Ethical Debates, Economic Theories, and Real-World Impacts

• Author: Deborah A. Geier
• Pages: 61-107

Chapter 3: Ethical Debates,

Economic Theories, and Real-World Impacts

Chapters 1 and 2 explored the contours of two common types of “tax base” (what is taxed):

income and consumption. Part A. of this chapter will relate information regarding the adoption

and development of the income tax over time and its impact on the Federal budget and living

standards. Part B. will explore the norms, theories, and politics of taxation, which will draw on

some of the information conveyed in Part A. regarding economic trends over time. While the

material in Chapters 1 and 2 was chiefly descriptive, some of the material in this chapter comes

with a lot of baggage in the political arena. Thus, I want to say a word first about how we

sometimes approach material of this type.

We all have unique ways of looking at the world and making sense of it. We all begin our

decision-making processes and evaluations with certain models in our minds of how the world

works and should work, which have been ingrained by culture, education, family, religion, events,

and perhaps even our genes. These models shape how we perceive the world. Thus, two different

people looking at precisely the same situation can have very different perceptions about what the

most consequential facts are. Indeed, cognitive psychologists have identified the so-called

confirmation bias as one of the most potent cognitive biases that we all share.

Although he is a cognitive psychologist and not an economist, Daniel Kahnman won the 2002

Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly referred

to as the Nobel Prize in Economics) in recognition of the contributions that he and the late Amos

Tversky made in helping us to better understand how thought patterns and behavior differ in

predictable ways from the “rational man” assumptions that economists often typically build into

their economic models. Their work (and the work of others) led to the burgeoning field of

“behavioral economics,” which seeks to study these behaviors in a systematic way.

Behavioral economists and cognitive psychologists have identified numerous “cognitive

biases” that we, as humans, all share. The confirmation bias mentioned above is the tendency to

search for or interpret information in a way that confirms one’s preconceptions.

“Disconfirmation bias,” as one would expect, is the opposite: the tendency for people to dismiss

or avoid information which contradicts their prior beliefs.

The technology revolution, with the introduction first of cable television and then the internet,

has created niches that make it ever easier to indulge in (or exploit) the confirmation bias. In the

dark ages of my childhood, with only three nationally broadcast news stations with a high number

of homes watching each evening, the three national news programs had to steer a path that appealed

broadly and thus could not cater in an obvious way to the extreme left or right of the political

spectrum. In addition, prior to 1987 the Federal Communications Commission (FCC) required,

under the so-called fairness doctrine, that radio and television broadcasters using the public air

waves must present multiple viewpoints on contentious public debates. The FCC members

appointed by President Ronald Reagan abolished the fairness doctrine in 1987. These events have

combined to allow us to subdivide ourselves into information niches in which we hear only echoes

of our prior beliefs, reinforcing them even further, turbo-charging the confirmation bias.

Another cognitive bias is the “bias blind spot,” or the tendency to see oneself as less biased

than other people, or to be able to identify more cognitive biases in others than in oneself.

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Particularly in my role as a teacher, I always try to remain sensitive to this bias in myself.

Other cognitive biases that can have an impact on taxation include the endowment effect (or

divestiture aversion), which is the tendency to ascribe more value to items or a position merely

because we own them. Studies show that people who are given, say, a coffee mug demand more

in cash to give up the mug than they would be willing to pay to purchase the item. This effect

contributes to the cognitive bias known as loss aversion, under which people strongly prefer

avoiding losses to acquiring gains. These biases can result in behavior that is inconsistent with

the “rational man” assumptions made by some economists in modeling predictions of anticipated

behavior changes in connection with a proposed change in law, including tax law.

