TAXATION and REDISTRIBUTION (Chapter) from: THE CONSTITUTION OF LIBERTY by F.A.Hayek, 1960.
In many ways I wish I could omit this chapter. Its argument is directed against beliefs so widely held that it is bound to offend many.
Redistribution by progressive taxation has come to be almost universally accepted as just. Yet it would be disingenuous to avoid discussing this issue. Moreover, to do so would mean to ignore what seems to me not only the chief source of irresponsibility of democratic action but the crucial issue on which the whole character of future society will depend.
After a long period in which there was practically no questioning of the principle of progressive taxation and in which little discussion took place that was new, there has lately appeared a much more critical approach to the problem.
It would be said at once that the only progression with which we shall be concerned and which we believe cannot in the long run be reconciled with free institutions is the progression of taxation as a whole, that is, the more than proportionally heavy taxation of the larger incomes when all taxes are considered together. Individual taxes, and especially the income tax, may be graduated for a good reason – that is, so as to compensate for the tendency of many indirect taxes to place a proportionally heavier burden on the smaller incomes. This is the only valid argument in favor of progression.
It is clearly possible to bring about considerable redistribution under a system of proportional taxation. All that is necessary is to use a substantial part of the revenue to provide services which benefit mainly a particular class or to subsidize it directly.
As is true of many similar measures, progressive taxation has assumed its present importance as a result of having been smuggled in under false pretenses. When at the time of the French Revolution and again during the socialist agitation preceding the revolutions of 1848 it was frankly advocated as a means of redistributing incomes, it was decisively rejected.
J.R. McCulloch expressed the chief objection in the often quoted statement: “The moment you abandon the cardinal principle of exacting from all individuals the same proportion of their income or of their property, you are at sea without rudder or compass, and there is no amount of injustice and folly you may not commit.” In 1848 Karl Marx and Friedrich Engels frankly proposed “a heavy progressive or graduated income tax” as one of the measures by which, after the first stage of the revolution, “the proletariat will use its political supremacy to wrest, by degrees, all capital from the bourgeois, to centralize all instruments of production in the hands of the state.”
But the general attitude was still well summed up in A. Thiers’s statement that “proportionality is a principle, but progression is simply hateful arbitrariness,” or John Stuart Mill’s description of progression as “a mild form of robbery.”
But after this first onslaught had been repelled, the agitation for progressive taxation reappeared in a new form. The social reformers, while generally disavowing any desire to alter the distribution of incomes, began to contend that the total tax burden, assumed to be determined by other considerations, should be distributed according to “ability to pay” in order to secure “equality of sacrifice” and that this would be best achieved by taxing incomes at progressive rates. (Its basic conception is that of the decreasing marginal utility of successive acts of consumption.) Modern developments within the field of utility analysis itself have, however, completely destroyed the foundations of this argument. There can now be little doubt that the use of utility analysis in the theory of taxation was a regrettable mistake (in which some of the most distinguished economists of the time shared) and that the sooner we can rid ourselves of the confusion it has caused, the better.
Those who advocated progressive taxation during the latter part of the nineteenth century generally stressed that their aim was only to achieve equality of sacrifice and not a redistribution of income; also they generally held that this aim could justify only a “moderate” degree of progression and that its “excessive” use was, of course, to be condemned.
The suggestion that rates would not stay within these limits was treated as a malicious distortion of the argument, betraying a reprehensible lack of confidence in the wisdom of democratic government.
In 1891, Prussia introduced a progressive income tax rising from 0.67 to 4 per cent. In vain did Rudolf von Gneist, the venerable leader of the then recently consummated movement for the Rechtsstaat, protest in the Diet that this meant the abandonment of the fundamental principle of equality before the law, “of the most sacred principle of equality,” which provided the only barrier against encroachment on property.
Though some other Continental countries soon followed Prussia, it took nearly twenty years for the movement to reach the great Anglo-Saxon powers. It was only in 1910 and 1913 that Great Britain and the United States adopted graduated income taxes rising to the then spectacular figures of 8.25 and 7 per cent, respectively. Yet within thirty years these figures had risen to 97.5 and 91 per cent. Thus in the space of a single generation what nearly all the supporters of progressive taxation had for half a century asserted could not happen came to pass.
