The high cost of low taxes - Fiscal Policy part 2

                 In this post, we will spend some time talking about the high costs of low taxes. This may seem somewhat paradoxical; we will enter these discussions by defining the two primary purposes of taxation and then move into some impacts on social welfare and equity before finishing with some tangible examples of the impact of holding taxes low.

Role of Taxation:

                While it is easy to take the view that the role of taxation is just for bureaucrats and government officials to line their pockets, unfortunately, there are plenty of examples of bad actors. The fact is that taxation serves two vitally important roles. Provision of non-private goods and services and incentivizing pro-social behaviours.

Provision of goods and services.

                To simplify, we can lump all goods and services provided into one of four categories, based on whether or not the good or service is excludable or rivalrous.

                An excludable good is one such that enjoyment of the good or service can be denied if a person does not pay to access it. For example, a cookie is excludable while a tree is not. I can prevent you from enjoying the cookie if I put it behind a viewing glass and only give it to you to enjoy if you pay me first. Alternatively, even if I have a tree in my yard, behind my fence, the tree provides shade, oxygen, and visual benefits to many in the area, and the owner of the tree cannot prevent others from gaining these benefits.

                A rivalrous good is one such that only one person can enjoy the benefit of the good or service at a time. For example, again, we can use a cookie as an example of a rivalrous good, while we can use a tree as an example of a non-rivalrous one. In the case of the cookie, If I eat and enjoy the cookie, you cannot, thus the benefit of this cookie is only received by the one who gets it. Alternatively, concerning the tree, this would be non-rivalrous. If you are enjoying the view of a tree, or its cooling properties, shade, etc. this does not prevent me or others from similarly enjoying the benefits of the tree.

                Typically speaking, the free market is really good and efficient at providing goods and services which are both excludable and rivalrous (we call these private goods). Unfortunately, the free market tends to have a significantly harder time providing goods which are either non-excludable or non-rivalrous or both. Let’s take a look at an example of some of these goods.

Club Goods:

                Goods or services which are excludable but non-rivalrous (up to some capacity) are considered to be club goods. A perfect example of club goods is roads.

                Although we typically do not charge a user fee to utilize a road, it is theoretically simple to throw up a toll booth or similar technology and prevent access to the road until a user pays. Thus, although we tend not to exclude them, roads are an excludable good. Similarly, roads are non-rivalrous (up to some capacity), meaning that typically if I decide to drive on a road, I am not precluding anyone access to this road. Of course, there is a point where the roadway becomes congested (traffic) and roads switch from being a club good to being a private good.

                The problem is that to efficiently provide a club good, we need to price it accordingly. That is, a club good should have a zero-user fee when there is no congestion, however when we move to a congested state, then the good has a price to reflect the cost that one person inflicts on another by denying them access.

                If roadways (or other infrastructure such as sewer, water, bridges, tunnels, pathways, etc.) are provided by the private sector, then typically the focus of the provision of these services is around areas that face congestion. That is, the private sector would have an incentive to under-invest in these goods and services to have congestion to be able to charge an effective (profitable) price for them.

                Thus we, as a society, have typically decided that due to the social benefits that are provided by these goods and services, we should have government over private enterprise to provide this good or service and typically allow them to be provided for zero user cost and instead finance the use of the good through general tax revenue.

                The problem that this then creates of course is that individuals have no incentive not to overutilize the resource (because it is free to use) thus creating rivalrous situations (such as traffic jams).

Common Resource Goods:

                A common resource good is almost the flip of the club good discussed above. In this case, we have a scenario where the good or service is non-excludable (no easy way to charge a user fee, or no natural way to have a market form for this) but the good or service itself is rivalrous. The outcome of this is often referred to as the tragedy of the commons. Such that the resulting outcome of everyone being able to access the good without paying for its use is that each person grabs the available benefit for themselves till none remains causing a collapse of the resource itself.

