Sunday, September 11, 2005

Lump sum taxes are interesting

Economic theory tells us that, if given the choice, you should always choose a lump sum tax over a per unit tax (assuming they raise identical amounts of revenue). The argument is that a per unit tax distorts the "true" price of a good, whereas a lump sum tax does not. Then the puzzle is: how do you assess this lump sum tax? Turns out, you have to do it after the fact and randomly, so people's behavior won't be changed by the prospect of having to pay the tax. That is, income tax is a per unit tax; if you instituted a lump sum income tax, the taxing body would randomly draw names of people who would have to pay random amounts of tax. I'm not sure if the amount could vary by income (for if it did, then people with higher income would, in theory, change their behavior to reflect the possibility of being randomly taxed in that higher bracket[Henry?]). This is obviously totally impractical, but it would have an interesting side effect: because you don't know if you are to be taxed that year (or how much you would be taxed if you were taxed), you would have to have access to capital in order to be able to pay the possible (and possibly enormous) tax. This means either more interesting credit instruments, or people start saving more. So either/or/or both, a lump sum income tax could raise savings rates, introduce new instruments in the credit market, and push more people into bankruptcy (who didn't save and didn't have access to credit). Fascinating.

Update: Henry makes an excellent point:
Very interesting about the effects of such a random tax. What I think would happen is that some sort of tax insurance would arise under a random-person-lump-sum-tax regime. There would be no adverse selection or moral hazard, just perfectly lovely risk sharing. The result being that everyone would pay the same amount anyway and perhaps a bit more to cover administrative costs.
It should be said that everyone would be everyone on average. Because people's tax liability would be dis-associated from their income, you'd do away with progressive taxation.

4 Comments:

Blogger henry said...

Right, taxing people in higher income brackets more would distort incentives, the incentive to make a higher income would be less than is "natural." I don't think that you would have to have people pay random amounts of tax. The idea being that the amount of tax and who is taxed should not depend on any choice that anyone makes. You could also have everyone pay a fixed amount each year, say $10,000. Or decide to tax a certain group of people on a whim, like all left-handed shoe shop managers.

10:39 AM  
Blogger henry said...

Very interesting about the effects of such a random tax. What I think would happen is that some sort of tax insurance would arise under a random-person-lump-sum-tax regime. There would be no adverse selection or moral hazard, just perfectly lovely risk sharing. The result being that everyone would pay the same amount anyway and perhaps a bit more to cover administrative costs.

10:43 AM  
Blogger henry said...

It should be said that everyone would be everyone on average. Because people's tax liability would be dis-associated from their income, you'd do away with progressive taxation.

Not only is it not progressive, it's very regressive. Everyone pays the same fixed amount, i.e. $10,000. Not just on average, right?

7:48 AM  
Blogger Isaac said...

Yeah, I realized that that was true after I posted: everyone would pay identical amounts of tax, provided you could set up the insurance scheme....

7:13 PM  

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