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.
