Does the Optimal Tax System Exist?

Is an optimal tax system that maximizes a society’s welfare possible?

While research on optimal taxation often focuses on the pure economic implications, it rarely considers cultural and societal differences that can lead to very different outcomes when trying to implement an optimal tax system.

Economic and Cultural Optimality

There are two kinds of optimality: economic and cultural. Economic optimality asserts that taxes should limit economic distortions and not drastically alter people’s decision-making. In this view, taxes should follow clear guidelines, like Tax Foundation’s Principles of Sound Tax Policy: neutrality, stability, transparency, and simplicity.

Cultural optimality, on the other hand, recognizes that countries have different values and suggests that tax policy should reflect those values. As a result, the same tax policies can lead to different outcomes in different countries due to cultural variables.

An example of this is an inheritance tax. The importance of equity across the income distribution (often called “vertical equity”) differs across countries. Therefore, even if the inheritance tax is structured in the most principled way, cultural optimality would vary drastically between, say, a country that favors social mobility and one that values dynastic wealth. In the former, an inheritance tax is likely to be accepted and complied with; in the latter, the chances of taxpayers welcoming such a proposal are slim.

Economic and cultural optimality are not mutually exclusive. Rather, cultural factors can inform the implementation of economic principles. When discussing tax policy reforms, cultural considerations should play a role.

The Unpleasant Truth about Multilateral Agreements

Today, a considerable part of tax policy concerns multilateral negotiations. And while countries strive to reach solutions every party can live with, political consensus usually never leads to the economically optimal policy solution.

To structure internationally optimal taxes, agreements would need to involve culture-specific provisions to adapt the taxes to the political economy and make policies compatible with the interests of each agreeing government. Because multilateral negotiations often end with a compromise, these considerations rarely find themselves represented; one set of cultural preferences typically wins out above others.

The current negotiations on Pillar One and Pillar Two depict this. They ignore cultural differences across countries, and instead treat them as if they had the same incentive structures and preferences for higher corporate taxation.

Information as a Constraint

Any attempt to structure an optimal tax system requires a lot of information. To make the correct choices, policymakers would have to draw upon the true preferences of the whole population—or at least a clearly representative sample. Capturing a representative sample is hard enough; assuring that their shared views are truthful is even harder. When decisions are made under time constraints and driven by political motives rather than economic ones, the construction of an optimal tax system becomes increasingly complicated.

Even if a government could collect all the necessary public information, two key problems remain: costs and interactions. First, the costs of collection and administration would likely outweigh the benefits, at least for the short or medium term. This is relevant for most politicians because the economic benefits of an optimal tax system accrue in the long run. The second stems from Hayek’s critique of central planning: that policymakers never have enough knowledge to discern optimal policy during the policymaking process. Interactions among actors and spontaneous order through prices and markets can lead to more efficient outcomes than central planning.

Relying primarily on a taste-based mix of social and economic priorities is, however, not the appropriate shortcut to take in this situation. Many social priorities are inconsistent and harm those they were intended to benefit. One case is the taxation of capital income, which commonly attempts to redistribute resources from rich to poor. Taxes decrease the available wage pool and opportunities for further productive investments in the future, both of which harm workers. Focusing on economic growth instead has been shown to alleviate many problems—including social ones.

In the end, a culturally optimal tax system may be impossible to achieve. But policymakers should not ignore cultural factors when designing and implementing economically optimal policies.

Story originally seen here