                In this case, we are not typically talking about the provision of a good or service, but rather the managing of an existing (typically natural) good or service. The solution to preventing a collapse of the resource itself is through the use of legislation and imposing a tax on the utilization of this good or service through the form of a user fee. This is often seen as a permitting fee, stumpage fee, or usage fee. The purpose of such fees is to limit consumption of the good or service to prevent its collapse. This is often the key argument for forestry bylaws, resource royalties, and water fees. That is, these fees are not being collected to provide a good or service, but rather being charged to limit the consumption of a good or service, and thus promote the effective and sustainable management of that good or service.

 

Public Goods.

                The final type of good or service to look at for public provision is a public good. This is a type of good that is both non-rivalrous and non-excludable. The classic example of a public good is a park or large green space.

                Due to the nature of public goods, the private market tends to significantly under-provide them. For example, let's look at the ability of individuals to come together to fund and build a new park.

                Suppose that there is an orphaned lot in your neighbourhood, and you and all your neighbours agree that this would be a great spot for a park, some green space, a few trees for shade and maybe even a small play structure. To get this to happen the neighbourhood needs to solicit donations to fund the construction of this. While scenarios like this do happen, and we are capable of building parks in this fashion – what is the difficulty we run up against? The issue is that everyone agrees they’d benefit from the park being built. This means that they’d benefit irrespective of whether they donate money or not, as long as it is built. From an individual view then, each person would be best off if they don’t donate, or only donate very little, while their neighbour donates more, allowing the park to be built. The issue of course is that everyone hopes that their neighbour donates so that they don’t have to and the result is either that a) the park does not get built or is underbuilt or b) a significant amount of time and resources have to go into raising funds. The result of either of these scenarios is that private individuals are generally unable to provide a satisfactory amount of public goods.

                The solution then is for the government to recognize the need and social benefit received by these public goods and then provide them through general taxation revenue.  Essentially forcing each member of society to contribute a little to a project to create a public good that nearly all will enjoy, thus increasing the social welfare as a whole.

A final note on public provision of private goods:

                There of course are certain private goods (excludable and rivalrous) that we as a society have decided to provide through taxation rather than allowing the free market to provide and charge. Some examples of these are policing, fire protection, education and health care.

                In each of the above cases, the service provided is rivalrous. If you need a police officer, firefighter or health care professional you are preventing someone else from accessing their service. While similarly these services could easily be excluded. You don’t get to utilize the service unless you have paid for it first, or alternatively, will be billed after the fact.

                Even though these (and other) goods and services are technically private and thus could be provided more efficiently through the private market, we have collectively decided that the social and equity impacts of having these provided through the public realm outweigh the potential inefficiencies that arise through its public provision.

Role of Taxes continued:

                This then brings us back to completing our conversation around the role of taxes. First and foremost the role of taxes is to collect general revenues to then be able to provide Club, Public and selected private goods to the residents at zero or low user cost. This is the provision of roadways, bridges, tunnels, bike lanes, schools, hospitals, parks, green spaces, rec centres, libraries, etc. This ensures in the case of club and public goods that enough of the good or service is being provided for the benefit of society, or in the case of a publicly provided private good, that we have equitable access to the good or service irrespective of ability to pay (IE. Schools, hospitals, etc.).

                The second role of taxes is to encourage pro-social behaviour. This is best seen in the case of common resource goods. As history has shown time and time again the zero cost to utilize certain resources results in the overuse and exhaustion of the resource. Just look at the Atlantic fisheries, many forests in eastern Canada and Europe, and our current use of a clean environment. In this case, the role of the government is to appropriately price the good or service to prevent its exhaustion and to ensure that it can be appropriately managed sustainably. Thus, the role of taxation is to prevent or limit consumption, and then to utilize the revenues raised to either subsidize non-exhaustive alternatives or to fund the costs of managing the resource at risk. A great modern example of this would be the introduction and implementation of the carbon tax which both discourages consumption of carbon-intensive resources, funds the management of climate-sensitive areas and subsidizes alternative forms of non-exhaustive (“green”) goods.

