In this miniseries we’re going to delve into everyone’s favourite topic, taxes. We’re also going to look at it from both the standpoint of Optimal Taxation and also how it would apply to a Network State.
While we’ve seen tremendous innovation in recent years, there has been almost no positive innovation when it comes to taxation. In the series that follows i will put forward what i believe is possible, if given the opportunity, how it could be done, and to put out the call to any and all Startup Cities and/or budding Network States looking to experiment with innovations in taxation, that it’s something i would very much like to be a part of, if the suggestions i make in this mini series align with the direction you have for your Startup City or Network State.
So if you’re looking to build the next Singapore or the next Dubai, settle in for some riveting reading on the future of taxation as i see it.
We’ll begin with a few basic fundamentals of taxation before jumping into some of the more specific details.
WHAT IS TAXATION & WHAT IS ITS PURPOSE
What is Taxation
At its most simplistic level Taxation is a compulsory transfer of resources to a governing body, levied according to predetermined laws of that governing body without any reference to the specific benefit to be received.
What is its Purpose
Taxation has a number of purposes:
- Its main being the provision of public or common goods, functions of government, and national goods (those which are perceived by a society as not being adequately provided by the free market).
- As an incentive system to encourage the private sector to provide services the government doesn’t have the ability or desire to provide by way of tax exemptions. An example of this is housing, and the negative gearing tax benefit rental property owners receive in Australia. It has encouraged many mum & dad investors to partake in creating housing available for people to rent. On the flip side there are also high taxes on things the government is trying to discourage, such as the excise taxes on tobacco products, aimed at discouraging people from taking up smoking.
- As one of the 2 levers of economic policy, Fiscal Policy (what the government spends its tax take on, as well as whether or not they run budget surpluses or deficits). The other lever, not linked to taxation being Monetary Policy (raising or lowering interest rates & money printing)
Types of Taxation
There are many different types of taxing, with some broad categories listed below:
- Income Tax (Tax on Salary, Business Profits, Capital Gains, etc)
- Payroll Tax (Tax payable by businesses based on salaries paid)
- Property Tax (Land taxes, inheritance taxes)
- Consumption Tax (GST/VAT/Sales Tax, Excise, Stamp Duty)
- Tariffs & Import Duties
- Fixed rate taxes
- Effective Taxes (Inflation, Seigniorage)
There are also 3 manners of taxing based on the government's relationship to the taxpayer:
- Citizenship based taxation
- The requirement of an individual to pay income tax on their worldwide income due to them being a citizen of the taxing country
- Currently there are only 4 places in the world that practice this: USA, Myanmar, Hungary & Eritrea
- Residency
- The requirement of an individual to pay income tax on their worldwide income due to them being a resident of the taxing country.
- The ways of determining residency for taxing purposes differs among countries and is dependent on a number of varying factors, but in broad terms it is where your main home is, where you spend most of your time, where your family spend most of their time and where your business and employment ties are.
- The vast majority of places in the world fall into this basket
- Territorial
- The requirement of an individual to pay income tax only on the income with a source in the taxing country
- Singapore & Hong Kong are notable places that only tax territorial income
- No Income tax on individuals
- Dubai (UAE) & The Cayman Islands are 2 notable places that have no personal income taxes at all
CHALLENGES
There are 2 broad types of challenges when it comes to taxation:
- In theory challenges are ones surrounding what to tax (only taxing negative externalities is great in theory, but difficult in practice)
- In practice challenges are ones surrounding administrative processes and compliance (income taxes are notoriously difficult to compel everyone to abide by 100% correctly, whereas land taxes are easy to enforce 100% compliance)
In Theory Challenges
When it comes to challenges in theory, our history is ripe with disagreement, and it also provides a treasure trove of data for analysis as to what works best.
Flat / Proportionate / Progressive
Everyone benefits from the public goods provided by the government so it stands to reason that we should tax everyone equally right?
Flat
Are those services worth say $10,000 per citizen per year? What happens if you are only earning $10,000 per year, you’d pay 100% of your income in taxes and be left with nothing to pay for your food or rent or anything else.
Proportionate
How about we instead have a sole transaction fee tax such as a 10% VAT / GST / Sales Tax? That way citizens are taxed based on how much they use the public goods and services the government is providing, in much the same way a business charges you only for what you buy from them. Surely if everyone pays the same rate then it all seems fair, right?
