While preparing for my presentation for the Friedman Conference this weekend, I came across a speech I gave to the LDP conference a couple of years ago. I’m not sure if I ever published here or not so for your reading pleasure I’m reproducing it below.
But anyone who after the twentieth century still thinks that thoroughgoing socialism, nationalism, imperialism, mobilization, central planning, regulation, zoning, price controls, tax policy, labor unions, business cartels, government spending, intrusive policing, adventurism in foreign policy, faith in entangling religion and politics, or most of the thoroughgoing nineteenth-century proposals for government action are still neat, harmless ideas for improving our lives is not paying attention. Deirdre McCloskey (2006: 50 – 51)
It is a great irony that the Liberal Democratic Party should be holding its annual general meeting in the Australian Capital Territory. Indeed it is a further irony that it was first founded in the ACT. Canberra is the belly of the beast – it is the location of Australia’s most left-wing state and territory government while also being the seat of the federal government, the most dangerous of all Australian governments. Several years ago my Institute of Public Affairs colleagues caused a bit of a kerfuffle when they listed Canberra as the 13th of Australia’s 13 greatest mistakes. Many thought this to be somehow inappropriate – I would have placed it much higher on the list. Perhaps at position one. To be fair to my IPA colleagues they did place the Uniform Tax Cases at position five and in all seriousness this has proven to be one of the greatest failings of our federal structure. The increasing power of the federal purse has led to the destruction of Australian federalism and the increasing encroachment of the nanny-state in almost all our affairs.
The powers of Canberra and the powers in Canberra need to be reduced. In the very first instance the definition of the ACT needs revision. John Stone has proposed that the ACT simply consist of the areas around Capitol Hill and those areas that contain the essential needs of government. Stone is generous in what comprises the essential needs of government and proposes that the remainder of the ACT be reincorporated back into New South Wales. This would lead, in the first instance, to the reduction of unnecessary duplicated government function across the ACT and NSW governments and would lead to the savings of two federal Senatorial salaries and their office staff. For those who worry that Canberrans would experience reduced political representation it should be pointed out that they would retain their representation in the House of Representatives and now be represented by 12 Senators instead of the current two. All up shrinking the ACT down to a minimum size is a no-lose proposition. More importantly it would signify a clear commitment to small government.
In this talk I’m going to set out some philosophical points about the need for taxation and small government and then point out some mistakes people can make when devising tax policy. After that, I’ll be ignoring my own advice and setting out some ideas for a sensible tax policy and platform.
Taxation and Coercion
Libertarians can argue amongst themselves as to how small government should be, but there must be agreement to the idea that at present government is too large. The powers of government have grown too large because there are no real limits on the scale or scope of governmental power. With the vast fiscal powers available to them it has proven exceptionally difficult to hold government to the limited powers that are set out within constitutions. At the same time, however, we need to be cognisant of the fact that small government need not necessarily be cheap government.
The twentieth century can be described as an experiment in big government. As the Deirdre McCloskey quote indicates perhaps things haven’t quite worked out as well as we might have hoped. Mind you things have probably worked out as well as some had expected. The great English philosopher Michael Oakeshott – mistakenly in my opinion described as being conservative – tells us that ‘The modern history of Europe is littered with the projects of the politics of Rationalism’. This is not a compliment – in the great comic and subsequent movie The Watchmen the Rorschach character asks the question, ‘What’s one more body amongst the foundations [of utopia]?’ The era of big government cannot be described as being overly successful. To be sure the last 100 years have been associated with large increases in human prosperity and welfare, yet we all understand that correlation is not causation.
Restricting the power of the state must begin by restricting its power to collect and spend money. Adam Smith describes the sources of state revenue; revenue from assets belonging to the state and revenue belonging to the people. Over time revenues from assets belonging to the state have tended to decline. `This is due to the growth in the size and functions of the state and because the state isn’t usually any good at running profitable businesses. There are exceptions, of course, oil rich states are able to finance themselves through their own assets and not levy taxes on their populations. But it is worth indicating that those states tend not to have large welfare expenditures and also tend to be autocratic.
