Index: I. Introduction 2 II. Introducing the problem 2 III. Income vs. Consumption Tax 3 IV.
A just tax base? 5 V. Liber utopia 6 VI. Conclusion 8 VII. References 9 Table of Figures: Figure 1: Consumption vs. income tax 3 Figure 2: Floating money and deposit money 4 I. Introduction In the debate of just taxation an argument came up, which insisted that any tax that distorts individual preferences should be considered as unjust.
This argument is known as the "fairness-to- savers-argument." The intention of this essay is to explain of what the fairness to savers argument consists, how to approach it and foremost why it is wrong. At first I will therefore explain the argument on the basis of it's most common example. The following chapter will then provide a better insight into to exact circumstances, under which the fairness to savers argument might arise. Here the functionalities of the, in the example presented, tax bases will be addressed.
To approach the rejection of the argument correctly, it will be necessary to determine what exactly "just" means and this will lead us to some assumption, which need to be made to prove the argument wrong. But before that, I will present the approach Murphy and Nagel make in their book "The myth of ownership" and why they are not able to reject the argument completely. Afterwards I will introduce my approach, which basically will show, that any kind of taxation will distort individual preferences and there from I derive, that the fairness to savers argue-men must be invalid. II. Introducing the problem The basic problem of the fairness to savers argument, is the effect of different tax bases on individual preferences. The name of the argument follows from it's most vivid example, which I want to address at first, for a better understanding of the issue.
The example is often illustrated with the comparison between two individuals preference for saving, both taxed once under an income tax and once under a consumption tax. Let's consider two people, Steve and John, both earn in t 0 100$, the rate of return is in every period constantly at 10% and they are in every aspect totally similar, despite their individual time preference, which is for Steve at 3% and for John at 9%. That means exactly, that Steve is willing to save his money as long he gets at least a net return rate of 3% and John is willing to save his money as long he gets at least a net return rate of 9%. In case their time preference is higher than the net return rate, the utility they derive from immediate consumption will be greater than the utility they derive from saving, thus they won't save their money. Considering now Steve and John under a consumption tax, both have to pay no tax for earning the 100$, they only will be taxed if they spend it on consumption. Under the assumption that their basic needs are already provided, both will decide to save the money, due to their time preference, which is in both cases lower than the net rate of return.
Therefore they will receive in t 1 both a payoff of 10$ through their return rate. Under an income tax the presented scenario would look somewhat different. At first both of them have to pay a tax for earning the 100$, due to the income tax. Since the concrete amount doesn't matter, we can assume an income tax of 50%, which would leave both Steve and John off with 50$ at their disposal. Now Steve and John need to consider whether to save their money or not, since any gain through the rate of return will be treated in t 1 as income and therefore will be taxed at 50%. Strictly speaking, the gross rate of return of 10% will be turned, through the income tax of 50%, to a net rate of return of 5%.
So in this case only Steve will decide to save, since his time preference is still below 5%, whereas John will decide for immediate consumption, because his time preference is higher than 5%. And exactly this change of mind forms the core of the "fair-ness-to-savers" argument. It is not the fact, that John and Steve are in total worse off under the income tax, as mentioned above the value of the tax is not important and can be altered, but the relevant point is, that the income tax changes Johns preference for saving. In the example John would like to save his money according to his time preference, but he only will do so under the consumption tax, since the income tax reduces the net rate of return and thereby affects his prefer-e nce for saving. In this rather simplified form, the "Fairness-to-Savers" argument states, a tax base is just, if it doesn't distort individual preferences in comparison to the no-tax world. In the above example of the preference for saving, this applies for the consumption tax.
III. Income vs. Consumption Tax Although the above argumentation is quite comprehensible it seems somewhat odd, especially under consideration of the functionality of both tax bases. Figure 1: Consumption vs. income tax As illustrated in Fig. 01, both tax bases tax money that flows between the market and the in di-visual.
The income tax, taxes money that flows from the market to the individual and the consume-ti on tax, taxes money that flows from the individual in the market. Assuming for both the same tax rate, they should cause the same tax yield. Obviously this argumentation assumes, that any gained income is spent on consumption and neglects the fact, that individuals have the option to save money. In the latter case, only the income tax will affect both, the saved and the spent money, whereas the consumption tax will only affect the money spent on consumption. But it is still pla usi-be to argue, that in the long term, any saved money will be spent again on consumption and there-fore will be taxed even under a consumption tax.