High cost of Low taxes:

                With the basis of why the government collects taxes and provides the above-mentioned goods and services, what happens if the government fails to collect sufficient tax revenues? While hardly an exhaustive list, there are a few potential outcomes which have varying levels of social, and fiscal implications. Keep in mind, while I have said the following list is nowhere near exhaustive, it is also not mutually exclusive, many of these outcomes likely take place in mixed scenarios.

 Postponing of costs:

                Let’s start with the most straightforward of scenarios. To keep taxes low today, a government decides to postpone known costs. That is, they continue to provide current goods and services as listed above, but they neglect the amortized maintenance and replacement of these assets that will have to be funded in the future. For example, let's suppose that we could forecast that a new police station is needed for $500,000 in ten years. We could explore a few different scenarios.

a)       1) Put aside $X each budget cycle to save for this project.

b)       2) Keep taxes low today and wait till some future time to start saving.

c)       3) Wait till the end and debt finance the whole thing.

Let’s explore what this looks like in each scenario, if we presume a 5% prevailing interest rate, and presume we could get this same rate on our savings and borrowing, we face the following decisions based on when we start financing:

That is, as we can plainly see, every choice to keep taxes low today, by not putting money aside for known costs, results in a larger tax lift needed tomorrow, Further, this decision puts a higher burden on the taxpayer as each year postponed is a year where compound interest cannot be earned.

While the final option, to borrow, results in an annual tax lift between beginning to save in years three and five, the resulting burden to the taxpayer is the highest of all. If we make a further presumption, we can see the impact of each as a percentage increase to the budget. To keep things as realistic as possible let’s presume that we began with a million-dollar budget that, by default, will have to increase at 3% a year to cover inflationary and growth pressures. That being the case we can witness the resulting required tax lift (above the 3%) to finance this replacement in each case:

                Again, we can see in the final row added, that each year of postponement results in a drastic increase to the tax lift needed to meet this future obligation.

                Moral of this story? You can kick the can down the road to keep low tax rates for a while, but eventually, all bills come due!  Even if you decide to leave it and just borrow in the future, the tax burden is significantly higher than had you simply made the tough choice up front.

Cutting services:

                One of the other options that governments have to keep the taxes lower, would be to cut services. Keep in mind the services provided are typically done so as they satisfy a need that is unmet by the private market due to the nature of non-rivalrous and non-excludable goods.

                The choice to cut services is fine. It is ultimately society’s role to determine which services are desired and which are not. As we progress, grow and change, our demands and desires for services also grow and change. Thus, over time certain services that were once provided by the government may no longer be beneficial, while others that were never on the radar are now pressing.

                The issue with cutting services is ultimately similar to that of postponing costs. If you cut funding for services, despite a growing population, you are asking those who work in that field to do more with less. While initially this can be done for a time, it ultimately leads to staff burnout, fatigue, and inability to deliver on the mandate given.

                The result is often a failure or a near collapse of the system. We can see this currently in the aftermath of decades of service level cuts across much of the public service, but arguably most painfully felt in the fields of education and healthcare.

Suppose that budgets were cut by a half percent based on the argument that this would improve efficiency. While this might not seem like a large impact, after 5 years, an increase of 2.54% would be needed to return to the original funding amount, and after 10 years an increase of 5.14% would be needed. That is, while you might be able to cut taxes to put the squeeze on a certain department, the continued squeeze on a department requires a large single-period increase to return to baseline service levels in the case that this ‘efficiency’ is not found.

The tangential case of cutting services is not allowing services to expand. Suppose that the population and service demanded is increasing by a half percent a year. Rather than meeting this increased demand with increased staffing and resourcing each year, you would be required to make a 2.54% increase in 5 years and a 5.14% increase in 10 years simply to catch up to the underinvestment in staff and resourcing.

Again, the resulting message is either a small pain today or a large pain tomorrow if you decide to kick the can down the road.

Charging user fees:

                One way to lower the general taxation rate is to shift some of the burden of provision of services from being funded by general tax revenue, towards being funded either entirely or partly through user fees. The more things you can shift towards user fees the less you can charge in general taxes, but the more the households that utilize this service tend to pay as a proportion of their incomes.

