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!