Although this is true, we didn't consider the rate of return so far, which was so essential in the fairness to savers argument. As long the rate of return is non zero, non negative, capital gains can be achieved by investors. They are considered as income and therefore they are taxed under an income tax, but not under a consumption tax, which is illus-treated in Fig. 02.
Figure 2: Floating money and deposit money Here, the individuals floating money and deposit money are considering separately, the in-come tax affects the return of both, where the consumption tax only affects the spending of the floating money. To balance this disparity out, it's possible to imagine an income tax, which is not levied on capital returns or a consumption tax, which is as well levied for the use of capital invest-ments. But as long the nature of these two tax bases differ that much, the line of argument pre-sent ed in section II seems pointless. Of course tax bases with different structures will have different results, concerning the effects on individual preferences as well as on the amount of the tax yield. Stating that, an income tax penalizes savers and a consumption tax doesn't, is like saying, a con-sumption tax on "luxury goods only" changes the preferences for these kind of goods, in compar i-son to an overall consumption tax. Well of course it does, but that lies in the very nature of this kind of tax.
IV. A just tax base? Certainly no one would have addressed the issue in terms of a "fairness to luxury-goods-consumers" with a pleading for a flat consumption tax, although this presentation of the argument can lead to the same conclusion and is casually more obvious. While this depiction may give us a better understanding of the fairness to savers argument, it will not help to disprove it. To proof the argument wrong, we need to look at it's conclusion: A tax base is just, if it doesn't distort individual preferences in comparison to the pre-tax world. Now we must consider two different interpretations of the term 'just'. In the first interpretation a tax is only considered just, if it creates a just post-tax world, since the tax is considered the only possibility to balance out the disparities, which have arisen between the individuals in an unjust pre-tax world.
Under these conditions the fairness to savers argument can be easily rejected, since it makes no assumption about the pre-tax world. So it is possible to assume an unjust pre-tax world, to which a just tax base is applied. But since the tax base alone cannot solve distributive matters, it is not given that the result in the post-tax world will be just, that still depends on the appropriate tax rate, which is not consid-e red in this case. Implicit, this interpretation is also favor ed by Murphy and Nagel, when they say that .".. there is no ground for treating the pretax distribution of welfare as an ethically significant baseline." In this case Murphy and Nagel didn't argue precisely enough, because the fairness to savers argument arose in the question of a just tax base, which is not the same as an overall just tax. The second interpretation assumes, that a tax base can be just in itself, no matter what the outcome is.
Under these conditions their argument is not beating. The pre-tax distribution doesn't have to be an ethically significant baseline, because it doesn't matter that the pre-tax world is unjust and that the preferences in this world are already distorted. A just tax base, doesn't alter these pref- again and therefore it is just and that's exactly the only implication the fairness to savers argument makes. To prove the fairness to savers argument under the latter conditions wrong, we need to look at a more insistent form of it.
V. LiberutopiaAccording to Murphy & Nagel, I will call this form of the fairness to savers argument the equal libertarianism version, since it makes two more assumptions. First, it assumes that everyone has the same equal starting point, considering initial resources and talents. Second, it assumes that any market outcomes that follow from this equal starting point are presumptively just. Moreover we make another assumption saying, that whatever tax base is finally chosen, the appropriate just tax rate will automatically be applied. This will guarantee that, if we find afterwards any unjust cond i-t ions, they must be caused by the tax base.
Through this assumption we are able to reject the argue-men in the end. Since we will at first take a look how Murphy and Nagel approach this form of the fairness to savers argument, it is important to note, that Murphy and Nagel didn't make this last assumption, but nevertheless it will have no affect on the approach they describe in their text. Murphy & Nagel approach this problem not by disputing the argument itself, but by attacking its premises. They question if it is a realistic assumption, that everyone starts with the same wealth and talents. Equal wealth might be established with equal property rights, but human capital is in- not equally distributed, only a tax is able to balance the natural disparities between the individuals out. But then the question of taxation would have already been answered.
In this line of argumentation 'the fairness to savers argument [... ] gets off the ground only in the equal libertarian's utopia'. But Murphy and Nagel have to admit, that it at least gets off the ground, although only in 'liber utopia'. To contradict Murphy and Nagel in this point, no one claimed that the equal liber tar-ian assumptions would be realistic. The approach presented here by Murphy and Nagel is quite comprehensible, but not adequate for rejecting the fairness to savers argument.
