Taxes Part 1: Lost in Translation
Being that it’s tax season, I’ve been thinking heavily on the subject of money. To be frank, money is always on my mind. This isn’t because I’m greedy. Nor is it because money tops my list of priorities. It’s simply that I, like most everybody else, spend the majority of my waking hours laboring for a wage. I don’t mean to imply that my life is difficult. I make my living, not by the sweat of my brow, but through mental labor, poised before a monitor in a somewhat comfortable chair — I count myself blessed for this.
Be that as it may, spending such a vast amount of time endeavoring to stockpile a sum of what is essentially digital tallies causes me to question the role of money in my life.
Nearly the entire first half of one of my favorite books, Free to Choose: A Personal Statement by Milton & Rose Friedman, is devoted to this exact question. What is the purpose of money? The answer can be reduced to this simple, yet infinitely complex answer: communication. At its most basic level, currency is used to communicate the value of goods and services. When I purchase a package of chewing-gum for $1, I’m telling Trident at what level I value their product. Sounds simple, right? Not quite. At that same time, I’m communicating the value of every singe ingredient used in the manufacturing of the product, as well as the labor and machinery. This is how a free-market economy works. Every purchase is a communication of value helping the provider of the service or good to set the most efficient price for their product and capture as much of the market as possible.
As with any form of communication, be it verbal, visual or written, the message transmitted through currency can be lost in translation. This is caused by multiple issues, one of which is taxes. Being the necessary evil that they are, taxes are a part of life and I’ll not argue that they shouldn't be. However, I do feel that one should understand the effects of taxation to ensure that the benefits aren’t outweighed by the costs. One of the effects of taxation is added noise in the above mentioned communication of value.
Taxes raise the cost of the raw materials, machinery and labor used in the creation of goods. This cost, though placed on the manufacturer, is realized in higher prices to the consumer and injects static in the communication lines. Although the pack of gum might be worth one dollar to me, I won’t purchase it for a $1.50. The added $.50 (the value of the tax put on the ingredients of the gum) has caused me to leave the market. Not because I don't perceive the same value in the product as before but because it’s become more expensive without increasing its value proposition. There is simply no way for me to communicate my frustration to the market other than not purchasing. However, that leaves me without any gum, Trident without any revenue , and the market without needed information on the actual value of the raw materials. This loss of efficiency is called a deadweight loss.
The ill effects don’t stop there. Not only do governments collect tax revenue, they must eventually spend it — usually before they’ve even collected it. Many would probably be surprised to learn that our tax rate here in America is actually about 40%. That leaves me only $.60 of every dollar earned to communicate with. The other $.40 is given to the government and spent how they see fit. Some of this tax revenue is used on essentials. The other portion is pumped back into the economy in ways that increase the signal to noise ratio. At first glance, it may seem like government spending is nothing but a good thing. However, one of the many downsides is the miscommunication of demand for certain goods or services.
One example of this is the recent Cash for Clunkers program. In this case, the government took a portion of the public’s wages and used them to discount the price of new vehicles; essentially lying to the system that vehicles, and the raw materials used to create them, were in high demand. This was a relatively short lived program, but this same thing is constantly occurring though subsidies, stimulus packages and the like.
At this point some might be thinking, "But the government might know how to better spend money than individuals. They’ll do what’s best." My rebuttal for this argument also comes from Free to Choose, in which Friedman explains that there are four types of spending:
1. Spending your own money on yourself
2. Spending your own money on somebody else
3. Spending somebody else's money on yourself
4. Spending somebody else's money on somebody else
The most inefficient method is the fourth because it comes with the least incentive to maximize the value of the money spent. This is exactly the type of spending that government does. Put simply, they can afford to be wasteful because they’re not spending out of their own pockets. For this reason, I believe that the more money that’s in the hands of private individuals the better the economy will run. Prices are forced down and innovation is fostered through competition. We only have this competition because individuals and businesses seek to get the best value out of their money. While governments are often incentivised to waste money in order to increase budgets.
It might seem as though I’m altogether against taxation. That’s not the case. I understand the importance of contributing to society. However, I feel that taxes and government spending are, and forever will be, an issue of paramount importance. If 40% of the money we make is controlled by government officials, that means they’ve have taken control of nearly half our power to communicate though currency and, through inefficiencies, are often using it against us. Sometimes they do it purposefully and sometimes haphazardly — I'm not sure which of the two frustrates me more.
Update: Part 2 now posted
