation helps it². The economy is not driven solely by capital accumulation and production, they do not exist in a vacuum. Without buyers, the economy falters just as badly as it would without capital investment.

A tax system which favors one kind of action, investment or income will tend to produce more of that option and less of all others. This is basic economics, but it needs to be repeated. Especially as many forget this truth and thus fail to see the unintended consequences. For example, many in office fail to see how the capital gains tax, by discouraging the sale of investments, tends to keep money in an investment too long, as well as discouraging investment entirely. In other words, it keeps people form investing, and for those who do eventually invest, it leads them to hold on to investments longer than they would otherwise, making the market a less efficient means of reallocating capital. Or how the interest deduction on mortgages tends to make people less concerned with mortgage rates, even in adjustable mortgages, which can lead them to forget that they have to actually make the payments before deducting them. So, in some ways the mortgage deduction helped lead to a borrower mindset which fueled the subprime crisis we see today.

I think I have covered all the basic points I wanted to explain. I know most were stated in lesser detail in my last post, but I thought a few deserved more attention. Having said all that, let me now proceed to explain those six points I raised in my previous post.

For those who missed the previous post, my statement was that an ideal tax system would do the following:

1. Minimizes the individual harm done
2. Treats all individuals and all types of income and wealth similarly
3. Does not target specific acts or assets for favorable or punitive treatment
4. Has the lowest total administrative cost per dollar of revenue
5. Taxes only enough to cover needs, not more
6. Produces consistent results

Let me address these points one by one.

Minimizes Individual Harm Done

This point goes beyond the superficial meaning of keeping the taxes assessed to a minimum. That is obviously a concern, but it is just one concern. As the truism goes "the power to tax is the power to destroy". We need to make sure that we use this power sparingly. However, as this point relates to all of the subsequent points, I think I will leave the discussion for later. We will return to this at the end to see how it relates to everything else we discussed.

Equal Treatment

This is the first principle and probably the most contentious. My starting point is that the economy runs best when left alone, that the free market allocates resource to those desires most keenly felt, so leaving the market alone produces the greatest net satisfaction. As a result, any government intervention will, of necessity, reduce that satisfaction.

On the other hand, the government does need money to operate, so some reduction of private wealth is inevitable. That will also, of necessity take money from desires more keenly felt and apply it to less keenly felt needs for government services. That minimal harm is unavoidable.

What we can avoid in funding the state is creating economic distortions which cause money to flow to purposes that would otherwise not receive that money. For example, by allowing a deduction for insulation the state causes people to spend more on insulation than they would otherwise. This leaves people less satisfied.

Now, if one believes the government knows better than individuals, then this is a good thing. As I do not believe the government is any better than an individual at knowing what that individual wants, I would prefer the tax system leave the economy, as much as possible, as it would exist without taxes. The easiest way to do that is to treat all sources of income, all types of spending and all other matters equally.

No Punitive Taxes

This follows the argument above. If we assess higher taxes on some acts, or forgive taxes on others, we cause economic dislocations, and we end up changing the economy. In other words, the tax system becomes a tool for social engineering. As I think the tax system is a tool, and a tool suited specifically for gather revenues, I would argue against using it for social engineering. First, it is a very inefficient means of social engineering compared to the other alternatives. Second, social engineering gets in the way of efficient tax collection. It is better to let the tax system collect taxes and the legislature engage in whatever social engineering we find appropriate.

Lowest Total Cost

Obviously, this is the best measure of a tax system int he most basic sense. All other things being equal, the system which collects the most money per administrative dollar is best. On the other hand, we need to apply this measure last, as all the other rules are more important.

How so?

Well, look at this plan. Every dime you earn is paid to the state which then remits a stipend to you. At the end of the year it calculates your tax burden and returns the remaining balance. As it is very simple, it probably produces pretty good revenues per administrative dollar, but it is hardly the best system. Or, to make it even more plain, if the state simply came into your home and took what it wanted, the administrative cost would be almost nothing, but I doubt any would consider that system ideal.

As I said at first, all other things being equal, the system is best which returns the most revenue per administrative dollar spent.