Libertarians do not always handle tax conversations well. Some even describe taxation as ‘theft’. The US libertarian philosopher Loren Lomasky has attempted to trace the origin of the ‘taxation is theft’ statement. There is an undated pamphlet entitled ‘Taxation is theft’ issued by the Society for Individual Liberty. But he suggests the origins lie with Lysander Spooner’s 1870 comment that taxation is robbery. ‘Robbery’ is, as Lomasky argues, a better word than ‘theft’ in describing taxation. The word ‘robbery’ suggests the taking by force or coercion, while ‘theft’ suggests an illegal action. It is a sad reality that taxation is not necessarily illegal. Please note that I do not wish to argue that aspects of the administration of taxation might not be illegal, or that tax agents of the state may not strain the laws of parliament and the norms of civilised society in their efforts to raise revenue but the act of taxation in and of itself is not illegal and therefore cannot be theft. Similarly it is not unreasonable to attempt to convince one’s friends and neighbours that the tax burden is unnecessarily onerous and should be reduced, but it isn’t reasonable to defraud the tax authorities. It is reasonable to organise one’s affairs so as to not pay tax just as you might reduce payments to the state by driving within the speed limit, not running red traffic lights, or by not parking in a no-parking zone. As Lomasky writes
I would therefore caution libertarians to shelve the “Taxation is theft!” slogan despite its sonorous ring, and if they cannot bring themselves to do that, then at least to cultivate a twinkle in the eye when they haul it forth.
Another argument that some libertarians make is that taxation is coercive and therefore immoral. The difficulty with this argument is whether any level of coercion is automatically as immoral as all other coercion. Economists tend not to think in such absolute terms but rather in terms of trade-offs. Robert Higgs deals with this question by pointing out that before 1865 US governments enforced the institution of slavery and after 1865 enforced its prohibition. To be sure the US government was coercive both pre-1865 and post-1865 but it cannot be argued that the level of coercion was constant simply because somebody was being coerced.
The question then becomes how much coercion is appropriate. To what extent can the state coerce its citizens? This is a tricky issue given that the existence of the state implies, at least some, coercion. As von Mises has recognised.
Liberalism is not anarchism, nor has it anything whatsoever to do with anarchism. The liberal understands quite clearly that without resort to compulsion, the existence of society would be endangered and that behind the rules of conduct whose observance is necessary to assure peaceful human cooperation must stand the threat of force if the whole edifice of society is not to be continually at the mercy of any one of its members. One must be in a position to compel the person who will not respect the lives, health, personal freedom, or private property of others to acquiesce in the rules of life in society. This is the function that the liberal doctrine assigns to the state: the protection of property, liberty, and peace.
As James Buchanan has argued liberal society stands between anarchy and Leviathan. Similarly Andrei Shleifer suggests that societies have to manage the trade-off between disorder and dictatorship. Disorder relates to the ability of private individuals to inflict harm on others, while dictatorship relates to the ability of government and its bureaucrats to inflict harm on others. Simeon Djankov, Edward Glaeser, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer have provided an excellent definition and discussion of disorder and dictatorship.
The two central dangers that any society faces are disorder and dictatorship. Disorder refers to the risk to individuals and their property of private expropriation in such forms as banditry, murder, theft, violation of agreements, torts, or monopoly pricing. Disorder is also reflected in the private subversion of public institutions, such as courts, through bribes and threats, which allows private violators to escape penalties. Dictatorship refers to the risk to individuals and their property of expropriation by the state and its agents in such forms as murder, taxation, or violation of property. Dictatorship is also reflected in expropriation through, rather than just by, the state, such as occurs when state regulators help firms to restrict competitive entry. Some phenomena, such as corruption, reflect both disorder and dictatorship. When individuals pay bribes to avoid penalties for harmful conduct, corruption is a reflection of disorder. When officials create harmful rules to collect bribes from individuals seeking to circumvent them, corruption is a cost of dictatorship.
Figure One: Rahn Curve
Daniel Mitchell explains the Rahn curve quite well.