The charging of user fees is an interesting economic case. On the one hand, if you can identify the individual who will benefit from the good or service, then they ought to pay for access to this benefit. Think of rec-centres and pools in this case. On the other hand, many of the goods and services provided by the government are provided due to the social benefit that they provide, and the charging of user fees acts as an additional per unit tax which typically adds to the regressivity of a tax system.

                There are many services provided by the government such that it is easily identifiable as to who is benefiting and thus able to charge them for access. From fire, police, education, public transportation infrastructure, recreation, sewer, garbage, water, I could go on. It is ultimately a policy choice whether or not to charge for any of these services through user fees.

                If the choice is made to not charge for these services, then we will tend towards over-utilizing, exhausting, or operating these resources over capacity – think of traffic on the highway partially due to no user fee, or wait times in the ER due to similar reasons.

                Alternatively, if the decision is made to charge for these services through a user fee, then the user fee in essence acts as a tax to access. As this tax is a flat rate ($10 to drop into the pool for example) then this user fee by definition would be regressive as a $10 fee is a larger proportion of income to someone who makes $500 a week versus someone who makes $1000 a week.

                Further, as the user fee is ultimately an optional tax (only pay it if you access it) the resulting social impacts are that those with lower incomes will tend to self-select out of these services, some of which are argued as vital for health and well-being.

                Thus, the choice to shift the tax burden from general tax revenue to user fees has the potential of adding to the regressive nature of taxation, predominately benefiting the higher-income earners while negatively affecting those who earn less.  

Privatization of services:

                To finish off this non-exhaustive list, let's look at the option of privatizing services. The idea of this was largely popularized with the rise of neo-liberalism and the move towards privatization of public assets seen worldwide but predominately championed by Margaret Thatcher in the UK and Ronald Reagan in the US.

The basic idea is that the private sector is more efficient than the public sector, thus if we privatize certain public services, these services will be able to be provided more cost-effectively.

While it may be true that the private sector can be more efficient, this is based on the assumption that the private sector is operating with high levels of competition. Many goods and services provided by governments are essentially monopolistic goods. Thus, the privatization of these lines of business provides a one-time boost to the budget as those assets are liquidated, but often results in long-term reduction in service levels and cost increases in line or greater than what may have been expected had it been kept in the public sphere.

Of course, this is not always the case – there are situations like the privatization of insurance in Alberta or the privatization of telecommunication where due to technological advancements competition was able to exist, thus driving a more efficient outcome than the government service. Unfortunately, however, more cases of privatization result in the privatization of a monopoly provider which we will continue to explore in this case.

Let’s presume that to keep taxes low today, the decision is made to privatize a certain line of public service that had a budget cost of $100,000. Again, if we keep things simple, for this to make sense the contracted provision of this service must be either the same or less than the current public provision cost. Let’s presume that the contractor can initially provide this service for $90,000 an instant savings of $10,000 as well as the positive cash flow from the sale of assets associated with this business line. Looks like a win.

Let’s look at some of the distributional effects. First, when this was provided publicly, it was typically provided by higher wage unionized workers, meaning that a larger proportion of this cost was going towards the labour force, those actually doing the work as well as the managers. When this is privatized and the service is now provided at a lower cost, the new entrepreneur has two options to turn a profit, either cut wages or cut service levels – typically both.

The result of the cutting of wages is a transfer of wealth from a distributed level between several workers into a concentrated level in the hands of the owner(s). Further, if possible, the reduction of service levels results in a lower provision per dollar spent by the public, thus society as a whole tends to lose while the few owners are the ones that tend to gain the most from the provision of a previously public service through privatization to a monopoly.

The outcome described above has been witnessed and played out time and time again. Without going into a full history of these events a brief look at the privatization of highway maintenance in Ontario, the privatization of prisons, the privatization of air ambulances and more highlight the frequent failures of privatization to monopoly providers.

The long-term effects of privatizing to a monopoly provider can be worse, in many ways binding governments to perpetual high-cost, low-service contracts. Many of these lines of business are monopolistic due to the extremely high capital cost of providing the service. As a result, there are often very few if any competing bids at each contract renewal. When this happens the monopolist provider knows that the government only has two options, accept their bid to provide the service or take the service back in-house.