Therefore we recall the example in section II with Steve and John. I made the assumption that Steve and John earn the same amount and are in every aspect totally the same, except of their time preference. If Steve and John are the only two persons in a state, than the equal libertarian version of the fairness to savers argument would apply for them in the presented example. In this case the income tax was not just, but the consumption tax was. Now we consider the inverted version of this example.
Steve and John are again totally equal, but this time their preference for immediate consume-ti on differs. For both the basic needs are already provided. They can either save their earned money or spend it on luxury goods, which cost 20$ each. Steve prefers immediate consumption, if one unit the luxury good costs no more than 15$ otherwise he derives more utility from saving.
John prefers immediate consumption, if one unit the luxury goods costs no more than 20$. In the pre-tax world John would consume and Steve would save. In the post-tax world we apply a flat consumption tax, since this seemed to be a just tax base in the former example. After applying it, John changes his mind and decides to save as well, as whatever the tax rate will be, as long it is non-zero, non-negative it will increase the price of the luxury good to more than 20$. This seems somewhat bogus, because it just proves the consumption tax in this very particular situation as unjust.
Still this doesn't prove the fairness to savers argument wrong, because it didn't state that a consumption tax is the proper tax base, in the example in section II it only seemed to support a tax based on consumption. At this point the question arises, if neither income nor consumption is the proper tax base ac-cording to the fairness to savers argument, is there a just tax base at all? Considering an endowment tax, we could imagine a preference for leisure, which then will be distorted. This preference for leisure would also be affected by a head tax, if we think of a person that has a preference for 8 hours leisure a day, given that he still has an adequate income. In case he has to pay a head tax, he must weigh the 8 hours leisure against the reduced income, based on his utility functions he might choose to reduce the leisure to maintain his income.
Since taxation will in most of the cases leave people with less money, the preference for leisure can nearly classify most of the tax bases as unjust, even arbitrary tax bases like a tax according to the size of shoe. Can we there from derive that the fairness to savers argument is invalid? When we applied the fairness to savers argument in the income vs. consumption tax question, it was enough to show that there might be someone with an identical time preference as John and from this followed, that income is not an appropriate tax base. So to disprove to fairness to savers argument, it is enough to show that any taxation might affect any individual preferences.
To deter-mine if this is the case, we think of circumstances under which definitely no preferences will be distorted. This can only be true, if all individuals have only one and the same utility function for every good and every action, which means that they are all totally indifferent. As long this is the case, they won't have any preferences that might be affected by taxation. But this assumption is not made in the fairness to savers argument. Moreover it seems far more realistic, that individuals have a variety of different utility functions between which preferences can arise.
So it follows from utility theory, that any decrease of ones income, wealth, property or saving can affect preferences, given that different utility functions exist. This distortion of preferences can, under the assumption made earlier this chapter, only be ascribed to the tax base. Based on this argumentation, the fairness to savers argument will, in the question of a just tax base, not be able to yield proper results, because any tax base would be classified as unjust. But since the question of taxation somehow needs to be answered, the fairness to savers argument must be invalid. VI. Conclusion As simple and comprehensible the fairness to savers argument seemed in the beginning, it turned out to be invalid in the end.
Although the argument was presented very plausible within the example of Steve and John, the following chapter about the functionality of income and consume-ti on tax already showed, that distorting preferences can lie in the nature of a tax. Another important point was the correct interpretation of the term "just", since the stricter definition allowed a rash rejection of the argument, which eventually wasn't applicable to the fairness to savers argument, as it only considered the tax base. Finally we found the right foundation for it's rejection in the equal libertarianism version of the argument. After introducing the approach Murphy and Nagel made and showing it's weaknesses, I illustrated a series of examples, which all showed different tax bases to be unjust, according to the fairness to savers argument. In the end, it was questionable if any tax base at all could fulfill the requirements stated by the argument and from utility theory we could derive, that it would only apply in the very special case of indifference. For all other cases the fairness to savers argument could be neglected, since it would classify any tax base as unjust.
VII. References Nagel, T. /Murphy, L. (2002): The Myth of Ownership - Taxes and Justice, Oxford.