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Just Taxation

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I. Introduction 2

II. Introducing the problem 2

III. Income vs. Consumption Tax 3

IV. A just tax base? 5

V. Liberutopia 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 argu-ment 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 t0 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 t1 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 t1 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-ence 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 indi-vidual. The income tax, taxes money that flows from the market to the individual and the consump-tion 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 plausi-ble 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-trated in Fig.02.



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