How to impose taxes (a guide for governments)

In 1789, Benjamin Franklin, now octogenarian, wrote a letter containing the famous opinion that “there is nothing certain in this world, except death and taxes.” Franklin was wrong. Many taxes can be easily and legally avoided by the simple means of not doing everything that attracts tax.

Our cities have been shaped by such tax-evading behaviour. Consider the slender canal houses in Amsterdam. As described by Kurt Kohlstedt and Roman Mars in The 99% Invisible City, these buildings developed in response to a tax code that focused on the canal frontage. Furniture joists have been deployed to bypass steep stairs. It was tough, but people will do everything they can for the tax break.

A less satisfactory example of tax-efficient architecture is the tiled window, common in London. A window tax was introduced in 1696 and increased sharply in 1797. At first glance it seemed to target the rich, but it also punished the urban poor in apartment buildings where landlords simply closed windows to save money.

The cruelty and ugliness of such a tax is self-evident, but there was another cost, less obvious until you think about it: None of those broken windows resulted in any tax revenue. Not only were the houses ugly, gloomy and airless, but they also generated less tax revenue than originally expected.

Economists call this “maximum gain loss.” When people distort their behavior to avoid taxes, no one wins. The tax avoider is worse off because avoidance is costly. The tax authorities are worse off because the tax is not paid.

An old French proverb says that the art of taxation is to “pluck the goose to get the most feathers with the least hiss”. But the experience of Dutch canal houses and window tax suggests something else: the art of taxation is to pluck those feathers without pushing the goose as a species to evolve into a featherless bird.

Unless, of course, a featherless bird is what is needed. In 1698, Peter the Great required the Russian nobility to purchase a “beard token” if they wished to keep their beards. The goal seems to have been not so much to increase revenues as to push the Russian nobility into the shaved fashions of Western Europe. (The story is told in Michael Caine and Joel Slimrod’s book, Delightful Rebellion, Scoundrels, and Revenue.)

Many governments have given tax incentives for having children. One clumsy example, introduced in Australia in 2004 at short notice, caused the birth rate to drop sharply the day before the baby bonus came into effect, as caesarean section and induction were postponed.

Unfortunately, the easiest way to earn a tax break is to make some change on paper. Governments have long offered tax incentives in hopes of encouraging companies to relocate, but it’s far too easy to move accounting profits in search of lower taxes, while allowing factories and offices to stay exactly where they are.

The alternative is to resort to legal maneuvers. Is tomato a fruit or a vegetable? Is Jaffa Cake a cake or a biscuit? The answer seems to be: whatever means less tax. Tomatoes are tax-efficient vegetables (according to the US Supreme Court in 1893) and jaffa cake is tax-efficient (according to a British court in 1991).

The model for tax-cutting governments, whether you know it or not, is British Prime Minister Henry Pelham’s halving of tea import duties. In 1745 Pelham reduced tea fees from more than 100 percent to about 50 percent. The result: less smuggling, a tripling of the legitimate tea trade, and higher tax revenues. As the English boiled more water for tea, the death rate fell, according to research by economist Francesca Antman.

It’s quite a consequence of lower taxes: less crime, less disease, more taxes, and more tea. Unfortunately, as Kane and Slimrod note, there are few opportunities to imitate him. “The victory of Pelham has become a fool’s errand… There is little evidence that major taxes worldwide are often above levels at which revenues can be increased by lowering rates.” In the case of exceptions such as cigarettes, we have good reasons not to follow Pelham’s example.

After I surveyed the horizon of tax evasion from channels to jaffa cakes, I drew three lessons.

First, taxes shape behaviour. Governments could do more to use tax incentives for good and pay less attention to the wasteful distortions that taxes can produce.

Second, if you want to tax something like income or spending – which most governments do – make the tax as wide as possible. Society does not benefit from court rulings regarding whether a tomato is a vegetable.

Third, even the power of a tax incentive has limits. Pregnant Australians delay childbirth by hours, but not months. Dutch canal houses grew, but the Dutch did not develop skyscrapers from the 17th century.

When inheritance tax was abolished in 1979 in Australia, some Australian deaths were deferred – or had death registrations deferred – in a very tax efficient manner. Of course, these deaths were only postponed for a few days. Franklin may have been wrong about taxes, but dying isn’t so easy.

Written for and first published in the Financial Times on October 14, 2022.

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