It has come to be generally accepted once more that the only ground on which a progressive scale of over-all taxation can be defended is the desirability of changing the distribution of income and that the defense cannot be based on any scientific argument but must be recognized as a frankly political postulate, that is, as an attempt to impose upon society a pattern of distribution determined by majority decision.
It seems at least probable (though nobody can speak on this with certainty) that under progressive taxation the gain to revenue is less than the reduction of real income which it causes. If the belief that the high rates levied on the rich make an indispensable contribution to total revenue is thus illusory, the claim that progression has served mainly to relieve the poorest classes is belied by what happened in the democracies during the greater part of the period since progression was introduced.
…once the principle of proportional taxation is abandoned, it is not necessarily those in greatest need but more likely the classes with the greatest voting strength that will profit…
The real reason why all the assurances that progression would remain moderate have proved false and why its development has gone far beyond the most pessimistic prognostications of its opponents is that all arguments in support of progression can be used to justify any degree of progression. … Unlike proportionality, progression provides no principle which tells us what the relative burden of different persons ought to be.
…democracy has yet to learn that, in order to be just, it must be guided in its action by general principles. What is true of individual action is equally true of collective action, except that a majority is perhaps even less likely to consider explicitly the long-term significance of its decision and therefore is even more in need of guidance by principles.
It is the great merit of proportional taxation that it provides a rule which is likely to be agreed upon by those who will pay absolutely more and those who will pay absolutely less and which, once accepted, raises no problem of a separate rule applying only to a minority. In no sense can a progressive scale of taxation be regarded as a general rule applicable equally to all – in no sense can it be said that a tax of 20 per cent on one person’s income and a tax of 75 per cent on the larger income of another person are equal. Progression provides no criterion whatever of what is and what is not to be regarded as just. …members of the majorities have found themselves again and again unexpectedly the victims of the discriminatory rates for which they had voted in the belief that they would not be affected. (my comment: think of 1970s bracket creep or more currently the alternative minimum tax from a 1969 tax act)
…proportional taxation leaves the relations between the net remunerations of different kinds of work unchanged. It concerns the effect, not on the relations between individual incomes, but on the relations between the net remunerations for particular services performed, and it is this which is the economically relevant factor.
There can be no doubt, however, whether or not the net remunerations for two services which before taxation were equal still stand in the same relation after taxes have been deducted. And this is where the effects of progressive taxation are significantly different from those of proportional taxation. The use that will be made of particular resources depends on the net reward for services, and, if the resources are to be used efficiently, it is important that taxation leave the relative recompenses that will be received for particular services as the market determines them. Progressive taxation alters this relation substantially by making net remuneration for a particular service dependent upon the other earnings of the individual over a certain period, usually a year.
…progressive taxation necessarily offends against what is probably the only universally recognized principle of economic justice, that of “equal pay for equal work.”
A man who has worked very hard, or for some reason is in greater demand, may receive a much smaller reward for further effort than one who has been idle or less lucky. Indeed, the more the consumers value a man’s services, the less worthwhile will it be for him to exert himself further. The fact that with progressive taxation the net remuneration for any service will vary with the time rate at which the earning accrues thus becomes a source not only of injustice but also of a misdirection or resources.
No practicable scheme of averaging incomes can do justice to the author or inventor, the artist or actor, who reaps the rewards of perhaps decades of effort in a few years. Nor should it be necessary to elaborate further on the effects of steeply progressive taxation on the willingness to undertake risky capital investments. It is obvious that such taxation discriminates against those risky ventures which are worthwhile only because, in case of success, they will bring a return big enough to compensate for the great risk of total loss.
Beyond the harmful effects on incentive and investment…, there are other effects which are less understood but at least equally important. Of these, one which perhaps still deserves emphasis is the frequent restriction or reduction of the division of labor. The tendency to “do it yourself” comes to produce the most absurd results when, for instance, a man who wishes to devote himself to more productive activities may have to earn in an hour twenty or even forty times as much in order to be able to pay another whose time is less valuable for an hour’s services.
We can also only briefly mention the very serious effect of progressive taxation on the supply of savings. The socialist answer to those who are concerned about this effect on savings is, in fact, no longer that these savings are not needed but that they should be supplied by the community, i.e., out of the funds raised from taxation. This, however, can be justified only if the long-term aim is socialism of the old kind, namely, government ownership of the means of production.