This creates a moral hazard problem as the monopolist provider knows the huge capital cost that the government would have to face to bring this back in-house, and thus knows that the government cannot likely repatriate the service. Thus, knowing this, the monopolist provider has the majority of the power in the contract negotiation, able to push the terms of the contract renewal to be increasingly in their favour over the public or taxpayers’ favour, thus resulting in even higher costs to the public, higher levels of wealth concentration in the hands of the few owner(s) and lower levels of service.

There is significantly more research that exists on this topic, a fairly straightforward, non-technical, analysis of the failure of privatization can be found here, or an even easier read is this economist article that can be found here.

Conclusion and summary

                Throughout this post, I have aimed to justify why the government has a role in providing goods and services and how the government can attempt to provide these services equitably (trying to promote vertical and horizontal equity of taxation). Further, I discussed the problems due to pandering to an electorate by artificially keeping taxes low by postponing costs, cutting services, shifting costs from taxation to user fees, or privatizing these services altogether.

                While it is the policymaker's prerogative to undertake any of the above actions to provide a momentary reprieve in general taxation, the policymaker needs to recognize that any reprieve today will result in a higher cost tomorrow as demonstrated in each of the above cases.

                Thus, the primary role of the policy maker is to determine which services are to be the responsibility of their government and ensure through proper governance, oversight of management, and planning that these services are provided in the most effective way to promote the highest possible social benefit.

Unless a given good or service is now obsolete or is not capable of being provided through a truly competitive market, then any decision to postpone, or cut funding to an effective service today, will result in a higher cost tomorrow, thus we have our high cost of low taxes.

As always should you have any questions, thoughts or comments, please feel free to reach out or comment below! 

Nothing is certain but death and taxes - Fiscal Policy part 1

        As we are approaching the municipal budget season with some local governments having already launched their draft budget, and others on the eve of doing so, I felt it would be worthwhile to spend a bit of time to speak about some of the theories around taxation and fiscal policy. To be clear, this is primarily aimed towards economics and public administration students or anyone who may have an interest in public and fiscal policy. I am aiming to educate on many common terms used in fiscal policy, and while I make some comments evaluating policy decisions, these are included as a learning aid to provide context to the discussion.

I Intend, over the coming weeks, to launch a series of blog posts on this topic. However, in this post I want to spend some time exploring the ability to pay, progressive vs flat vs regressive taxation, and tax equity, and then wrap up by looking at how property taxes fit into these definitions.

Ability to Pay

First, we need to define and look at ability to pay. While, here, I will explore the full range of ability to pay, it will be important to recognize that the rest of this conversation focuses only on Income, not ability to pay.

To think about ability to pay we need to define the difference between flow and stock variables and how they relate to income and wealth.

The classic example used is that of a bathtub or a sink. The tap that adds water is the positive flow of water into the tub, while the drain that, drains, water is the negative flow out of the tub. The amount in the tub is the stock of water.

In this same way, we can view an individual’s ability to pay. One’s income is the flow of money in, and one’s expenses are the flow of money out. Beyond this, we also have one’s savings, which is their wealth.

All else equal, if Income is greater than expenses, then one’s wealth is growing, that is the bathtub is filling. If one’s expenses are greater than income, then one’s wealth is shrinking, that is the bathtub is draining. Of course, we have the added complexity with money that one’s wealth is capable of growing or shrinking on its own through appreciation or depreciation or through earning income itself through interest or dividend payments.

While ultimately one’s ability to pay is determined through their total ability to pay from either income or wealth, from a taxation perspective the focus is primarily (and historically) based on one’s ability to pay purely from income. That is, the stock of wealth is predominately ignored, and the focus of the discussion around taxation regimes tends to focus on the flow of income.

Focusing then, just on income, let’s move on to define some commonly used terms that define different taxation structures.

Flat Taxes

                We will begin this by looking at what is arguably the simplest form of taxation, which is a flat tax.

