How to tax (a guide for governments)

How to tax (a guide for governments) 17th November, 2022

In 1789, an octogenarian Benjamin Franklin wrote a letter containing the famous opinion that “in this world nothing can be said to be certain, except death and taxes”. Franklin was mistaken. Many taxes are easily and legally avoided by the simple expedient of not doing whatever it is that attracts the tax.

Our cities have been shaped by such tax-avoiding behaviour. Consider the slender canal houses of Amsterdam. As Kurt Kohlstedt and Roman Mars describe in The 99% Invisible City, these buildings developed in response to a tax code that focused on canal frontage. Furniture hoists were deployed to bypass precipitous staircases. It was a hassle, but people will go to quite some lengths for a tax break.

A less pleasing example of tax-efficient architecture is the bricked-up window, common in London. The window tax was introduced in 1696 and sharply raised in 1797. At first glance it seemed to target the rich, but it also penalised the urban poor in tenement buildings as their landlords simply blocked up the windows to save money.

The cruelty and ugliness of such a tax is self-evident, but there was another cost, less obvious until you think about it: none of those bricked-up windows generated any tax revenue. Not only were the houses ugly, gloomy and airless, but they were also producing less tax revenue than originally hoped.

Economists call this “deadweight loss”; when people distort their behaviour to avoid a tax, nobody wins. The tax-avoider is worse off because the avoidance is costly. The tax authorities are worse off because the tax is not paid.

An old French saying has it that the art of taxation is “to pluck the goose so as to obtain the largest number of feathers with the least hissing”. But the experience of Dutch canal houses and the window tax suggests something else: the art of taxation is to pluck those feathers without prompting the goose as a species to evolve into a featherless fowl.

Unless a featherless fowl is what is desired, of course. In 1698, Peter the Great required Russian nobles to purchase a “beard token” if they wished to retain their beards. The aim, it seems, was less to raise revenue than to push the Russian nobility into the clean-shaven fashions of western Europe. (The story is told in Michael Keen and Joel Slemrod’s delightful Rebellion, Rascals, and Revenue.)

Many governments have given tax incentives for bearing children. One clumsy example, introduced in Australia in 2004 at short notice, caused the birth rate to drop precipitously the day before the baby bonus came into force, as C-sections and inductions were postponed.

Unfortunately, the easiest way to earn a tax break is to make some change on paper. Governments have long offered tax incentives in the hope of encouraging businesses to relocate, but it is all too easy to move accounting profits around in search of low taxes, while letting factories and offices stay exactly where they are.

An alternative is to resort to legal manoeuvrings. Are tomatoes a fruit or a vegetable? Are Jaffa Cakes a cake or a biscuit? The answer seems to be: whatever means less tax. Tomatoes are a tax-efficient vegetable (according to the US Supreme Court in 1893) and Jaffa Cakes are a tax-efficient cake (according to a UK tribunal in 1991).

The model for tax-cutting governments, whether they know it or not, is the British prime minister Henry Pelham’s halving of import duties on tea. In 1745, Pelham cut tea duty from more than 100 per cent to about 50 per cent. The result: less smuggling, a tripling of the legal tea trade and higher tax revenues. As the English boiled more water for tea, the death rate fell, according to research by the economist Francisca Antman.

It is quite a result for the tax-cutters: less crime, less disease, more tax and more tea. Alas, as Keen and Slemrod note, there are few opportunities to copy him. “Pelham’s triumph has become a fool’s errand . . . there is little evidence that major taxes around the world are often above levels at which revenue would be increased by cutting rates.” In the case of exceptions such as cigarettes, we have good reasons not to follow Pelham’s example.

Having surveyed the tax-avoiding horizon from canals to Jaffa Cakes, I draw three lessons.

First, taxes shape behaviour. Governments could do more to use tax incentives for good and pay too little attention to the wasteful distortions that taxes can produce.

Second, if you want to tax something like income or spending — and most governments do — then make the tax as broad-based as possible. Society does not profit from court rulings as to whether tomatoes are a vegetable.

Third, even the power of a tax incentive has limits. Pregnant Australians delayed births by hours, but not by months. Dutch canal houses grew tall, but the Dutch did not develop 17th-century skyscrapers.

When inheritance tax was abolished in 1979 in Australia, some Australian deaths were postponed — or registration of the deaths was postponed — in a highly tax-efficient way. Of course, these deaths were postponed only by a few days. Franklin may have been wrong about taxes, but death is not so easily cheated.

Written for and first published in the Financial Times on 14 October 2022.

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