Progressive
But because poorer people spend a higher proportion of their money than do richer people, who often save or invest higher proportions of their income instead of spending it, poorer people pay more tax, as a proportion of their income than richer people do. This argument invariably leads to Progressive taxation.
Progressive taxation is the system whereby you pay a higher rate of tax the more you are deemed to be able to afford. It is common in current income tax and capital gains tax systems. Say for example in Australia if your income is less than $18,200 per year you pay 0% tax, but if you earn $45,000 you pay 19% tax, and if you earn above $180,000 you pay 45% tax
What to do with all this? What is Optimal?
There is no silver bullet answer to these questions, because the best taxes are those that create the least distortions in the market, flat taxes, but these are also the least politically popular. The most politically popular are highly progressive taxes, but these have the worst distortion effects and negatively impact the market from operating optimally.
What do we want to encourage using the tax system as an incentive mechanism and what things do we want to discourage?
- Should we tax businesses more than people?
- Should we aim at preventing nepotism and dynastic wealth by having inheritance taxes?
- How do we deal with competition from other states? Do we implement trade tariffs and import duties?
Pigouvian Taxes
We could implement pigouvian taxes, that only tax negative externalities (negative things the market does not correct for) such as land taxes, for holding exclusive use over land and not sharing it with others in the community, or carbon taxes for causing damage to the environment and not having it included in the purchase price of a product.
In our future posts we’ll go into the details of what works and what doesn’t based on our 1,000s of years of history and all the empirical evidence, but for now all we need to know is that the reasons a nation sits on its particular point in the spectrum are mostly decided by the political powers that be, within (and sometimes outside) that nation state.
Effective Taxes
The last tax challenge to manage is the silent killer, the tax on the uneducated: inflation. Because this is the only tax that occurs in our societies today, with all their progressivism, taking from the rich and giving to the poor rhetoric, that massively takes away from the poor and gives back to the rich. The reason i say it is a tax on the uneducated and not specifically on the poor is that you don’t need to be rich to benefit from inflation, you just need to know how it works. And once you do, you’ll understand why it overwhelmingly benefits the rich.
Let’s say you have an economy that provides X number of goods and services and has Y dollars (or any fiat currency for that matter) in total circulation of its currency. When you print more money, as governments frequently do, that increase in money circulating in the economy gets divided between the same amount of goods, if the amount of money printed doubles the money supply it has the effect of doubling the price of goods and services in the economy. But here is where it affects the poor, the rate at which this inflation occurs is rarely less than the amount by which wages increase, so if you are just a lower class wage earner, you get poorer, as your wage can buy less goods and services.
This is shown in the below diagram. The picture on the left shows the before inflation amounts. With a hypothetical economy: $100 in total money supply, and 3 goods, 2 worth $25 and one worth $50. The right shows this after inflation, with the money supply now $200 but it’s still only producing 3 goods, which would now be worth $50 for the 2 smaller items and $100 for the one larger item.
On top of this, there is a strategy you can use to win in this environment. Borrow money, Buy Assets. Let’s say pre-inflation you borrowed $50 and bought a house (or any other hard asset) you own a $50 asset but owe the bank $50 so have no net asset. But you get to post-inflation and that same house is now worth $100 and even if you didn’t pay off any of your principal you still only owe the bank $50 so you’ve made yourself $50
Now think of the reverse, a person who just takes their salary and puts it in the bank pre-inflation, they could have bought the house too, but they didn’t. Post-inflation they still have their $50, but now this can only buy them half the house it could before.
This method is utilised by almost all the wealthy in society today. They don't keep their money in the bank, they invest it into property, businesses and hard assets like Bitcoin, they then take loans out against those assets to live on. Over time their assets become worth more due to inflation, and their loans become worth less due to the debasement of the currency they were borrowed in.
In Practice Challenges
Compliance
For as long as there have been taxes there have been tax evaders, from the earliest of taxes in Egypt around 3000 BC to our current day. How do you make sure that everyone pays what they are supposed to and no one cheats the system?
The more complex and further removed the taxing authority is from the source of the item being taxed the higher the compliance costs are to enforce the rules and ensure everyone pays what they are supposed to.