Least Possible Tax

This is a problem with our current system, taking far more in withholding than is actually due. Ideally, the tax system would take only what is owed to the state and not a dime more. But our current system is actually engineered to produce modest rebate checks in order to mollify the public, so that will never happen.

Why do I say that this is important? The reason is simple. Every dollar which is paid to the state in excess of taxes owed amounts to an interest free loan to the state.As state investment is less efficient than private, this produces a net drag on the economy. Beyond that collective ill, there is also an individual ill, as citizens are compelled to make such interest free loans, not only violating their property rights, but robbing them of whatever returns they would have earned on that money, or what satisfaction they would have received form spending it.

Obviously, few systems exist which will never take a dollar to which the state is not entitled. My earlier proposal of eliminating withholding and requiring quarterly checks would, but people would be quite unhappy with the massive checks they would write³. Other than that, any system which operates on the principle of ongoing collection,m be it withholding or the  sales tax used in the FairTax runs the risk of taking in more in taxation than is required by the state.

So, since we likely cannot avoid this problem, I would argue that, if avoiding the problem is impossible, we should still favor a system which reduces to a minimum payments in excess of taxes owed.

Consistent Results

This is one point on which yt_knight and I agree, though he seemed to sometimes confuse simplicity and consistency. Regardless, it is evident that tax systems should produce consistent results. We should not have a system such as we have now, where the same facts can produce multiple outcomes, depending upon the expert answering. However, that is more the result of the sheer volume of rules, not so much of internal inconsistencies. I think our current system would be almost consistent were an individual able to hold all of the rules in mind while preparing taxes. There are some vague rules, but for the most part any confusion is more the result of the limits of human memory combined with a massive set of rules than of internal inconsistencies.

Conclusion

So, having said all of that, let me look at three options. Our current system, the FairTax, and my proposed flat tax without withholding, corporate taxes, or anything else, excepting perhaps a small tariff⁴.

The current system obviously falls short in almost every category. As I just said, the sheer volume of rules precludes consistency, not to mention contradictory or vague rules, which, though not that numerous, do make certainty impossible.There are numerous punitive taxes to either encourage or discourage activities, producing huge economic dislocations. And it withholds far more than is actually owed. The only area in which it is arguably somewhat efficient is in terms of administrative costs. Despite the claims of the FairTax advocates, the income tax is relatively cheap in terms of total revenue generated. When we add in individual costs for tax preparations the cost does rise, however. So, once we consider both the obvious and hidden costs, our present system fails in every respect.

Now let us look at the FairTax. It is, for the most part, consistent. I have said before that I think distinction between new and used and wholesale and retail will generate some confusion, but for most cases, it is sufficiently consistent. I do think that the administrative costs will be much higher than the advocates admit, mostly because those costs will be hidden in increased costs for the Social Security Administration and state tax agencies, but how the revenue per administrative dollar figures compare to other choices will remain to be seen.

Where the FairTax really fails is in the area of consistent treatment. It is based entirely on treating purchases as a select class, subject to taxes which do not effect other areas. In addition, it distinguishes between retail and wholesale purchases and new and used goods. As I have said over and over, this will cause massive economic dislocations.Some will argue that these dislocations will be "beneficial", but I would ask by what standard? If people who would make a purchase now decide to invest, who is to say that is "better"? If they wanted to purchase, that would make them more satisfied, and as they are the sole judge of their own needs, investing rather than spending is a net loss for them. How can someone argue that "in reality" they are better off now?

In short, arguments for the advantages of the FairTax rest on the assumption that the speaker knows better than other individuals what is in their own interest. And that I cannot accept.

Finally, let us look at the variation of the flat tax I once proposed. It does have the shortcoming of all income taxes, that of treating earned income as different from other money, and thus it does violate my second and third rules. On the other hand, earning income is unavoidable for most people, so I doubt taxing income will cause much change in behavior. In addition, by applying a flat schedule it does over come the current problem of avoiding pay raises lest one jump into a higher bracket. So, while it violates the second and third rules, it does as little harm in so doing as possible.

Other than that, there is nothing objectionable. Obviously, there will be some difficulty over defining what is considered income, but that is the only area for uncertainty. With no deductions, or exemptions, it will doubtless be more simple than the current system. It has a relatively low administrative cost, as I remove all taxes other than the income tax, and without withholding or exemptions, it will allow a massive reduction of IRS size. The rate can be adjusted to match anticipated needs, reducing or eliminating excessive taxation worries.

