Pareto's Republic and the New Science of Peace

by Filip Palda

  Efficient taxation theory became like Scheherazade’s telescoping stories in the Arabian Nights. Some economists felt that the theory had become a baroque, confusing, and ultimately quixotic quest to engineer behaviour on a mass scale through detailed modifications to the tax system. Most economists simply turned their backs on the subject. In the end, even the experts returned to a simpler conception of what efficient taxation should be. Summing up a vast body of research in a survey on taxation, Nobel Prize winning economist Joseph Stiglitz came to the following conclusion

  The suggestion contained in some of the numerical calculations, namely that the overall welfare gains from optimal taxation (using a utilitarian welfare criterion) are small and that the optimal tax structure may be close to linear, indicates that it may not be unreasonable to focus attention on linear tax structures” (page 1038).

  A linear tax structure is a flat tax. At the end of the hunt for an efficient tax, economists return to a proportional distribution of taxes amongst all.

  The political side of efficient taxation

  Simple tax systems based on a broad spreading of the burden make not only good economic sense but also good political sense because their inbuilt simplicity thwarts the efforts of those who would bend the tax system to their advantage. When we allow tax rates to vary from good to good, or between income classes as prescribed by some of the more complex theories about optimal taxation, the effect is akin to a siren blaring out and calling interest groups that are keen on seeing taxes amended in their favour. The staggering complexity of the US income tax code is not due to politicians following the tutelage of Ramsey-minded economics professors who advise subtly, but the consequence of interest groups pushing ceaselessly for changes to the tax code in their favour and of politicians promoting, perhaps unconsciously, class hatred through progressive income taxation.

  Europe does not suffer from a similar tax code complexity because most taxes in Europe are simple “flat” taxes, such as sales taxes, and social security levies that do not allow exceptions. US economists became interested in European-style flat taxes in the 1980s when it became clear that the theory of optimal taxation was not just a mechanical template based on demand and supply but also had to be tempered by the theory of interest group pressure. As Ramsey’s theory shows, flat taxes may or may not minimize deadweight loss. But the salient advantage of flat taxes is that they are simple.

  Simplicity discourages tax accountants and professional lobbyists from trying to get around taxes. This is an important benefit because when smart people divert their efforts from productive pursuits in the sciences, the arts, and construction towards the evasion of taxes, riches are lost. The riches lost by the “brain drain” away from productive pursuits to the pursuit of cutting the government pie by altering the tax code is a deadweight loss that plagues tax systems that open themselves up to complicated amendments.

  Regulations as hidden taxes

  The political angle to taxation is difficult enough to spy when talking about taxes that are plainly labeled taxes. What about taxes in disguise? That is, what about regulation? Regulations belong in this chapter because they are taxes and spending rolled into one. Take the Lex Roscia Theatralis of 67 BC, which, as I am sure you are aware, reserved fourteen rows in the theatre for members of Rome’s equestrian order. These rows represented lost revenues to theatre owners and as such were a form of tax. The law also specified how these rows were to be used. Allocating a resource to a specific use is a form of expense. Politicians may be tempted to allocate a theatre owner’s seats instead of taxing the population directly and spending the money openly on those seats. A tax is a visible irritant apt to provoke protest. The burden of a regulation falls on just a few theatre owners whose ability to protest may be feeble.

  Regulations are also a way for governments to spend money without having to present accounts to the public or the legislature. Who has heard of a government budget that includes the tax implicit in price controls, regulation of telephony, or worker safety standards? All are taxes and expenditures, but by virtue of being called regulations they pass unnoticed by tax theorists, and unspoken of in discussions of optimal taxation.

  If government can get a job done either by taxing or regulating, which “policy instrument” should it choose? The answer could bring new insights to the debate over the minimum wage. The minimum wage is a regulation that forces employers to pay more for workers than they would have to pay for them in a competitive market. The difference between the minimum wage and what the competitive wage would be is the “tax” which the regulation levies on the employer, and at the same time is the “expenditure” devoted to improving the lot of the worker. As a tax, the minimum wage imposes a deadweight loss. Faced with increased labour costs, some employers go out of business, and some workers lose their jobs. A government that wants to avoid this sort of collateral damage could help workers directly by giving them a handout. But this also creates collateral damage because the handout has to be financed by taxes. Government should choose the intervention that produces the desired result at the least deadweight cost.

  The choice between handouts and the minimum wage hinges on whether the minimum wage is a precise instrument that can target mainly the poor. The problem with the minimum wage is that it goes not just to the working poor, but to students from well-to-do families who flip burgers for pocket money, and to well-off retirees who work for amusement. It is an imprecise instrument for redistribution because it expands the ranks of beneficiaries to include those who cannot really be considered needy.