If government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very difficult if there were no government at all. In other words, some government spending is necessary for the successful operation of the rule of law. Figure 1 illustrates this point. Economic activity is very low or nonexistent in the absence of government, but it jumps dramatically as core functions of government are financed. This does not mean that government costs nothing, but that the benefits outweigh the costs.
Unlike Mitchell, however, I do not define the size of government as simply being spending, but rather would include all government interventions. Government is able to influence the economy beyond simply spending through regulation and prohibition. Nonetheless the general principle is established that some government intervention and some coercion is appropriate to support economic activity.
Friedrich von Hayek has written extensively on the use of coercion and the rule of law in his magnum opus, The constitution of liberty. Hayek tells us that coercion occurs ‘when one man’s actions are made to serve another man’s will, not for his own but for the other’s purpose’. Hayek explores the overlap between the proper functions of the state and the limits of coercion. I suspect many libertarians would be content for the state’s powers of coercion to be limited to the provision of public goods, where public goods are strictly defined as those goods that are non-excludable and non-rival. Adam Smith, for example, describes three functions of government being national security, justice and public goods. He also has as the first of his great maxims of taxation, ‘The subjects of every state ought to contribute towards the support of the government …’. Taxation and the functions are government are clearly linked. Herbert Spencer had a more limited role for government; ‘to defend the natural rights of man – to protect person and property – to prevent the aggressions of the powerful upon the weak – in a word, to administer justice’. Ludwig von Mises provides a similar perspective.
As the liberal sees it, the task of the state consists solely and exclusively in guaranteeing the protection of life, health, liberty, and private property against violent attacks. Everything that goes beyond this is an evil. A government that, instead of fulfilling its task, sought to go so far as actually to infringe on personal security of life and health, freedom, and property would, of course, be altogether bad.
That is not Hayek’s view. Most modern states employ their coercive powers beyond the provision of public goods. It is here that Hayek makes an intriguing comment (emphasis added).
Outside of the field of taxation, it is probably desirable that we should accept only the prevention of more severe coercion as the justification for the use of coercion by government.
This begs the question; within the field of taxation what are the limits of state coercion? Hayek sets out some principles of coercion. The government should never coerce anyone except in the enforcement of a known rule that is certain, general and applied equally. With the exception of progressive aspects of taxation, it is very likely that most aspects of taxation would meet those criteria. In other words, it seems that Hayek has little objection to state coercion in raising taxation revenue, rather he has objections to the purposes that revenue may be expended on and the methods that the state employs to achieve its ends. Hayek’s concerns about taxation, and over-taxation, relate to issues of progression and fiscal illusion. In terms of over-government Hayek is of the view that as long as the community fully understands the costs and benefits of intervention and follow the rule of law, then most interventions need to be considered on a cost-benefit basis and cannot be rejected on a priori grounds.
These ideas can be represented in matrix form. The matrix below shows the combination of public goods and coercion. The state provides public goods and needs to raise tax revenue in order to pay for those public goods. To the extent that individuals do not pay tax to pay for public goods, society faces a free-rider problem. As Frank Cowell has argued, ‘The financing of government cannot be organized like the financing of Oxfam or like that of a parish church’. The private economy is characterised as that area where there is no (government coercion) and public goods are not being traded. There is, however, an area of dispute; the presence of coercion where public goods are not being traded. Hayek’s argument is that there is no automatic presumption against government in that area – a cost–benefit analysis must be undertaken. Here he finds some support from James Buchanan who argues, ‘Some extensions of state power are more legitimate than others’. Yet James Buchanan also argues, ‘The “wealth of nations” is maximised when persons are “free to choose”.’ As the government expands beyond the provision of public goods, individuals are less free to choose. To be sure as the economy expands and more goods and services become available individuals might find themselves making more choices, nonetheless as Leviathan expands so individuals will face fewer choices in areas where before they had more choice.
That disputed territory is not only getting larger over time, but the disputes will get stronger and more urgent too. Arthur Seldon explains
What politicians maintain as the necessary costs of government are increasingly sensed as unnecessary costs of ‘over-government’. And its taxes, originally seen by William Pitt as income tax, and accepted for a few years as payment for a good bargain, are being subconsciously but finally resented as too high for the quality and relevance of services available at lower cost and higher quality from competing suppliers in the market.
