Taxes

Should countries have a wealth tax?

Image source: Norwegian Taxation Authoritry (Skattetaten)

Norway is one of the few countries in the world with a wealth tax. In 2020 a Norwegian would need to pay 0.7% of their wealth over 1.5 million kroners (about 150,000 Euro) to their local principality and an additional 0.15% to the state.

The wealth tax has been controversial in Norway. Both Sweden and Denmark abolished their wealth taxes years ago, in 2007 and 1997. Many countries like the US and Great Britain have never had a wealth tax.

Yet the idea of taxing wealth has had a bit of a come back in recent years. One of the reasons for this has been skyrocketing inequality in many countries. The French economist Thomas Pikketty has promoted taxing wealth as a way of dealing with inequality. Even prominent politicians in the US, like Bernie Sanders and Elisabeth Warren, have promoted a wealth tax.

But opponents of the wealth tax in Norway have several strong arguments as well. One argument is that the tax is inherently unfair. Since income is already taxed at a high marginal rate, taxing wealth--which is just the accumulation of after-tax income--becomes a form of double taxation

Other arguments are of a more practical bent. Wealth taxes, it is argued, are economically inefficient. In other words, they are harmful to the economy because they act as a tax on investment. Liquidity concerns are also often brought up. The owners of a family firm may, on paper, have substantial wealth, but that wealth may mostly be in the form of the value of the company. In order to pay a wealth tax, it is argued, they would need to in effect sell their companies. Then there is the question of whether wealth taxes even manage to bring in substantial amounts of revenue. Several rich Norwegians have decided to move to other countries--notably Switzerland--in order to avoid a wealth tax, thereby depriving the Norwegian state of not only wealth taxes but also other taxes that these wealthy individuals might pay.

Among economists, there is no general agreement on weather wealth taxes should be used, this is an active area of both research and debate. On the other hand, economists agree that all taxes create economic inefficiencies. This is not because the state takes money, this is just a redistribution of wealth. Instead, economists think of taxes as leading to inefficienies since they alter price signals in markets. This leads to sub-optimal equilibriums. In other words, were those taxes not imposed, we could have had more trades where both sides benefited.

This is not to say that taxes are bad or should not be imposed. All economists also acknowledge that governments need some form of taxation to fund necessary services. But these taxes will necessarily distort a market economy.

Taxes, tax wedges and dead-weight loss.

The figure above shows a market equilibirum, with a market supply and market demand curves.

But here we have also inkluded a simple unit tax. This tax is in the form of a fixed sum that comes on top of the normal price for each good. We use this type of tax not because it is a common form of taxation (it is not), but instead because it makes our analysis relatively simple.

Road fees for a new car purchase is one example of such taxes. Let us say that you pay 20,000 Euro for a car and the road fees are 5,000 Euro, then then buyer must pay 250,000 in total.

The light-blue triangle is again consumer surplus. The purple triangle represents producer surplus. And the green rectangle represents revenues that the government gets from the tax. This is the the portion of market surplus that the government uses to finance public goods like roads, hospitals, etc. So we should not consider this an economic loss, just a redistribution.

Instead, the economic loss comes from wedge that the tax creates between price that consumers pay (which includes the tax) and the amount that the companies recieve (which does not include the tax).

To see this better, press the Reduce the tax button. When we have less tax, then the companies can reduce the price so that more people will buy the product. Since they will get more in revenue of the final sales price, they are also willing to produce more even though the marginal cost increases. Without the tax, we get more mutually beneficial transactions. These transactions would not have happened with the tax, and that is the source of the economic loss from taxation.

If we continue to reduce our tax, we will eventually end up at our free market equilibrium where we have maximized our social surplus.

Does this mean governments should stop taxation?

No. Taxes are necessary to finance public infrastructure and services that are essential to a well-funcitoning society and economy. But we should be aware of the economic costs of taxation

Dead-weight loss and elasticity

Taxes lead to a social cost (less social surplus) because of the wedge between the price facing the consumers and the income that the producers receive. But the size of that loss will depend on how a tax affects the behavior of producers and consumers.

If a higher sales price (price+tax) leads to much less demand, then the loss will be large. That is, if we have a high demand elasticity, then the loss will be larger.

In the same vein, if production decreases by a large amount when a firm gets less income for selling a good (because more goes to tax), then it will also lead to higher social costs.

One simple rule of thumb is that the tax that affects the market the least, is often best.

Try pressing the buttons for more and less elastic demand and supply to see the effect of deadweight loss (the red triangle).

Deadweight loss is also shown in the small figure as a red circle where the x- and y-axes represent demand- and supply-elasticity.

Quiz

Problems

1.) Let us say that we have the following market demand and supply curves:

$$P^D = 200 - 0,5X^D$$ $$P^S = 50 + X^S$$

a.) What is the price and quantity in the free market equilibrium?

b.) Now a unit tax of 20 is imposed. What is the new price (for the consumer), \(P^K\), the seller-price, \(P^S\) and quantity sold, X?

c.) How much dead-weight loss does the tax create?

a.) Setting the supply- and demand functions equal to each other:

$$200-0,5X = 50 + X$$ $$X = 100$$ $$P = 200-100*.5 = 150$$

b.) Now putting in our unit tax:

$$P^D = P^S +20$$

Equilbrium for our quantity will be when \(X^D = X^S\)

Rewriting our demand and supply curves:

$$X^D = 400 - 2P^D$$ $$X^S = P^S - 50$$

Inserting our conditions for equilibrium:

$$X^D = 400 - 2(P^S+20)$$ $$X^D = 400 - 2*P^S-40$$ $$X^D = 360 - 2*P^S$$

Calculating the equilibrium:

$$360 - 2P^D = P^S - 50$$ $$3P^S = 410$$ $$P^S = 410/3 \approx 136,7$$

and

$$P^K = 136,7 + 20 = 156,7$$

Quantity becomes:

$$X = P^S - 50 = 136,7-50 = 86,7$$

Double checking:

$$X = 360 - 2*136,7 = 86,7$$

c.) Using our formula for a triangle: 1/2b*h

$$b=P^K-P^S = T = 20$$ $$h=X_F - X_{T} =100-86,7 = 13,3$$

Where \(X_F\) is quantity under free market conditions and \(X_T\) is quantity with a tax imposed.

2.) Economists often see property taxes as one of the most efficient forms of taxation. Can you explain why?

A few things you could note:

  • It is not a transaction tax, so it will not affect the number of transactions.
  • The supply of property in the form of land is usually seen as relatively fixed (it is hard to produce more land), so supply is also very inelastic.
  • Demand for property is also often seen as quite inelastic: People need a place to live, and businesses need offices and factories.
  • It is difficult to evade: You can not move your property to a country with more favorable tax rules.
  • Property taxes can often be progressive: People with higher incomes and wealth often have many and expensive properties.