What to Tax or Subsidize

There are precisely three reasons for any tax or subsidy. They are:

  1. To directly affect the welfare of the recipient.
  2. To address an externality (Pigovian taxes/subsidies).
  3. Because the income was unearned, thus taxing it away won’t decrease the incentive to create wealth. E.g land value tax.

In the former case, the relevant consideration in the recipient’s wealth. Money has a diminishing marginal utility so the more money you have, the less affected you are by a change in wealth. Thus we want to tax from the richest people and subsidize the poorest. (Yes, I’m proposing a wealth tax.) This is about the allocation of existing wealth.

In the second case, an example would be a carbon tax or a renewable energy subsidy. These act to correct incentives and thereby change behavior, affecting not only the welfare of the recipients, but of other parties as well. In contrast to #1, these should be imposed on activities rather than on the wealth of a particular individual. This is about maximizing the total available wealth.

Reason #3 is similar to #2, because it has to do with incentives rather than the negative utility impact caused by taking the wealth away. But rather than correct (internalizing) a negative externality, a tax on unearned wealth (a “lottery tax”) is simply not causing a dead weight loss, because it doesn’t distort incentives to create wealth.

Failure to misunderstand these basic principles leads to a number of terrible economic policies such as the corporate income tax. A corporate tax is blindly assessed to shareholders on a per-share basis whether they’re billionaires or blue collar pensioners. And it obviously doesn’t address an externality.

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Clay Shentrup

Clay Shentrup

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advocate of score voting and approval voting. software engineer. father. husband. american.