                In this case, everyone pays a constant proportion of their income in taxation, say 10%.  Thus, whether you earn $10,000 or $50,000 or $100,000 a year all will pay 10% of their income in taxes. Of important note, while all three of these listed incomes pay the same proportion, the amount of taxes they pay is clearly increasing. This can be seen in the table below:

Progressive Taxes

Progressive taxation is a case where higher income earners pay higher proportions of their income in taxation.

It is difficult to have a conversation around progressive taxation if one does not fully comprehend the notion of a marginal tax rate. As a discussion of marginal tax rates would be a post on its own, I would recommend that anyone who does not fully understand marginal tax rates take a moment and look this up to obtain a cursory understanding.

If we were to continue to utilize the same incomes as introduced above, under a progressive taxation system we might expect each of the above income earners to pay an average marginal tax rate of 0%, 10%, and 20% respectively.

That is the lowest income earner may not even pay taxes, and as one’s income increases, so does the proportion of the tax that they pay. The amount of taxes paid under the above-imagined progressive system can be visualized in the table below:

Regressive Taxes

                Finally, let’s explore a regressive taxation scheme. A regressive scheme is really just the opposite of a progressive one. That is in this scenario an individual would pay a lower proportion of their income towards taxation as their income rises. An example of this would be a scenario such that as one’s income rises; they are capable of hiring a tax professional which allows them to take advantage of tax loopholes to lower their overall rate of taxation. The result of such a taxation scheme can be visualized in the table below:

                It is important to note that the value of the taxation, in this case, is still increasing as income increases. Those earning $100,000 are still paying more in taxes than a person earning $10,000. However, the proportion of their income that is going towards taxes is shrinking. That is, the value of the tax payment does not need to be decreasing for a system to be regressive.  

Tax Equity

                Above we introduced three different taxation regimes, flat, progressive and regressive with respect to income. Next, in this section, we will introduce two ideals, which when utilized, help create a taxation system that is typically understood to be fair and just. These are the ideals of vertical and horizontal equity.

Vertical Equity

                Vertical equity is actually the foundation for a progressive taxation structure. A taxation system would have greater levels of vertical equity if those with greater ability, pay a higher proportion of their income towards taxation. While this might be intuitively believed by some, it is of course challenged by others. So, let’s take a moment and look at a few arguments as to why a taxation system that is preferred from an equity viewpoint.

            Maslow’s Hierarchy of Needs

While I have not found any actual reference to this. The concept of vertical equity was explained to me years ago along the lines of Maslow’s Hierarchy of needs.

We have as our base physiological needs such as water, food, shelter, and clothing. If our income is such that we can only provide these needs for ourselves we have very little if any capacity to support society through taxation. Thus, the idea is that at these income levels, you ideally would not be subject to taxation. Without getting into the policy discussion of whether or not this is an adequate amount, this is the rationale that your first $15,000 (approx.) of income is tax-free – this provides one with the ability to meet their own base needs before they start paying into services that help meet collective needs.

As we move up Maslow’s Hierarchy to the next zone which covers safety needs such as security, employment, and health we are now at a zone where the necessities of life (food, shelter, warmth) have been covered, and we are now able to begin investing in our safety and well-being. Many of these needs can be best met through public provision through legislation, policing, laws, and our legal system. Thus, the belief is that since your base needs are met, and some of the next level of needs can be considered public goods, they can be provided through a tax and re-distribution system. Thus, if your income rises such that you can begin to concern yourself with this level, you ought to begin paying a proportion of your income to the government to provide these services.

As one receives higher and higher incomes that allow them to devote a smaller proportion of this income to these basic physiological needs, they have a greater ability (although not necessarily willingness) to pay into taxation to provide a greater provision to society as a whole.

Along these lines, it has been justified to have low-income earners pay a small percentage of their total income towards taxation, and when income increases the proportion, they pay in taxation would also increase through the marginal tax rate.

Marginal Propensity to Consume

                The other basis for vertical equity is based on the notion of the marginal propensity to consume (MPC). While a mouth full, the marginal propensity to consume is a measure of how much extra money you will spend on consumption for an extra dollar earned.