It is here that libertarians can engage in good sensible debate about the tax burden and the role of government. Arguing about the non-existence of public goods and all taxation being theft and so on is a strategy and a tactic that should be avoided. There is more than enough debate to be had in areas of legitimate dispute that we can all agree on without having to venture into more controversial areas.
Playing God and Tax Policy
Thinking about tax policy gives individuals the opportunity to devise their own ‘great society’. Libertarians, however, should be well aware that planned great societies end in failure. But the temptations remain. As James Buchanan explains
Many economists, along with other social scientists and social philosophers, enjoy playing God, by which I mean laying out in detail their own private versions of the “good society” without being required to suggest ways and means of implementing their precepts or even to defend the consistency of these precepts with democratic political processes.
I fear many libertarians can be added to the list of social scientists and philosophers. Harold Demsetz warns of nirvana policies that follow when playing God. People engaging in nirvana policies make three mistakes. First, they believe the grass will be greener on the other side, second they believe in free lunches and third, they believe people could be different. The free lunch fallacy is very popular in Australia right now; this is the idea that it is possible to devise tax policies with zero deadweight losses – the idea that something called ‘rent’ can be taxed with impunity. It can’t be done. That doesn’t mean that there might not be good reasons to tax land values and mining profits and whatever, but it does mean that these taxes will have behavioural consequences that should be properly measured and not assumed to be zero.
The grass will be greener fallacy also appears from time to time. Recently this has manifest itself in arguments that the tax base for the GST should be revised. Two arguments are made in this respect. First, if only GST were collected on imports less than $1,000 the Australian retail sector would thrive. Well no. If only the Australian retail sector would keep a tighter control over costs and offer competitive prices, the Australian retail sector would thrive. Tax doesn’t come into that equation. The second argument relates to the structure of the GST. Not a week passes without some business lobby or tax group calling for the GST to be debated. This is code for exemptions reduced and/or the rate to be increased. While a consumption tax has many benefits, it is also an invitation for politicians to skin taxpayers. The Australian GST is unique in that it the rate has not been increased in just over ten years. For as long as the federal government bears all the political cost of collecting the GST and changing the base or rates while receiving none of the revenue this situation will likely remain the case. That is one reason the Rudd government health policy of stripping GST funds from the States and Territories was such a bad idea.
Can people be different? Probably not. In the tax debate there are all sorts of conflicting visions of humanity. Those who prefer lower levels of taxation are pilloried as being selfish, anti-social, and greedy, and the like. While the beneficiaries of taxation are described as the poor, the disadvantaged, the disabled and so on. Libertarians have a wonderful term ‘taxeater’ to describe the beneficiaries of taxation. A growing problem is that the median voter is becoming a taxeater. Deirdre McCloskey explains how this works quite nicely. She asks the question if one-quarter of the US government tax take went to poor Americans how much money they would receive. Some back of the envelope calculations show that each poor American would receive US$30,000 – for a family of four that would be $120,000. In other words, there would be no poor people if the taxpayers were really redistributing income to the poor. Rather the biggest beneficiary of taxation is government employees (many of whom live here is Canberra) and the middle class – home of the median voter (and dare I say it, university professors).
The tax churn that Peter Saunders, of the Centre for Independent Studies, so eloquently warned us about is no longer a bug in the tax system; it is a feature of our democracy. Many voters believe they are getting a bargain from the government (and given the distortions in the tax system, they very often are getting a bargain). Voters are victims of fiscal illusion. To campaign for lower taxes and to expect the voter to simply go along is to believe that people could be different. It is not enough to appeal to voters’ better (or worse) natures, tax debate must target specific issues. For example, the electorate was convinced by the argument that the Resource Super Profit Tax was poorly designed and would have adverse consequences to the economy and their superannuation accounts. This was not an appeal to high moral principle or equity or fairness.
So what to do?