It is far from ideal, but in terms of reducing the harm done, keeping costs low, and avoiding economic distortions it is about as good as one can expect from a politically palatable solution.

The only nationwide tax alternative which avoids even those problems is a straight capitation tax, paid monthly. Every citizen over 18 would be charged monthly for the costs incurred during the previous month. It is simple, cheap, and does not distort the economy. On the other hand it is a political impossibility, as it makes no allowances for income. Not to mention the fact that after maybe two months the nation would be up in arms demanding massive cuts in spending, which means no politician would ever propose it.

Ideally, I would return taxation to the states, create fifty little labs where these questions could be worked out. But I was asked to propose a national tax scheme, so my first choice is not an option.

Hopefully that answered all of yt_knight's questions. I doubt he will agree with my conclusions, but at least I think I made clear how I reached them.

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1. For my purposes I am ignoring disguised welfare scheme such as the EITC. They are not truly taxation but a welfare plan which uses yearly tax filings as a means to distribute them. They have nothing to do with taxation proper.

2. To clarify, capital formation is essential to industry, but so is a vibrant consumer base. If we save every dime we earn then I have to wonder who will be buying anything? The economy requires two parties, a buyer and a seller. If we remove the buyer,t hen all the capital formation in the world won't save the economy.

3. The pain could be reduced with monthly, rather than quarterly checks. On the other hand, part of my reasoning was that I wanted taxes to hurt. I believe that only if people have to pay taxes out of their pocket, without the fig leaf of withholding, or the FairTax's embedded sales tax, will citizens begin to question what they are receiving for the money they pay.

4. This tax is not my first choice, but as yt_knight continues to insist I propose an alternative, this is the closest I can come. Ideally I would leave taxation to the individual states, with the states themselves funding the federal government directly, as was envisioned in the Constitution. But no one seems to accept that position as my alternative, so I will pretend that I advocate the flat tax, as it is the national system I find least objectionable. Actually, I would favor a capitation tax even more, but as it is seen as "unfair" I doubt it will ever see the light of day.

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UPDATE 05/27/2008

I read my post again, and want to clarify something I said in my third general statement about taxation and in footnote #2. I do not want readers to think I am pushing some sort of Keynesian "consumerism". What I am trying to do is balance out the opposite error, let us call it "producerism".

Consumerism is a silly theory that focuses on spending to the exclusion of all else. It is at the heart of silly ideas such as the "stimulus" checks that went out recently. However, as a reaction to that theory, many, including many FairTax advocates, have fallen into the opposite error, and made a fetish of capital formation and productive capacity. Now production and capital formation are important, but to accumulate capital at the expense of radical reductions in consumption can be just as harmful as the opposite fallacy.

Perhaps an analogy would help. The consumerist is the wastrel who immediately spends every die he receives. The productionist is the old man who hoards every dime despite the fact that he has no heirs.

Our economy does grow when we accumulate capital and refrain from excessive consumption, however that misses the point of the economy. While the productionists are busy laying up treasures they forget why we want treasures, to consume them. If the FairTax does discourage consumption to favor production, then it also changes consumer behavior to their detriment. There is no absolute value in capital accumulation, the value of any act of savings or consumption is what the consumer or saver puts on that act. And to force them to change their behavior is to leave them less satisfied. To argue that "growth" in itself is good is to engage in the fallacy of forcing one's own valuation onto the economy as a whole. Growth is only as valuable as the collective assessment of all participants make it, no more no less. And they express those valuations through their spending and saving decisions.

And that is one more objection to the FairTax, by telling people they should spend less and save more it is setting the value judgments of the plan originators as more valuable than the valuations of all other citizens. Admittedly, the FairTax does this in a fairly limited area, but it is still a principle I do not want to incorporate, as it leads to the acceptance of  all kinds of bad ideas. Basically, the FairTax is founded, in many ways, on the view of other citizens as stupid, at least too stupid to save a smuch as they should.

But I will leave that subject alone for now. I just wanted to make clear that I did not mean to adopt a consumerist theory, just balance out what appeared to be an error in the opposite direction.