Not only does it impose an administrative burden on taxpayers to ensure they are doing the right thing, but it also imposes costs on the taxing authority to check everyone is complying.
Cost to Government of Compliance
If you compare the difference between say a transaction fee tax with an income tax. The income tax system requires everyone to track all their incomes and self report them to the taxing authority. It also is very difficult to ensure 100% compliance at scale. Compare this with say the economy of all transactions on the amex card network. The 3% tax (transaction fee) that amex imposes on its network has 100% compliance at zero cost.
Taxing negative externalities face this same compliance challenge, let’s say you want to implement a carbon tax, and let’s say you even manage to come up with an effective way to measure carbon emissions, how do you police this and achieve 100% compliance? And even if you come up with a system that does achieve 100% compliance how much does that cost to administer?
Why is cost important? let's say you implement a tax that raises $100M for your government, but the admin required to enforce that tax costs the government $200M. Is this tax worthwhile? The answer is likely no, because this tax takes away from the public goods and services that you as a government should be providing your constituents.
That being said, modern compliance systems are not that out of whack. The Australian Tax Office publishes its numbers each year, and for the 2022 financial year it was 0.58% or in other words, they spent $3.9B and raised $672B. They also publish the estimated tax gap which refers to how much they believe they should have collected pre-audit activity and post-audit activity. Which shows based on a breakdown of each tax type the gap ranges from 0.2% - 21.8% / $0.13B - 12B depending on the tax type, or a total of $41.3B / 6.1% in missed revenue that dropped to $33.1B / 4.9% in missed revenue after their audit activities.
One final note on this as well, is that some of this data gets a little skewed when looked at in aggregate, and it is important to look at the numbers specific to each individual tax. For perspective Australia has 125 different taxes but 90% of the total tax revenue is generated by just the top 10. So in other words we could axe 115 taxes and government revenue would only decrease by 10% along with an outsized proportion of the administration cost.
Cost to Taxpayers of Compliance
Going back to the Income tax example, let’s compare how much it costs for a business to pay the amex tax as compared to their annual income taxes. The amex compliance costs are absolute 0 as the fee is taken out by the network itself at the point of sale, no calculation required.
However the costs to an individual or business to prepare and file their monthly, quarterly and annual tax lodgements would be substantially more, usually involving external accountants as well as internal administrative staff. This can also vary greatly depending on the person or business. A salaried employee has little to calculate as the burden of providing income details is forced onto their employer, a pure consulting business would likely have low compliance costs compared to and a manufacturing business which would have highly complex compliance obligations, but most Australian businesses are usually in the 1% - 2% range, so while also not being off the charts, is still a cost on top of the taxes they are paying just in making sure they comply with the rules.
The last thing i want to point out is how this gives a new lens through which to view corruption in places such as Africa. Most people by and large are honest and want to play by the rules, and for the few rule breakers the audit activities of governments bring a significant proportion into line. Australia has a 10% GST, so if you want to import products from overseas you need to pay this 10% top up tax as the goods pass through customs and you can then on-sell it to Australian locals. In Africa these taxes can be as high as 50% which shifts the incentive to bribe officials significantly.
Say you want to sell a car in Africa and it costs $50,000, the import tariff could be as high as $25,000, if you pay the customs official $5,000 you save $20,000 and he gets an extra $5,000 he wouldn’t have otherwise earned, it’s a win win for everybody except the government. If the import duty was only 10% ($5,000) to begin with there is less incentive to cheat the system as you have less to gain and more to lose, so businesses are more likely to just pay the tax and move on.
This creates 2 tiered systems. Where you have the people abiding by the law on one side, rendered uncompetitive and forced out of business, and those paying the bribes on the other side, flaunting the rules and becoming the only ones left in business.
Next in our miniseries
Now that we know:
- What taxes are
- What they are for
- And have an overview of the challenges faced in architecting a tax system.
We can in our next articles will go into:
- How much tax is enough
- Results of trying different taxes
- Elasticity of demand and how this affects optimal tax rates
- Intended and unintended outcomes of certain taxes
- What should we incentivise & discourage?
- Politically popular but detrimental taxes & Politically unpopular but beneficial taxes
- What can the market provide?
- What public goods needs to be provided by taxation
- How a network state could be funded based on optimal taxation
- The roadmap to do this from the starting point of a society with a suboptimal current taxation