  If for every hundred dollars of aid to the poor, the minimum wage also gives a hundred dollars to the rich, then its precision is fifty percent. If government can identify the needy with greater than fifty percent precision, then the case for handouts over minimum wages strengthens. The final verdict depends on a comparison of how broadly the tax can be spread over the population and how broadly the minimum wage falls on employers. If tax evasion is under control, then the taxable base becomes the whole economy. Since employers of low wage labour are a subset of the economy, we can conclude that the minimum wage falls on a narrower section of the economy than do handouts financed by direct taxes. Taxes involve almost everyone in financing the state and so allow the burden of government action to be spread evenly. Regulations target a narrow range of businesses as those to be involved in financing. By transferring more money than the tax does and drawing that transfer from a narrow base, the minimum wage generates more deadweight loss than do taxes imposed on a broad base and used to pinpoint aid to the needy. Its imprecision, combined with the narrow base upon which it falls, can make the minimum wage a sloppy and expensive way of helping the poor.

  Such is the case for economies in which tax evasion is low and governments can precisely target needy groups. Minimum wages can make sense in countries where governments are neither competent enough to collect taxes nor skilful or honest enough to target aid to those in need. Think of the minimum wage as a means of controlling the price of labour. When you control a price you are doing something similar to taxing or subsidizing, which are the basic activities of government. If government is unable to raise revenues by taxing directly then it may need to control prices in order to mimic what taxes might do. This may explain why edicts to control prices were popular with governments until the mid-19th century. We still see poor countries taking seriously controls on the price of food and wages. Their lack of an efficient tax system forces them into this posture. In rich countries, price controls have almost disappeared. Minimum wages are relics of an earlier time. Today most governments set them so low that their nuisance to market forces is nugatory.

  Governments in rich countries have weaned themselves from direct price controls, but they still depend on a type of regulation that resembles the feudal rights granted by kings. These rights arose in the Middle Ages, sometime after the fall of Rome, when governments lost the ability to tax and administer their domains. The king delegated t
o a knight the right to rule over a fief. In return, knights pledged to fight for the king in war, and in peace to kick back revenues extracted from serfs. Knights also took upon themselves the administration of local justice.

  Today we need not look far to discover that in some industries the spirit of feudal systems lingers. This is no more apparent than in the cable television industry. One becomes a cable operator by lobbying government for the right to a monopoly over the distribution of television signals. The monopoly allows the operator to charge a price in excess of that which would prevail in a competitive market. The excess can be considered a tax. In return for the right to levy this tax, government asks the monopolist to subsidize the production of cultural and public service programming that would normally not appear in a competitive market. Here, as in the case of the minimum wage, the question is whether the cable monopolist’s levy falls on a sufficiently broad base to be deemed efficient in comparison to a government tax that could be spent to achieve the same results of subsidizing culture.

  Telephony is another example of an industry in which government delegates its powers of taxation and expenditure to corporate barons. In return for a monopoly over land lines, the telephone company agrees to install connections in private homes free of charge for the multi-thousand dollar cost of this service. The company recoups its costs by inflating the price of long-distance calling in an exercise known as cross-subsidization, thereby taxing heavy users of long-distance telephone calls. As with the case of cable monopolies, we must ask whether the telephone “tax” falls on too narrow a base, thereby provoking large deadweight losses compared to the losses that would result from taxing the general population and subsidizing local installation of lines from general government revenues. At the height of this form of hidden taxation, corporations in North America were having their own private telephone lines strung between cities to bypass the punitive long-distance rates they faced. Such a diversion of corporate effort from the real business of the company must be considered a significant deadweight loss.

  The lesson from these examples is that we must look at regulations in the same way we look at taxes. Does the regulation spread its burden over a broad base? Is the regulation well-targeted? Unless the answer to both these questions is in the affirmative, the validity of regulation as a means of fixing some gap left by market failure must be questioned.

  The Buchanan-Brennan conjecture

  To summarize this chapter, taxes discourage people from investing, consuming, and working. The result is a loss of Pareto efficiency. There is no point in whining about this because we need taxes to finance collective enterprises such as property rights protected by law, and the provision of public goods and the protection of common property. If we can devise taxes that minimally disrupt Pareto efficiency, then we can afford more of the public goods that themselves add to Pareto efficiency. The key insight in devising an efficient tax is to recognize the non-linear nature of deadweight losses from taxation. Non-linearity means that taxes produce deadweight losses that mount exponentially if they are levied upon some narrow group in society. The solution is to find some means of spreading the tax burden in such a way that no one is forced to carry a crushing fiscal backpack. What exactly this means is a question for economic specialists, but opinion is converging on the flat tax as one that may minimize the deadweight loss per dollar of government revenue gained. Such is the meaning of an efficient tax.

  The theory of efficient taxation and regulation would be good news for those living in Pareto’s Republic if all else remained constant. Yet the world seldom joins us in our conspiracy to keep things just as they are. Increases in efficiency may provoke reactions. Efficient taxation encourages people to demand big government, as Gary Becker and Casey Mulligan showed. With larger government comes the challenge of knowing what people want and informing them of what they are getting. Without such information, bigger government may become a financial cow ready for milking by selfish interest groups.