One of the chief reasons why progressive taxation has come to be so widely accepted is that the great majority of people have come to think of an appropriate income as the only legitimate and socially desirable form of reward. They think of income not as related to the value of the services rendered but as conferring what is regarded as an appropriate status in society. …this contention lacks all foundation and appeals only to emotion and prejudice… There is no necessary relation between the time an action takes and the benefit that society will derive from it. The whole attitude which regards large gains as unnecessary and socially undesirable springs from the state of mind of people who are used to selling their time for a fixed salary or fixed wages and who consequently regard a remuneration of so much per unit of time as the normal thing. … It is meaningless for men whose task is to administer resources at their own risk and responsibility and whose main aim is to increase the resources under their control out of their own earnings.
Profits and losses are mainly a mechanism for redistributing capital among these men rather than a means providing their current sustenance. The conception that current net receipts are normally intended for current consumption, though natural to the salaried man, is alien to the thinking of those whose aim is to build up a business. Even the conception of income itself is in their case largely an abstraction forced upon them by the income tax. …I doubt whether a society consisting mainly of “self-employed” individuals would ever have come to take the concept of income so much for granted as we do or would ever have thought of taxing the earnings from certain services according to the rate at which they accrued in time. It is questionable whether a society which will recognize no reward other than what appears to its majority as an appropriate income, and which does not regard the acquisition of a fortune in a relatively short time as a legitimate form of remuneration for certain kinds of activities, can in the long run preserve a system of private enterprise.
…the building-up of new enterprises is still and probably always will be done mainly by individuals controlling considerable resources. New developments, as a rule, will still have to be backed by a few persons intimately acquainted with particular opportunities; and it is certainly not to be wished that all future evolution should be dependent on the established financial and industrial corporations.
It is one of the advantages of a competitive system that successful new ventures are likely for a short time to bring very large profits and that thus the capital needed for development will be formed by the persons who have the best opportunity of using it.
Much of the individual formation of new capital, since it is offset by capital losses of others, should be realistically seen as part of a continuous process of redistribution of capital among the entrepreneurs. The taxation of such profits, at more or less confiscatory rates, amounts to a heavy tax on that turnover of capital which is part of the driving force of a progressive society.
The most serious consequence, however, of the discouragement of individual capital formation where there are temporary opportunities for large profits is the restriction of competition. … taxes today absorb the greater part of the newcomer’s “excessive” profits… The old firms do not need to fear his competition: they are sheltered by the tax collector. …what is more important for them is that it prevents the dangerous newcomer from accumulating any capital. They are virtually privileged by the tax system. In this sense progressive taxation checks economic progress and makes for rigidity.
An even more paradoxical and socially grave effect of progressive taxation is that, though intended to reduce inequality, it in fact helps to perpetuate existing inequalities and eliminates the most important compensation for that inequality which is inevitable in a free-enterprise society. … A system based on private property and control of the means of production presupposes that such property and control can be acquired by any successful man. If this is made impossible, even the men who otherwise would have been the most eminent capitalists of the new generation are bound to become the enemies of the established rich.
Can there be much doubt that poor countries, by preventing individuals from getting rich, will also slow down the general growth of wealth? And does not what applies to the poor countries apply equally to the rich?
It is probable that the practice is based on ideas which most people would not approve if they were stated abstractly. That a majority should be free to impose a discriminatory tax burden on a minority; that, in consequence, equal services should be remunerated differently; and that for a whole class, merely because its incomes are not in line with those of the rest, the normal incentives should be practically made ineffective – all these are principles which cannot be defended on grounds of justice.
Yet experience in this field shows how rapidly habit blunts the sense of justice and even elevates into a principle what in fact has no better basis than envy. If a reasonable system of taxation is to be achieved, people must recognize as a principle that the majority which determines what the total amount of taxation should be must also bear it at the maximum rate.
…some progression in personal income taxation is probably justified as a way of compensating for the effects of indirect taxation.
What is needed is a principle that will limit the maximum rate of direct taxation in some relation to the total burden of taxation. The most reasonable rule of the kind would seem to be one that fixed the maximum admissible (marginal) rate of direct taxation at that percentage of the total national income which the government takes in taxation. This would mean that if government took 25 per cent of the national income, 25 per cent would also be the maximum rate of direct taxation of any part of individual incomes.
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