The tax debate and tax policy needs to confront fiscal illusion. The most obvious first point to address here is complexity of the tax system and tax administration. The Tax Pack is far too complicated. I’m told that this allows the ATO to collect more tax as some individuals end up paying more tax than they’re required to under the law. I cannot say if is this is true or not; yet it seems to me that collecting more tax than is authorised by the parliament is theft and if Australia wants to operate a progressive tax system whereby high-income individuals pay more tax than low-income individuals then the authorities need to ensure that high-income tax-payers don’t pay too little and that low-income tax-payers don’t pay too much. I find it remarkable that the nanny state interferes in private transactions to ensure that citizens are not over-charge or cheated, yet conducts its own affairs in such a predatory manner.
People have been complaining about the tax pack and the complexity of the tax system for years and more or less nothing has been done. There is no incentive for political elites to actually do anything. So I propose that all members of parliament, their spouses and their office staff and then all employees of the Australian Taxation Office and their spouses be required to submit their tax return using the tax pack in their own handwriting. No exceptions. If that is good enough for the long-suffering Australian taxpayer it is good enough for the political elites. An argument might be made that some politicians are too busy or too important to complete their own tax returns but this argument is bunkum. Nobody is too important to perform their civic duty of paying tax. A uniquely libertarian argument is that this proposal involves coercing some members of the community in regard to their tax return. Yes. I suspect, however, that the benefits of this coercion will quickly manifest itself in a much less complex tax system.
Another component of fiscal illusion is disguising how much it costs to run government programs. Medicare, in Australia, is very popular. Why shouldn’t it be? It costs a mere 1.5 percent of income, collected via the Medicare levy. Actually, no. It costs a lot more than that. But telling people that health care costs a bit more than they think won’t go very far. So too with expensive school halls, or home insulation, or almost any other form of government spending. Some states of the United States have taken to publishing their chequebook registers online in a searchable format. This allows citizen-taxpayers to observe exactly what the government is spending money on. This allows individuals to check the claims made by government officials. Rather than simply be told that the government has spent eleventy billion dollars on education, individuals can look up and see that only $10 was spent on classroom teachers or that the entire sum of money was spent on classroom teachers and so on. So not only telling citizen-voters a final cost figure but also a breakdown of actual expenditure would go a long way to informing citizen-taxpayers of the true cost of government.
But these sorts of suggestions, and I can come up with many more, are really the low-hanging fruit. The Australian tax system faces two fundamental problems. The biggest challenge facing the Australian tax system from a libertarian perspective is the vertical fiscal imbalance. States spend a lot more than they can raise in revenue, while the Commonwealth usually taxes much more than it can spend. The current Commonwealth government has proven to be extraordinarily good at wasting money. Not only have they managed to spend more than they can tax, but they have managed to do so with little to show for it.
My proposal to deal with this problem would be to devolve personal income tax powers to the states. Let each state and territory set its own tax base and tax rates and then compete with each other in the provision of public goods and value for tax dollar. Of course, the states would resist this proposal. Right now they are cosy and somewhat sleepy jurisdictions where the Commonwealth runs a tax cartel and they enjoy the benefits. Devolving the personal income tax power would break that tax cartel. I would be inclined to leave the corporate tax at a commonwealth level – if only to maintain the benefits of economic integration.
The second challenge is the interconnectedness of the tax system and the welfare system. A lot of heat is generated by so-called effective marginal tax rates. This is a function of Australia’s highly targeted and means tested welfare system. As earned income rises so welfare payments (actually unearned income) falls and that combined with tax payments gives the appearance of a high tax rate. There is a bit of dishonesty involved in this argument. Not receiving a welfare payment that you’re not entitled to is not a tax. There is a similar piece of dishonesty where some argue that not being taxed is akin to receiving a subsidy. Nonetheless high effective marginal tax rates do appear to operate as a disincentive to work. The best practical solution to this problem remains Milton Friedman’s negative income tax idea. This was articulated in the Australian context by John Humphrey’s 30/30 proposal. I still like the concept – although a 30 percent tax rate is probably too high.
It must be clear, however, that devolving income tax powers to the states might mean that a national 30/30 tax and welfare system could not be adopted. In choosing between the two, my choice would be for devolution.
