Income tax is the most prevalent form of taxation throughout the world. A special case of income tax termed progressive income tax is touted to be the best of all possible worlds. But is it? Before we come to conclusions, let’s step back a bit to understand the basic purpose of taxation.

Why government?

Any justification of taxes requires a justification for government. And yes there is clear justification for government. If there was no government what would prevent me from murdering you and taking all your money. You need a government to protect you against me. And even I need someone to protect me against someone stealing the stuff I have. Protection of individual property rights is a justification for government because otherwise the world would be worse for all. Goodwill is a good attribute but any system which depends on goodwill for its functioning is unsustainable. That’s why government. To reduce the society’s dependency on my goodwill to do good and not do bad to others.

Yes there are anarchist theories but even they predict evolution of some form of voluntary government though not coerced government. It would be ok to conclude for the time being that yes we need a government.

Why taxes?

Governments comprise of people among us who need resources to live off. We need to pay them money because even though they are not producing goods and services directly they are enabling others to direct their energies more efficiently into producing goods and services without the fear of burglary in their houses, or murders, or another country making us slaves. Expenditure to support the establishment of a market i.e. protecting property rights and enforcing contracts is good enough justifications for taxation. There are many more arguments in favor of taxation. Redistribution of wealth is one. Fixing market failures is another. We might agree or disagree with either or both but we will still agree that we need taxes. Let’s discuss these four heads under which people justify taxation and check how the purpose dictates the mechanism of taxation.

How should we tax for establishing the market? How do we use market principles to determine how to tax?

So we understand that the government needs to collect money from the citizens for its own maintenance, to manage expenses for the army, police, judiciary etc. Should the government take from all citizens a fixed proportion of their income? Or should it take from citizens a proportion which increases with the income? Or should the government mandate a ‘cut’ for itself when any commercial transaction takes place and call it sales tax? What is the ‘right’ rule?

Let’s use the free market approach to analyze this problem! Consider that the government is providing a service of protection of private property to individuals in the society. What should the payment rule be?

To get an answer, let’s ask another question – how much would a person be willing to pay to the government to retain the services of the police and army if threatened by the prospect of his belongings being forcibly taken away by others? How would the amount compare which two different individuals will be willing to pay to retain these services?

They will be ready to pay in the proportion of what they own. For example if one person owns Rs 1000, another owns Rs 100 , they would be ready to pay in the ratio of 10:1 because that’s the ratio of what they risk losing if the army and police didn’t exist.

So the market rule tells us that the tax for establishing a market should be a fixed fraction of an individual’s wealth. Now this is very different from an income tax which looks only at the positive change in your wealth during a year. It is quite evident that your usage of the services of private property protection closely relate to your wealth rather than your income. Consider one person who owns Rs 10 crore and loses Rs 2 crore in a business during a year, another owns 1 crore and earns 1 crore in a business during the year. I would say the individuals must pay taxes in the proportion of their average ownerships throughout the year rather than on their income. In the income tax model the former pays no tax whereas the latter pays tax which is obviously unjustified.

Wealth tax clearly seems the ideal form of taxation for establishment of the market. Any form of income tax is regressive because it puts maximum penalty on those who are producing most for the society.

Taxes for contract enforcement

What should be the payment structure for this important function of government? Shouldn’t it be paid by those who actually enter into contracts which they want enforced by government? Shouldn’t it be a fixed fraction of the size of the transaction? This line of reasoning directs us to some form of transaction tax. Transactions mean any buying/selling of goods/services/labor. This is the collection mechanism which takes the externalities involved in the contract enforcement framework to the minimum.

The beauty of this structure is that the government will have no responsibilities of contract enforcement for those transactions where the transaction tax has not been paid. This will be a natural incentive for people to pay these taxes and retain records. But not paying such taxes should not be illegal, it just means that both the individuals involved forfeit any governmental recourse in disputes arising later. This will also be a natural check on the efficiency of the contract enforcement apparatus of the government. It will have to work to the satisfaction of the citizens to be funded.