                For example, if you receive an extra dollar in income and spend 80 cents on consumption (thus saving the other 20 cents) it would be said that you have a marginal propensity to consume of 0.80.

It is typically found that the marginal propensity to consume is not constant with income. In many ways, this supports the previous conversation around Maslow’s Hierarchy of needs. It is often found that at the lower ends of the income spectrum, households will have a marginal propensity to consume close to, if not equal to 1.00. This means, that for every extra dollar of income earned, they will spend this entire dollar on consumption. Having been in this state for many years, I can attest that every dollar has immense value as it provides extra goods and services which are utilized to meet one’s base physiological needs of food, clothing and shelter.

However, as one’s income begins to increase, we find that one’s marginal propensity to consume begins to decrease. That is, as one has access to more income, they can cover their base physiological needs, and then have leftover income which they are then able to save or invest to meet future or other needs.

Robert Reich in his Netflix documentary “Saving Capitalism” makes the analogy that a person only needs so many pairs of pants, food, shelter, etc. At lower levels of income, all your resources are going toward obtaining these basic necessities. As your income rises you may begin to buy more pants, food, shelter, etc. but at some point, you don’t need another pair of pants, or another cup of coffee, thus your consumption slows, and this extra income is moved into savings instead.

Based off of both of these theories, it would be largely unethical to place a tax burden on those with low incomes as they may be already struggling to meet their base physiological needs which can be evidenced by the higher marginal propensity to consume. However, as one’s income increases, their ability to pay also increases and thus one ought to increase their contribution to society through taxation.

Of important note – hardly ever does an increased ability to pay translate to a higher willingness to pay

Further supporting the notion that vertical equity is preferred in taxation structures is the common desire for a level of income equality, or more specifically, a low level of income inequality. Thomas Piketty is one the world's leading economists exploring the role of income inequality and some of its causes. One of Piketty’s more surprising discoveries is that taxation systems that are more progressive result in more equal incomes before taxation.

This is surprising, as it was often understood that a highly progressive taxation structure results in greater income equality after tax, because the rich are taxed more, with some of this tax being re-distributed to the bottom. While this is true, the discovery was that highly progressive taxation structures also result in more equal income distributions before the taxes are even collected.

I won’t get further into the weeds on this, other than to say that there is plenty of work done showing the importance of income equality in promoting social cohesion and stability. Thus, for all the reasons mentioned above, it is often accepted that a progressive taxation system that holds to notions of vertical equity is a desired state for a fair and just tax system. The area of controversy or argument is around how progressive such a system should be.

Horizontal Equity

                I won’t take nearly as long to go through this term as it is by far less controversial and much better understood.

                The notion of horizontal equity is that those who earn the same income should pay about the same in taxes. That is all households with an income of $50,000 should pay about the same amount of taxes for a given system to be fair and just.

Property Taxes

                Let’s then attempt to overlay the above discussion about fair and just taxation to property taxes. To briefly summarize to start us off, it is argued that a fair and just system of taxation is a system that appeals to notions of both vertical and horizontal equity, that is, a system which is progressive as incomes rise, and relatively constant across similar incomes.

                Property taxes however are not an income tax, but closer to a wealth tax. This is because you are taxed based on the value of your real estate. The rate at which the value of your real estate is taxed is a flat rate. That is if we suppose a given municipality had a tax rate of 2%, all property would have to pay 2% of its value in taxation irrespective of if the property was worth $100,000 or $500,000 or a million dollars. This can be seen in the table below:

Note, in reality, property tax rates are typically less than a half percent of the property’s value, for example in Langford BC the Municipal tax rate was $2.08835 per $1000 of value, or 0.2088%).

                Now – to determine if these property tax rates have a level of vertical equity, we need to attempt to transition this tax rate from being taxed based on wealth to being taxed based on income. To do so we must assume that higher incomes can purchase higher-valued homes. If we make a simplifying assumption that the maximum qualified amount is a payment equal to a third of one’s income we get the following incomes, and then the following property tax/income rates:

                What we witness is that based on this assumption a flat rate across property values translates to a flat rate to our incomes.

