How should we design a tax system? This is partially a technical question and partially an ethical question because we have both efficiency and equity as desiderata. There are technical and moral aspects to both, but it is easier for me to see the technical aspects in efficiency and the ethical concerns in equity.
President Obama recently took heat for having the unmitigated gall to suggest that entrepreneurs did not build their businesses independently of social and public capital. This should not be controversial. It is just a statement of fact.
But used in conjunction with an argument to let the BTCs expire on the hyperrich, it is an application of the benefits principle of taxation. The benefits principle states that those who benefit more from social and public goods should pay more in taxes. This is a normative principle and not a positive one, so of course in this sense it should be controversial. I agree with it.
There is another major normative principle of taxation: the ability to pay principle. It is the proposition that people should pay taxes according to their ability. Vertical equity is subsumed under this principle. Vertical equity implies that someone with greater ability to pay should pay more than someone with lesser ability to pay.
All of this talk is about the engineering feat of designing a tax system. So how should we design a tax system? This is partially a technical question and partially an ethical question because we have both efficiency and equity as desiderata. There are technical and moral aspects to both, but it is easier for me to see the technical aspects in efficiency and the ethical concerns in equity.
The technical aspect is this: because efficiency is a desideratum it motivates the question how do we design a tax system that minimizes both the deadweight loss and the administrative burden? The easiest way is to impose a flat lump sum tax on everyone. But this runs contrary to our other desideratum equity because it requires the people who earn less to pay relatively more which violates vertical equity.
We also run into inefficiencies when we levy taxes which distort economic behavior in undesirable ways. The way to avoid tax distortion is to levy the tax in such a way that it generates the necessary revenues subject to a minimization of the marginal tax rate. We could achieve revenues in whatever amount desired subject to the constraint that we minimize the maximum marginal tax rate.
An ethically-oriented approach would be the modern liberal approach of John Rawls. This approach is concerned with vertical equity as it requires the most advantaged to pay more for less utility than is achievable. Vertical equity is part of the ability to pay principle. Rawls’ difference principle of distributive justice as articulated in Justice as Fairness: A Restatement requires that the only permissible economic inequality is that which maximizes the benefit to the least well-off. The logic of the difference principle runs on the notion that instead of maximizing total product as economists may advocate or utility as Benthamites might advocate, we maximize the prospects for lifetime wealth and income for the least advantaged group in society.
So if we think of all after tax income (the portion the government lets you keep) as a basket of goods to be distributed by the government between the least advantaged group and the most advantaged group, we would distribute the portion of after-tax income so that the least advantaged group was as well-off as possible over the course of their lives (notice this means a sort of intra-generational tax scheme).
This need not be a point of perfect equity between the least advantaged group and the most advantaged group (which would make the group names trivial). It is just a point which achieves a considerable amount of utility for society while maximizing the lifetime potential of the least among us. So we would design a tax system that achieves this highest “equal justice line” as Rawls put it.
One reasonable application of this principle might be to an estate tax. Intergenerational transfers confer wealth and privilege for and provide advantages to the most advantaged group in society. These silver spoon children are at an advantage from the time they were born. This advantage distorts incentives, because it is an advantage they did not earn and so to achieve a state of comparable material good they have to work less hard than the offspring of the least advantaged. The silver spoon children will draw down this wealth over the course of their lifetime if they consume more that is sustainable from the sum of recurring income streams and their income earned from working. So, if these silver spoon children become less wealthy as they get older, then to enjoy a comparable state of wealth gets easier for the Horatio Alger children as they get older.
At any rate, if the silver spoon children are working to maintain then they are at least engaged in some productive activity and are not just a leisure class burden on society and for their part are contributing to their own material privilege. Thus, the benefit to being a silver spoon child is relatively greater earlier in their lives—they have more comparable wealth and more leisure.
Satisfaction from material wealth is relative. For instance, if you give me a Lexus but give everyone else in my neighborhood a Bugatti Veyron each, then I am better off but I do not feel better off because everyone else is still doing much better than me. The most advantaged crowd out the satisfaction of the least advantaged because the better off that they are the worse off the least advantaged feel. Therefore, to minimize this effect we should deprive the most advantaged of wealth and privilege as early on as possible, which means we should levy heavy estate taxes. Note that this is not damaging to production or incentives because they did not earn it any way. Parents will still have an incentive to work hard for their children, because knowing that their children will have to depend more on their own initiative they will work hard to set a good example for their children and will instill the values of hard work and frugality, rather than inadvertently instilling an ethos of conspicuous consumption and leisure class laziness.
The inheritance tax rate should be raised and the wealth level at which it applies should be lowered. I believe the rate is currently at 55% and I believe it applies to estates >/= $3mm. In an economic culture which runs on a sort of naive social darwinism it is hard to justify massive inheritance. If an argument against social welfare is that people should not receive financial benefits they did not earn, then why should children who by some accident of the universe happened to be high-born get financial benefits they did not earn?
Some may argue that it infringes on economic liberty to restrict what families can pass on to the next generation. But we already do it to some degree and it has not motivated a Shays' Rebellion yet. Microeconomists may argue against the arbitrary limiting effects of infringements on economic liberties. But to do so couched in any terms other than supply and demand and market efficient social welfare is to take a point of departure from microeconomics and delve into political philosophy and the normative philosophy of rights.
Microeconomists believe taxes distort incentives. Tax consumption and consumers will consume less. Tax labor and workers will labor less. But what is the distortive effect of taxing intergenerational wealth transfers? Intergenerational wealth transfers do not occur in a market. They occur based on statutory rules of intestate succession, which means government is already heavily involved. Such taxes may reduce the marginal propensity to save of the taxpayer population affected by the taxes. But that means considerable additions to current consumption and charitable giving. That is not a reduction of Qs,d below the socially optimal quantity of any good sold.