  Nobellist James Buchanan and his colleague Geoffrey Brennan anticipated with dread Becker and Mulligan’s findings. Years before, they feared that efficient taxes would seduce citizens into allowing government to grow into a mythical monster they referred to from Hobbes’ writings as “Leviathan.” Yes, efficient taxes reduce the disruptions to Pareto efficiency that are the by-product of government intervention, but the large government that results will exploit its coercive power in a way that makes it a direct threat to Pareto efficiency.

  Up to a point, increasingly efficient taxation will allow government to strengthen its protection of property and the commons. Yet as government grows, it becomes more difficult for the people to understand whether they are getting a good deal for their tax dollars. Politicians and interest groups exploit this gap in voter knowledge to enrich themselves, and government becomes needlessly costly. A tax has attained its optimum level of efficiency at the point where the benefits of efficiency begin to be outweighed by the costs of losing control over our leaders. Even if this style of thinking seems daunting to non-economists, the point Buchanan and Brennan made was simple. Designing a tax system should not only be an exercise in economic science, but also an exercise in political science. So let us explore politics to see how it can be harnessed to serve the purpose of Pareto’s Republic.

  POLITICS

  The previous three chapters of this book gave a fairly complete tour of the setting in which Pareto efficiency can thrive and the wealth that can result. But something is missing from this tour of Pareto’s Republic. So far, I have been talking about government as if it were an impartial force doing the best it can to promote Pareto efficiency in the face of the challenge of the breakdown of property rights. Where does such a beneficent government come from? In the private market we saw that efficient producers emerge from a struggle for survival within the peaceful strictures of the rule of law. Competition allows efficient producers to replace inefficient ones. Who drives government to be efficient?

  Government, as we have described it, is an institution with a monopoly on power. It is not an entity you would think would yield easily to being replaced by a more efficient competitor. After all, if you have the army and police behind you, why would you cede your place to an alternate regime that can manage the state better than you can? The monopoly that government retains on power is an important and sometimes determining factor that stops societies from attaining Pareto efficiency.

  Yet we have no choice but to concede a monopoly of force to government. Think what it means to have two governments ruling the same domain. That is a recipe for confusion, if not for all-out civil war. The trick to getting a government that acts Pareto-efficiently is to accept that only one government may rule at a time, but it must simulate around it the conditions of peaceful market competition. Somehow we must devise a means by which a government may be replaced peacefully by another government at some reasonable interval. A more subtle simulation of competition is to create a decentralized political system in which people can move to other jurisdictions that may be run differently and offer an alternate model of governance to citizens who are not pleased with the regime under which they are living. “Voting with your feet” is perhaps the strongest method of containing governments that abuse their monopoly over coercion.

  The payoff from creating competition in the “political market” is riches. Peaceful political competition attracts rulers who are best suited to providing the most efficient level of public goods and to protecting common property resources. As we saw in the previous three chapters, these are the two functions of government that create a setting in which people can fully explore the potential for creating wealth. Political competition attracts the most productive rulers in the same manner that private competition under the rule of law attracts people into functions and roles best suited to their abilities.

  In private markets, rule of law ensures that the ability to get away with bullying and intimidation are not factors in the individual’s rise to
success. Rule of law strips people of the power to intimidate, leaving them to use only their productive talents to make their way in the world. In the same manner, peaceful political competition does not allow strongmen or women to shoot or intimidate or bribe their way into office. The road to power is then open to people of all political talents. Bill Clinton’s rise from poverty to become one of the most highly acclaimed American presidents is an example of what political competition can produce. Conversely, the rise of dictators who preside over stagnation shows that countries ruled by intimidation are missing out on the chance to create riches. Think of the incredibly fertile country of Zimbabwe which is mired in poverty bordering on famine, courtesy of the paralyzing effect its violent ruler has had on any private initiative to exploit the country’s fertility. One can imagine a picture of trees with low hanging fruit just above the reach of a populace debilitated by the numbing action of truncheons bouncing off innocent heads.

  In his celebrated treatise, The Rise and Decline of Nations, Mancur Olson called such unexploited riches “big bills on the pavement,” which are there for the taking if a country invests in property rights, curbs tax evasion, and provides public goods. The big bills remain lying there when the peaceful political competition that would allow the best leaders the chance to pick them is stifled. Potholes are the best example of such uncollected riches. One pothole on a city street can produce tens or hundreds of thousands of dollars of damage to cars’ suspensions as drivers pass over them with teeth clenched. Yet the pothole would cost little more than a few hundred dollars to fill by city workers. Here is clearly a case where if drivers paid a little more in taxes they could save much more in repair bills and city workers could benefit from the extra demand for their services. The fact that this potential for improvement on the side of consumers and producers of the political service goes unrealized represents a big bill lying on the pavement, almost literally. That bill could be collected by both citizens and government employees if we had a political system that allowed us to pick up these big bills. How to get such a political system, one that can unite voter-consumers with politician-producers in a union that serves the interest of both, is the subject of the present chapter. It will not surprise you to learn that the lessons of Pareto efficiency in private markets can also be our guide in political markets. This is perhaps the most challenging chapter in the book because it brings together in a unified whole various concepts of the private search for efficiency with society’s collective search for the right type and size of government.