"Real" Tax Reform

Edward J. Dodson

[Reprinted from Equal Rights, Fall 1985]

The President has promised that his administration would introduce no taxes, despite the growing federal deficit and an escalating national debt. He has committed himself to a continuing program of tax reform. Regardless of what those reforms contain, one thing is certain: the federal government will be looking for new ways fo ways to raise more and more revenue. Rhetoric notwithstanding, even President Reagan has been ineffective at halting growth of government spending. Revenue must come either from increased tax raising rates, removing exclusions or broadening the base), the sale of government securities, or fees obtained in exchange for services or the use of government-owned assets (the nation's land, natural resources or facilities). Almost everyone -- economists included -- acknowledge that seeking to raise more revenue by hiking tax rates on individual or business income is sure to short-circuit economic growth. More borrowing, on the other hand, increases the national debt and, as a result, the proportion of tax revenue that must go to pay interest on that debt.

EVEN MORE PROBLEMS

Look deeper into the economy and one finds even more problems. The big are far from out of the woods on their foreign loans. At home, many farmers are in default on their debt and are losing their farms in growing numbers. Lenders are sure to turn conservative to all but corporate borrowers.

Should the Federal Reserve move direction of a more expansionary policy, the impact might turn out to be opposite of that planned. Rather than lower interest rates, the expansion could trigger a more powerful and offsetting expectation of renewed inflation -- pushing interest rates higher.

Supply-side economic actions thus far adopted are based on the rationale that lower rates of taxation on production provide incentives to produce and leave more income with individuals for consumption. And, despite what one hears, it is consumption that provides the stimulus for greater production. From this perspective it should be apparent that investment in physical capital (e.g., machinery, buildings, etc.) is a response to anticipated future consumption. For this reason taxing consumption could end in disaster. There is a problem, however, with the policy of simply reducing all tax rates. The problem has to do with the impact of taxation on the owners of what economists call the "factors of production."

There are three factors of production: land, labor and capital. Some economists add a subdivision of labor abstractly described as "entrepreneural ability" on the theory that the qualities necessary to put together and run a business are somehow qualitatively different from other kinds of "labor." The economic theory becomes quite involved (perhaps unnecessarily so) but what essentially happens in the real world is that the owner of any factor is supposed to retain the value of what that factor contributes to production. Our tax system has tended to lump all three factors together for the purposes of taxing income; some common sense logic reveals that this approach is seriously flawed and stifles economic activity. To understand what I mean, let's briefly analyze the effect of taxation on each of the three factors.

Land does not have to be produced; it simply exists to be used when the demand arises. As a result, its economic value has increased or decreased with little regard for what its owner does (unless the owner is either negligent or consciously destroys its value for alternative uses by permitting its use for a hazardous waste site, causing soil erosion or other serious misuses). A landowner receives income primarily in two ways: current income in the form of leasing fees; or capital gains that accrue over time if the land becomes more valuable. The result of our tax treatment of land as a factor of production is that very small amounts of taxes are collected from land unless sold, encouraging the holding of land over long periods -- often simply for speculation and not contributing to the production of goods and services. It is also interesting that our tax laws have been structured to think of rising land values as capital gains (and subject to lower rates of taxation); capital in its economic sense is something produced. I can hold land for fifty years at almost no significant cost, without producing anything, and end up a millionaire. Lowering the tax rates on land is an incentive to play the speculation game rather than risk one's financial reserves on producing goods and services the consumers may reject. Is this an outcome of our tax system that is in the best interest of the nation?

Our system of social welfare requires the use of so-called "transfer payments" to redistribute money, goods and services from those who supposedly have too much to those who have too little. From a humanitarian perspective this may be a good thing. The effect on the individual is to use the tax system to capture (for society's needs) a portion of the economic value person received because of labor exerted. Some economists have argued that wage and income taxes, the taxes on labor, induce people to work harder to overcome the tax burden. That may be true for a small number of unfortunates. Supply-siders have identified such taxes as a significant cause of tax avoidance and growth in the "cash only" underground economy.

INCOME TAXED TWICE

Owners of capital are normally less able to conduct business on a cash basis. For one thing, they deal primarily with the production and sale of goods more so than the exchange of services. To encourage investment in physical capital the tax laws have been moderated to give more favorable treatment to capital by providing accelerated methods of calculating depreciation and offering direct tax credits for investment. These measures contribute in many cases to the incentive to produce, particularly where the profit potential is marginal. On the other hand, our tax system taxes corporate income twice -- first, as income to the business entity and, second, as individual income to the stockholder. To the extent that business income is the result of capital investment, taxes discourage some investment.

What our political leaders should be concerned about is the large number of companies leaving the country to escape the high costs of land, business taxes and regulatory controls.

To the extent that our tax system encourages or discourages speculation in land and encourages or discourages production of goods and services, its impact on the economic health of the country is significant. We have moved in the right direction where labor and capital are concerned. The situation with regard to the taxation of land simply gets worse. The demand for land and for its natural resources grows more intense with each passing day, and so its value in the marketplace. Yet, hardly any land is assessed for tax purposes at more than a fraction of market value. As wages and salaries rise, so do the taxes taken -- with more of each additional dollar earned taken as income rises. The allowances for depreciation better protects capital from escalating taxes. However, the bottom line is that land ownership -- which contributes least to the creation of wealth (is essentially a static activity) -- ends up as the sacred cow of the tax system.

RESPONSE (Toby)

I think that Ed Dodson's article in the Fall '85 issue, "REAL" TAX REFORM?, was on the whole a good one. However, I beg to differ with him where he discusses the Federal Reserve and interest rates.

George, in "Progress & Poverty", explains over and over that wages and interest rates go hand in hand.

As Georgists we should not fall into the popular trap of blaming high interest rates for our troubles as Dodson hinted in his article. Also I think he put too much blame on the Federal Reserve.

ED DODSON REPLIES

Today, more than ever before, monetary units have become commodities in their own right (not useful commodities, but commodities nonetheless). Speculation in such currencies is a zero sum game involving no creation of wealth but certainly results in a massive redistribution of purchasing power from losers to winners. As to the purpose of the Federal Reserve, there are many who would argue that its purpose was not to counteract but to protect the interests of those who controlled the medium of exchange from the consequences of competition. I am reminded of Murray Rothbard's judgment that all of the: so-called "liberal" reforms (of which the Federal Reserve is a key one) were conceived, written, and lobbied for by the very privileged groups themselves." Money as well as land must be free.