An important aspect here is that the transaction taxes on exchange of services or labor will function as an income tax though from a very different perspective. If both employer and employee agree, they can legally choose not to pay it and forgo all rights to governmental resolution of disputes.

Taxes for redistribution

Redistribution is an undesirable but a temporary necessity to fix the inequalities created in the society due to ill thought government action. A healthy economy should not need redistribution but persistent socialist government action throughout the world has prevented markets from staying healthy. There are multiple examples of government action which result in an unjustified transfer of wealth from the poorest to the richest, they being minimum wage laws, public schooling and health, regulation of the market and government involvement as a player in the economy. Atonement for these failures of our society make some time bound redistributive corrections necessary.

If we finally decide to redistribute wealth what should our mechanism be? As far as giving to poor is concerned , cash transfers is the best approach because it minimizes corruption, keeps government activity to minimum and disturbs the market minimally.

How should the collection of this money be done? Should we take from those who are trying hard to climb the economic ladder or should we take from those who are already near the top?

If redistribution has to happen, it must happen from the wealthy to the poor rather than the productive to the poor. This is not to say that wealthy and productive are disjoint sets. It is to say that if the government taxes you for redistribution it should be by virtue of you being wealthy and not due to you being productive.

So as we see, here also wealth tax looks more appropriate a mechanism to collect money for redistribution than income tax.

Taxes for making the market ‘more efficient’!

Taxes under this head are primarily justified by two kinds of people. First are those who understand what a free market is but are mal-intentioned. Second those who are good intentioned but do not understand what a free market is.

You will hear arguments like: In the real world there is no perfect competition so free markets cannot exist and hence you need the government to somehow polish the market to resemble some utopian vision of the market.

These arguments come from both mal-intentioned and well intentioned people. They actually have different ideas in their mind when they say this.

The mal-intentioned ones actually mean: I have a lot of money which I can use to influence the government to polish the market in a manner which will benefit me. But if the government does not have power over the market, how will I do this. So let me somehow justify government powers on the pretext of making the market ‘more efficient’. This is what crony capitalism is. A defining characteristic of these crony capitalists is that they will vote for specific regulatory powers of the market for preventing entry for other entrepreneurs into the market.

The well-intentioned are primarily those who see specific market results as undesirable without understanding the bigger picture. For example you will see many common well-intentioned people as justifying minimum wage laws. They see the market result of some people earning less, as undesirable and without understanding the bigger picture will blindly vote for government regulation of the market in the form of minimum wage laws.

Government regulation of markets can lead only to two consequences depending on whether the regulation is corrupt or honest.

If the regulation is corrupt or inefficient the beneficiaries are the bureaucrats, ministers and crony capitalists. The losers are the consumers and honest capitalists.

When regulations work as intended they benefit those with high consumption at the cost of those with low consumption. That translates to benefitting rich at the cost of the poor. This is because in existing models of regulation, the money spent on regulation comes from government coffers which are owned equally by all citizens of the country but the benefits if any are enjoyed by those who have more money to spend.

What we need to do is move to a pay-per-use model of regulation. How will that work? The first step is to get government out of it. Let private regulatory organizations certify products and let companies sell such products for a premium. People have more choice and only those who want to use the service of regulation pay for it. This is the model most in line with social justice, efficiency and innovation.

Where Piketty is right for the wrong reasons ! And where he is wrong!

Recently, the French economist Thomas Piketty has
risen to fame
for his book: Capital in the 21st century . It has become a rage among leftists in the USA and Europe due to its contents providing justification for government action in the economy. The policy suggestions therein are a global wealth tax and extremely ‘progressive’ incomes taxes.

