Discouraging Effort and Success

Why do we tax labor? We know that any tax on an activity discourages people from engaging in that activity by reducing the rewards for doing it. So why do we tax hard work, production, and wise investment? Do we really want less of those things?

We need to fund our government (some claim), so we need to tax something. Why not tax behaviors that we want less of? Wouldn't that be killing two birds with one stone?

What would happen if we ditched all income taxes (including capital gains, and corporate income taxes) in favor of taxation levied exclusively against consumption? How would our society change?

I imagine a system wherein my income is not monitored by the government, but the total amount of my consumptive spending is instead. It's easy enough to do - just give up cash and require banks to report the amount of spending. As long as my consumptive spending total for the tax period stays below a legally established minimum, I pay no tax. But when my total rises above that level, I begin to pay tax out of each additional dollar spent. So if I don't spend much beyond the limit, the taxation I experience will be very low.

There are many advantages to such a system. For one, we'd stop punishing smart and hardworking people for being so productive. Every dollar they earn would be theirs to keep. This would include dollars earned for good investments (capital gains). Similarly, we'd stop punishing businesses for competence in producing and selling products and services to people who need them. When a highly successful business has to pay a large amount of income tax while its less successful competitor pays no tax (due to writing off business losses) the playing field is being unfairly tipped to reward poor performance! Not only that, but why tax production at all when production is what gives us the things we need and desire?

Also very important is the fact that taxing consumption, instead of labor, production, and investment, allows individuals to adjust their tax liability to fit their circumstances and desires. If I don't want to pay so much in taxes this year, I can reduce my consumption and pay less. And, I bear no penalty for working extra hard to earn additional money to fund my future, or my children's future.

Under this kind of system saving would be strongly incentivized. For those who wished to avoid taxation, saving and wise investment would be the safest harbor for their money. Everyone would be faced with compelling reasons to defer spending to a later date. Government subsidized retirement could become unnecessary for average Americans.

It's possible to take this idea to a more extreme level and suggest that leisure (time spent not producing or learning) could be taxed when it exceeded a certain minimum amount. This could spur the indolent and chronically unemployed (whether poor or wealthy) to return to productivity, lending their efforts to the improvement of society.

Undoubtedly there are many weaknesses in such a plan, and opportunities for clever gaming of the system. But that is no different from our current system for taxation.

Are there structural problems with this proposition?

Picking Winners

In an earlier post I asked "How do you think the founders of Tesla feel about GM being propped up by the government?" Well, it turns out that Tesla can't complain too much. I guess I should have known.


I'm worried about the government funding companies, whether startups or established players, because government investment drives out private investment, and because the companies who receive support have a competitive advantage over the ones that don't. Why is this an important problem? Because the government doesn't know which companies are going to be enormously productive, and which ones won't. Just as an example, what if the government had propped up Ask Jeeves at the expense of Google? Of course I don't actually know what would have happened, but it's possible and maybe likely that Google would have been crushed or absorbed before it had a chance to bring so much value to so many people.


Econtalk has a great interview with Y-combinator partner Paul Graham. Graham says that government attempts to 'create the next Google' are doomed to failure because no one knows what the next Google is going to be like. By definition, the next big innovation is going to be something that is not currently understood well enough for the value to be obvious. It's ludicrous to me to think that government bureaucrats, no matter how competent, are going to be able to predict which companies are the future sources of important innovation, and which aren't.

Survival of the Most Fit

I know that it's not an original observation, but Too Big to Fail and similar policies to protect people and businesses who do a poor job are seriously interfering with the basic premise of a market economy.

James Kwak has written a post about how Citigroup CEO Vikram Pandit seems unable to present a meaningful description of his business strategy.

It's not uncommon to witness top business leadership governing on ego or otherwise failing to understand the limits of their firm's competency, and value in the market. One of my favorite examples is Daimler Benz CEO Jurgen Schrempp's famously bad decision to acquire Chrysler. The evidence suggests that Daimler's management team had no workable strategy for how to make use of their purchase or how to integrate it into their organization. No meaningful synergies were ever anticipated, nor did any emerge - as was practically guaranteed by leadership's policy against platform and technology sharing between Chrysler and Mercedes. In the end Schrempp was fired and Daimler paid Cerberus to take Chrysler off its hands.

This story perfectly illustrates how a competitive market is supposed to function, with severe chastening for incompetence. Interference in this process, even for the best reasons, will introduce pernicious effects.

Moral Hazard - Moral Hazard is a technical term that means that the risks of my actions are borne by others, not by myself. Moral Hazard explains why innovations in automobile safety systems, like airbags and seat belts, has resulted in increasing risk to pedestrians. It also explains why beach homes continue to be built in locations that put them at risk in the event of a hurricane (because the government has historically bailed out the wealthy owners of these sometimes non-insurable properties).

Picking Winners - When an incompetently managed firm shrinks or dies, an opportunity opens for the most efficient competitors to take market share. Bailing out large incumbent firms that perform badly interferes with the success of other, better run companies who are then forced to compete without the benefit of government backing. It also tends to strangle small upstarts who are bringing new value and innovation to the market. How do you think the founders of Tesla feel about GM being propped up by the government?

Regime Uncertainty - Perhaps most pernicious of all is the effect of Regime Uncertainty. This is a reluctance on the part of investors to put their money into markets, industries, or countries where the rules are not clear, or could change at any moment. Why has sub-Saharan Africa failed to develop? Well, one reason is because people are reluctant to build businesses in a region that suffers from frequent civil war and political tumult. If I build a factory in Tanzania today, will it be destroyed or seized by government tomorrow? Similarly, how willing am I to try to operate a business in any market where the government is making up the rules of competition and ownership day by day? Consider how the government chose to take money from GM's bond holders and transfer it to the UAW.

Systemic risk is a matter of incentives. Too Big to Fail is magnifying the wrong incentives.