There are other serious issues too. Some of these were highlighted in the Henry Review – ninety percent of tax revenue is raised by just ten taxes, 115 other taxes raise the last ten percent of revenue. There are a lot of nuisance taxes in the system. Many of them should be simply abolished. What is the role, if any, for capital gains tax? I am of the opinion that this too should be abolished. Of course, without capital gains tax there would be no basis for negative gearing. But I do think that negative gearing should be abolished while maintaining capital gains tax. The international tax regime should be abandoned for a source-based system – we should refuse to co-operate with foreign governments in the maintenance and administration of their tax laws, just as they would refuse to assist us. Low tax rates at home and respect for privacy and private property would attract sufficient investment and economic activity to overcome any leakage from the economy due to Australians moving their tax liability offshore.
This business of sending ‘tax cheats’ to prison is an extraordinary waste. While in prison their entrepreneurial skills atrophy and they don’t earn income that can be taxed. It is counter-productive to undermine people’s taxpaying potential because they haven’t been paying tax.
All up, it seems to me that there is ample scope for an innovative approach to taxation in Australia. Rather than having the tax-tail wag the dog, it is time to think carefully and clearly beyond the current tired arguments and conventions of taxation.
 Michael Oakeshott, 1991, Rationalism in politics, In Rationalism in politics and other essays, Liberty Fund, pg. 10.
 Loren Lomasky, 1998, Libertarianism as if (the 99 percent of) people mattered. Social Philosophy and Policy. 15, 350 – 371.
 Lomasky, pg. 364.
 Robert Higgs, 2004, Coercion is not a societal constant, In Against Leviathan: Government power and a free society, The Independent Institute, pg. 110.
 Ludwig von Mises, 1927 , above, pg. 17.
 James Buchanan, 1975 , The limits of liberty: Between anarchy and leviathan, Indianapolis: Liberty Fund.
 Andrei Shleifer, 2005, Understanding regulation, European Financial Management 11, 439.
 Simeon Djankov, Edward Glaeser, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, 2003, The new comparative economics, Journal of Comparative Economics 32, 598.
 Dan Mitchell, ‘The Impact of Government Spending on Economic Growth’ (2005) 1831 Heritage Foundation Backgrounder 4.
 Hayek, F. 1960, The constitution of liberty, Routledge, pg. 117 – 129.
 Hayek, as above, pg. 117.
 Adam Smith, 1776 , An inquiry into the nature and causes of the wealth of nations, University of Chicago Press, pg. 350.
 Herbert Spencer, 1843 , The proper sphere of government, In The man versus the state: With six essays on government, society, and freedom, Liberty Fund, pg. 187.
 Ludwig von Mises, 1927 , Liberalism: The classical tradition, Liberty Fund, pg. 30.
 Hayek, as above, pg. 127.
 See Hayek, The constitution of liberty, pg. 194 and Hayek, 1979, The political order of a free people, University of Chicago Press, pg. 41.
 Frank Cowell, 1990, Cheating the government: The economics of evasion, MIT Press, pg. 37.
 Mises on the other hand takes the view that government involvement in this area is ‘an evil’ and ‘altogether bad’.
 James Buchanan, 1977 , The libertarian legitimacy of the state, In Moral science and moral order, Liberty Fund, pg. 428.
 James Buchanan, 1987, Towards the simple economics of natural liberty: An exploratory analysis, Kyklos, 40, 3 – 20.
 Arthur Seldon, 1998 , The dilemma of democracy, In Government failure and over-government, Liberty Fund, pg.91.
 James Buchanan, 1977, Democratic values in taxation, Freedom in Constitutional Contract: Perspectives of a Political Economist, Texas A&M University Press, 243 – 253.
 Harold Demsetz, 1969, ‘Information and efficiency: Another viewpoint’, Journal of Law and Economics. Reproduced in Harold Demsetz, 1989, Efficiency, Competition and Policy, Oxford: Basil Blackwell.
 Deirdre McCloskey, 2006, pg. 45 – 46.
 Fiscal illusion is a set of strategies that the state adopts in the hope of altering voters’ fiscal consciousness. In particular the state hopes to convince voters that the tax burden isn’t nearly as onerous as it is, while the benefits of public spending are greater than they are.