Piketty is actually right when he proposes a wealth tax. The flaw in his reasoning is that he is looking at it from a unidimensional aspect of wealth redistribution. This leads him to come to erroneous proposals on the quantum of wealth tax. His proposals are qualitatively valid but quantitatively arbitrary precisely because of this flaw in the reasoning. A justification for wealth tax based on free market principles does not initiate legal action on citizens for not paying wealth taxes. It just renders them ineligible for any claims by them on the government for loss of property. This places a natural check on the quantum of tax and forces the government to provide a quality of service such that the citizens are satisfied. Piketty’s train of thought leaves the quantum of tax completely arbitrary because he is looking at it purely from a redistributive point of view.

Income taxes as proposed by Piketty suffer from all the same deficiencies as discussed earlier in this piece about income taxes.

Piketty’s conclusion that rate of return on capital is higher than rate of economic growth leading to widening inequality is absolutely correct. But he misses the most basic point. His conclusions hold true for economies under government intervention, not for free markets, after all that’s where he is getting his data from! It can be shown conclusively that all government actions except cash transfers leads to wealth transfer from poor to rich either due to skewed consumption capacities or corruption.

But people can hide their wealth!

The primary arguments against this proposal revolve around the apparatus required to collect wealth tax as compared to income tax. Critics argue that it is easier for the government to track income than wealth. Of course ease of implementation can never be a justification for choosing a wrong policy over a right policy but more than that, if you follow the argument, the government does not need to track it. Citizens should be free to evaluate the market price of their assets and pay taxes accordingly.

And governments should be free to acquire the lowest priced properties by paying the owner the price as evaluated by the owners themselves, if the government’s expenses are not being met. With these rules let the citizens evaluate their own property’s value. If you hide an asset and don’t pay taxes for it, it’s perfectly fine because your not depending on the government to protect this property for you, you are taking care of it yourself by hiding it , it’s quite justified that you are not forced to pay. There is a plot of land which is owned by someone but has not been declared as owned by them for taxation. Government has all the right to confiscate it and pay nothing to you since you never claimed you owned it in the first place. Of course there will be more details to be etched out but the basic idea holds.

So if you look at it, wealth tax for the service of property protection is actually much easier to implement than income tax.

But this can lead to capital outflows from the country!

Another common argument which also is one of the reasons which forced Piketty to recommend a ‘global’ uniform wealth tax is that wealth taxes can lead to capital outflows out of the country. But if you look at it, it is not something to be feared, it’s actually a very important factor which makes the system work. This fear is exactly what will force governments to reduce the rate of taxation to ensure wealth does not flow out of the country. This will benefit countries which have an efficient law enforcement structure which gives maximum outcomes with minimum outlays allowing those governments to charge a low rate of tax. This will force your government to improve its law enforcement services.

This puts a natural limit on the taxation powers of the government forcing the government to be small.

How can we make Warren Buffet happier!

A common anecdote is how Warren Buffet expresses his sorrow at the fact that he pays a lower rate of tax than his employees because most of his income comes from capital returns.1 Cronies like Warren use this argument to support increase in income tax rates.

The real test of whether Warren in sincere in his expressed sorrow or not will be his reaction to the above proposal. Let’s see if Warren actually wants to pay his fair share of taxes!

Wealth and transaction taxes and no income taxes are a win-win

The above proposals prevent most means of governmental exploitation which are prevalent around the world. We get a market determined wealth tax rate. We get the most efficient law enforcement framework. We prevent all mechanisms which were leading to wealth transfer from poor to rich and increasing inequality. We reward productive people. We penalize people who sit on capital without using it for the society. We give poor people the fairest chance to move up the economic ladder. We nip socialist ideas in the bud by limiting government’s taxation powers using the market. This is the best deal for society.


1. Chris Isidore, “Buffett says he’s still paying lower tax rate than his secretary” CNN, March 4, 2013, accessed May 31, 2014,

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Gaurav Sinha

Gaurav is a Software Engineer currently employed with in USA. Gaurav graduated from IIT Delhi in 2007 with an Integrated Masters degree in Mathematics and Computing. He is deeply interested in physics and economics and spends most of his free time reading and thinking about these topics. He closely follows political developments in both India and USA and has strong views on both.