Tax Potentials, Not Actuals
|November 3, 2013||Posted by Fred Foldvary under Editorials|
Taxes can fall either on actual events and values, or on potential values. Actual events include transactions such as the sale of goods and the payment of wages, rent, and interest. Actual values include the profit from enterprise. Most taxes today are imposed on such actuals.
Potential prices are based on the usual or maximum capacity of a person or asset to obtain market value. Suppose that a specialized medical doctor could normally earn $200,000 per year. That is his potential income, although he could be earning less than that if he choose to work fewer hours or to be employed in a setting that pays less. As another example, suppose one has $100,000 in stocks and bonds, and the average real return (adjusting for inflation) has been five percent. The potential income is $5000 per year.
If taxes were based on potentials, the doctor would not be taxed on his actual income, but rather on his potential income. Suppose the tax rate is ten percent. His wage tax would be $20,000 even if he earned more than $200,000 in a particular year. If he chose to work half time, the tax is still $20,000. Hence the effect of the tax on potential income is to push the doctor to work at least normal hours, and the effect is also to avoid any disincentive to work extra hours. In economic terms, the tax would be a fixed cost, with no tax on extra actual income. In contrast, a tax on actual income imposes a disincentive to work longer.
To analyze taxes on potential versus actual wages, we need to assume the best possible implementations. So, to be equitable, a tax on potential income should include a deduction for charitable work. Suppose that the doctor worked for a charity that provides medical services for the poor, at a wage of $50,000. There would be a $150,000 deduction for taxable income, so the tax would be ten percent of $50,000, since the doctor is working at his potential, and donating 3/4 of his potential to charity.
If income from financial assets were taxed based on potentials, the best implementation would postpone the tax in years when market returns were low. The tax would promote prudent behavior, such as investing in market index funds, so that the probability of returns being close to potentials would be higher.
A tax on the potential value of buildings and other improvements would be based on their being optimally maintained. If the owner allowed his building to deteriorate due to lack of repairs, the tax would be based on the value when maintained, and so the tax on potential building value promotes optimal maintenance, in contrast to today’s taxes on actual value, which reduce maintenance by making it more costly after paying extra taxes.
The best application of taxes on potential value is on land. Indeed, taxes on real estate are typically applied to the potential value of the property, based on the highest and best use of the site. The property is assessed annually based on the prevailing market prices in the neighborhood. One exception is California, whose Proposition 13 limits the tax increase to two percent per year even when the market prices are rising faster, so long as the title does not get transferred.
A tax on potential land value promotes the optimal use of land, and that also promotes optimal production and employment, especially if there is no tax on actuals.
A tax on potential land value is morally optimal as well, since title holders pay back the value received from government’s public goods, and because self-ownership does not apply to natural resources and the value derived from the community’s population and commerce.
While a tax on potential wages would push employment towards its potential, it would in some cases amount to forced labor for those who prefer more leisure. It would deprive workers of the freedom of choice, and thus not be equitable. It would not even be efficient, since leisure is a desired good.
Taxes on potential financial returns could reduce entrepreneurship in business and investments, and so would probably have negative effects.
A tax on pollution is based on its potential damage, and so is efficient and equitable.
Therefore taxes on potential land value and pollution are the best applications of taxes on potentials. Taxes on transactions reduce production and trade, while taxes on potentials promote production and trade. For maximum equity, efficiency, tax potentials, not actuals.