Do we really want our taxes optimal?

One debate we may have in the upcoming federal election, though if so only deeply implicitly, is whether we’d like our taxes to be optimal. It sounds a silly thing to debate. Of course we’d like our taxes to be optimal. Twenty-first century citizens and consumers are fully empowered. We want everything to be optimal.

In tax selling, it seems, adjectives are crucial. First there was progressive taxation, and who among us wouldn’t want to be progressive? And now there’s optimal taxation. Just as nobody would step forward to say they favoured regressive taxation, you won’t get a lot of volunteers for whatever the antonym of optimal might be: useless taxation?

But what is optimal taxation? For most of us, an optimal tax is one that somebody else pays. As you might expect, economists have a different definition. An optimal tax is one that raises revenue with as little disruption as possible to economic activity. The truly optimal tax produces the least disruption. Taxes will always be disruptive. Anyone who gets hit with a tax suffers a reduction of purchasing power and that will at the very least reduce his or her purchasing. But if that’s as far as the disruption goes, you’ve got yourself a great tax. It’s also an unusual tax. With most taxes, people probably do change their behaviour. In particular, they cut back on the activity that makes them liable to tax. If it’s an income tax, they may cut back on working or investing. If it’s a property tax, they may avoid home-improving repairs. And so on.

In a sense, optimal taxation is value-free: It only focuses on efficiency. As UBC economist Kevin Milligan put it in his 2014 C.D. Howe Institute Benefactor’s Lecture, which just won him the Purvis Prize of the Canadian Economics Association for best economic policy writing of the year: “If technology and preferences were such that heavily taxing income derived from selling apples produced” the most tax revenue with the least disruption to economic behaviour, then that would be the best way to raise tax revenue. Maybe apple-eaters are so addicted to apples and apple-growers so in love with patrolling their orchards that both groups would continue more or less exactly as before, despite the now-high taxes on their beloved fruit. The rest of us, less afflicted by strong taxable enthusiasms, would benefit by paying lower taxes.

To cast the argument using a more ancient metaphor: Jean-Baptiste Colbert, Louis XIV’s finance minister, said, “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” On first hearing that memorable phrase, most of us probably think the hissing rep-

For most of us, an optimal tax is one that somebody else pays

resents complaining. But in the optimal taxation view of the world, it represents economic harm. If you have a quota of goose feathers to extract, you want to take them from the geese with either the highest pain threshold, the least securely attached feathers or some combination of the two. So if you’re going to pursue optimal feather extraction, you need to know your geese.

Which is the main problem with optimal taxation. You’ve got to have good information about people’s likely response to taxation. In economic jargon, you have to know the elasticities, an elasticity being, in this context, people’s responsiveness to the price changes taxation brings. For a given increase in tax, how much do they reduce their good economic activity: their working, their educating themselves, their investing or their saving?

Unless the CRA, CSIS or the CIA is holding back, we don’t actually have good information about how given individuals respond to taxes. And we probably do have moral compunctions about setting up customized taxes for different people depending on our view of their devotion to whatever they’re doing. Maybe in the 23rd or 24th centuries, when privacy is a distant memory (unless memory is a distant memory, too), we’ll have full information about people’s motivations. But for now, thank Orwell, we don’t.

Unfortunately, we don’t really have very good information about how groups of people respond, either. If we thought all rich people were in love with their jobs, which may actually be the case, judging by the hours many of them work in a week, we could hit them with much higher rates of income tax and not worry about their all retiring to the golf course — though presumably, we should still worry about their hiring smart tax lawyers to try to get around the high taxes (which is itself a form of economic distortion: the tax lawyers could be doing something useful instead).

In the 1970s, when economists first got into the theory of optimal income taxation in a big way, they thought top-earners were actually quite sensitive geese, so the most efficient system might even be income tax rates that faded away for higher-income citizens, because high marginal rates would cause them to withdraw effort or maybe even their persons, which they could do by taking wing and moving elsewhere.

Since then, even as marginal rates have been brought down in most places, the consensus among economists has moved more toward the view that you probably can get away with higher taxes, maybe even higher than we currently levy, for upper-income types. They may complain a lot and change their behaviour a bit, but not so much that you’ll lose either them or most of the revenues you aim to get from them.

But it’s only a consensus. And it’s a consensus among economists, based on not very many econometric studies. They may be the best econometric studies available, but if I were a finance minister, I’m not sure I’d bet my career and, to a certain extent, my country and its economy on what they recommended.

Better, I might think, to skip optimal taxation and stick with principles-based taxation, such as keeping tax rules as simple as possible, tax rates as low as possible, and tax bases as broad as possible, and in no case letting rates rise above 50 per cent, whether on average or at the margin, on the grounds that me taking from people more than half what they earn seems unfair on the face of it.