Governments impose taxes in order to raise revenue that, in turn, funds government function and services.[fn1] In designing a tax system, tax theorists generally try to create provisions that will raise revenue without significantly altering taxpayers’ economic choices. That is, ideally, taxpayers will act in approximately the same way as they would have in a world without tax.[fn2]
But we can’t hit the ideal. The income tax alters people’s actions, because it alters the price calculus. One way is in our work-leisure decisions. Assume with me that I earn $10 an hour. That said, I enjoy not working, too–my leisure is worth $8/hour to me. In the absence of an income tax, if I have a choice between work and leisure, I’ll choose work. Even with a 10% tax, I’ll choose work, because I’ll bring home $9 after taxes, while my leisure is still worth only $8/hour. However, if the income tax is at a 25% rate, I’ll only bring home $7.50 after taxes. Suddenly, an hour of leisure is worth more to me than an hour of work; the income tax has caused my to substitute less-valuable leisure for more-valuable work.[fn3]
One way you could eliminate this problem, according to some economists and tax theorists, would be to replace our income tax with an endowment tax.[fn4] An endowment tax is, in broad strokes, a tax on potential income, rather than on actual income. An example (though not a rigorous example): suppose you go to Columbia Law School and do fairly well. You get a job offer at a prestigious firm that will pay you $100,000 a year.[fn5] But during law school, you discover that you would rather make and sell surfboards, a job that will pay you $20,000 a year, but leave you plenty of time to surf. So after graduation, while all of your friends study for the Bar and wear business casual, you shape fiberglass and wear flipflops. At the end of the year, however, you are taxed on the $100,000 that you could have earned, rather than the $20,000 that you did earn.[fn6]
I was thinking about the Parable of the Talents recently. Remember, the traveler gave his servants money, each “according to his several ability.” Two took the money, invested it, and doubled it. The third buried it. When the man got back, he praised the two servants who double their money and condemned the one who didn’t.
I’ve never heard anybody object to the inequity of holding the third servant responsible for his potential; as a matter of fact, the parable is usually used as evidence that God will hold us responsible for developing our talents and abilities. But what if this servant decided that, rather than work as an investment manager, he wanted to make and sell surfboards? Why don’t we see the results of the parable as being as outrageous as endowment taxation? They have their differences, sure, but in holding us accountable for our potential, irrespective of our preferences, they have a lot in common.[fn7]
[fn1] Yes, I know there are some of you who believe that taxes are illegitimate theft. But please don’t bother repeating it on this thread. It is completely irrelevant to the point that I may, eventually, make.
[fn2] I recognize that this isn’t always the case. Sin taxes, for example, have the dual purposes of raising lots of money and discouraging things that society finds unsavory. And I also realize that a tax-free world would be significantly different than the world with taxes (for example, we wouldn’t have the same government-provided infrastructure that we currently have), and so a taxpayer can’t truly know how it would act in a tax-free world. Nonetheless, these are assumptions we make, and assumptions that we really have to make.
[fn3] If you really geek out on this kind of thing, you could fix this problem by also taxing leisure and other imputed income. But you wouldn’t.
[fn4] Don’t bother looking it up on Wikipedia. Its article is about the taxation of university endowments, not endowment taxation. But if you want a good overview of the endowment tax, check out Lawrence Zelenak, Taxing Endowment, 55 Duke L.J. 1145 (2006).
[fn5] Yes, I know $100,000 isn’t what my hypothetical person would make. But I’m a tax professor: I always use $100,000, because it makes the math I have to do off the top of my head in front of a class really, really easy.
[fn6] Before you rage in the comments about how outrageous endowment taxation is (and you know who you are), keep in mind that (a) an endowment tax regime can be designed to ameliorate the most outrageous aspects, and (b) nobody really thinks endowment tax will be adopted full-scale–your outrage would doubtless be shared by all Americans except for a select few economists and tax theorists, plus it would be practically impossible to actually determine a person’s potential income, whereas it is relatively easy to determine her actual income.
[fn7] Please keep in mind that I do recognize the differences between taxation and the master’s requirements of his servants. And I’m not suggesting that the parable is wrong, or even unjust. I’m just wondering why we intuitively shrink from endowment taxation, but are comfortable championing the idea that we will be held accountable for developing our talents.