                However, it would similarly not be a stretch to presume that those at lower income levels may be forced to ‘max out’ their qualification limits to be able to afford shelter, while those at higher income levels may choose to devote a lower proportion of their income towards their shelter. The result of this would cause a property taxation regime to skew towards being regressive as can be seen below:

Note: the assumption is that each income category devotes 33% (1/3), 25% (1/4), and 20% (1/5) of their income to shelter respectively

Thus, our takeaway from this is that, at best, a property tax scheme is a flat tax rate, and at worst is regressive. Most likely we are more in the regressive realm than the flat realm. That is, property tax likely fails at being a fair and just taxation structure as it fails to achieve vertical equity.

Can we try to make property taxes more equitable?

                If property taxes are by default likely a regressive form of taxation, there is a natural question that arises.

I)                    Can municipalities change their taxation structure to make this system more progressive?

There are a few answers to this. The simple answer is ‘no’. As municipalities are not a level of government defined in the constitution, they have no prescribed authority to collect taxes beyond the authorities given to them by the provinces. That is, their ability to raise funds through taxation is strictly dictated to them by the province. As such, municipalities can change the rate of taxation but have very little flexibility beyond that.

This however doesn’t mean there is nothing that can be done to promote a more progressive system. It just means that policymakers need to be a bit more creative, looking at all the social outcomes, not just the tax incidence.

For example, municipalities do collect revenue through other sources such as user fees and developer amenity contributions. Focusing for example on amenity contributions, these funds could be utilized in one of two ways:

I)                    Provide new community amenities such as green space, parks, community centers, or public services.

II)                  Re-direct these funds back to the taxpayer in the form of a transfer.

         Now in many ways, the economist in me sees tremendous value in option (II). After all individuals have a much better understanding of where a dollar should be spent to give them the best benefit. Unfortunately, given the nature of the municipal tax and transfer system, a transfer back to the taxpayer by cutting tax rates (say we cut by 100bps from 2% to 1%) will disproportionately benefit the taxpayers with the highest value homes, thus doing nothing to promote vertical equity as can be seen in the table below:

                Option (I) on the other hand provides parks, green spaces and public spaces that can be utilized by everyone. Here is the crux. While everyone benefits from these community spaces being provided, those at the middle to lower end of the income spectrum tend to benefit disproportionately from such services.

                Why?

                One of the biggest arguments put forward as to why this is the case is that higher value real estate often includes larger yards, which can be thought of as a private park, or private piece of green space, while lower value real estate typically has less of a yard if any.

                Thus, while the public provision of parks and greenspace does positively affect everyone, those without private yards (lower-valued real estate) are the ones who tend to benefit disproportionately from such policies.

                That is, by engaging in option (II) one is in many ways adding insult to injury, as by doing so the policymaker is choosing to disproportionately subsidize those who already have highly valued real estate and typically have access to private green space while simultaneously not providing public green space for the rest of the residents.

                Thus, while option (I) will not necessarily result in lower taxes, and may not necessarily result in a move towards vertical equity, it does have the potential to increase social welfare by allowing for a more fair and equitable provision of public amenities which may greatly increase the welfare of those who are already paying a higher proportion of their incomes in property taxes.  

Summary

                Throughout this post we have introduced the basis of ability to pay, differentiating between income and wealth. From here we moved on to evaluate flat, progressive and regressive taxation structures before moving on to look at the notions of vertical and horizontal equity in an attempt to define a fair and just taxation structure. We then saw that property taxes fail to achieve vertical equity, and are in fact typically regressive in nature. Based on this a brief thought experiment was explored to evaluate whether or not property taxes could be made more progressive, or at the very least, be utilized in such a way as to improve social benefit.

Continuing on this theme the next post will be on the topic of the high cost of low taxes followed by a discussion on user fees, pay-for-access services, and their potential role in the provision of public goods and services as well as the role they play in tilting the total taxation system more toward a progressive or regressive one.

If you have any thoughts or comments, please feel free to comment below.