Several other cognitive biases combine to make us sometimes make judgments based on a

personally known anecdote or widely reported example in the press of one case or incident, while

downplaying larger pools of evidence or data that contradict the individual anecdote. These include

the base rate neglect or base rate fallacy, or the tendency to base judgments on specifics,

ignoring general statistical information; the availability heuristic, or estimating what is more

likely by what is more available in memory, which is biased toward vivid, unusual, or

emotionally charged examples; and the anchoring effect, or the tendency to rely too heavily,

or “anchor,” on a past reference or on one trait or piece of information when making

decisions (also called “insufficient adjustment”). As an example of this cognitive bias in the tax

policy setting, the popular press widely reported that the French actor Gerard Depardieu obtained

a Russian passport after the former French President recommended temporarily raising (for two

years) the top marginal income tax rate from 41% to 75% on income exceeding €1 million. This

vivid example of fleeing a country (or a state in the U.S.) in response to an increase in the top tax

rate can cause a reader to believe that this response is a common one, a belief that can affect the

analysis of the policy issue, but broader empirical data is not consistent with this assumption.1

As an aside, those looking for good empirical data can often find it by looking at material

published by the Congressional Budget Office, the Tax Policy Center (a joint undertaking between

the Urban Institute and the Brookings Institution), the Census Bureau, the IRS Statistics of Income

Division, and the Joint Committee on Taxation, a committee nominally made up of the members

of the House Ways & Means Committee and the Senate Finance Committee, but whose work is

done by its professional staff consisting of economists and lawyers charged with, among other

duties, scoring tax bills and doing studies mandated by Congress. Information pertaining to the

experience of other nations can often be found in data compiled by the Organization for Economic

Cooperation and Development (OECD).

A. The development of the income tax and

how taxes affect the Federal budget and living standards

Under the Articles of Confederation that preceded the Constitution, the Federal government

had no power to tax individuals, states, or business entities directly. Rather, the Federal

government could only send a “requisition” to each state to collect a stated amount to turn over to

the Federal government, and the states were left to decide for themselves how to fulfill the

requisition. As you might expect, states often failed to comply, and the very survival of the new

1 See, e.g., James B. Stewart, The Myth of the Rich Who Flee from Taxes, at

www.nytimes.com/2013/02/16/business/high-taxes-are-not-a-prime-reason-for-relocation-studies-say.html.

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country was threatened, as the Federal government needed revenue to retire the Revolutionary War

debt, maintain the military and courts, etc. Thus, a primary reason for calling a Constitutional

Convention to replace the Articles of Confederation was the need to provide the Federal

government with the power to tax citizens and residents directly, without going through the states.

“For a generation that had fought a war with England about taxation, however, it was equally

important that any taxing power be constrained.”2 Thus, both a “uniformity” and “apportionment”

requirement were included with respect to the Federal taxing power.

Under Article 1, § 8, clause 1, of the Constitution, Congress is granted power to “lay and collect

Taxes, Duties, Imposts, and Excises” on individuals, entities, transactions, etc., without going

through the states, but these levies must “be uniform throughout the United States.” This

“uniformity” requirement prevents express discrimination among the states. Thus, for example, if

Congress enacted an excise tax tomorrow on the extraction of each barrel of oil from the ground,

it could not impose that tax at a rate of, say, 10% for oil found in Texas but 20% for oil found in

Alaska without violating the uniformity clause. The fact that oil is distributed unevenly among the

states, however, which means that entities and individuals in Texas and Alaska would pay much

more of this hypothetical oil excise tax than would residents in Tennessee or Vermont, would not

violate the uniformity clause.

Article 1, § 9, clause 4, requires that all “direct” taxes, including any “capitation” tax (or per-

person head tax), be apportioned among the states according to population. Taxes that are not

“direct” taxes are not subject to the apportionment requirement. Though the Constitution does not

use the term, taxes that do not qualify as direct have come to be known as “indirect” taxes. The

distinction between a direct and indirect tax is somewhat cloudy (more below), but taxes imposed

on individuals for merely existing (a capitation tax) or merely owning property (such as real estate)

have been held to be direct taxes, while taxes imposed only on a transaction, such as the

hypothetical oil excise tax described above or a retail sales tax imposed on the purchase of

consumer items, have been held to be indirect.

Direct taxes were thought to have greater potential for abuse in that they were imposed merely

for existing or owning real estate and thus could not easily be escaped by citizens and residents.

Excise and sales taxes, in contrast, were relatively noncontroversial forms of taxation becaus e they

could be avoided simply by choosing not to extract the oil (in the hypothetical example provided

above) or choosing not to purchase the consumer item. As Alexander Hamilton wrote in Federalist

21:

It is a signal advantage of taxes on articles of consumption that they contain in their

own nature a security against excess. They prescribe their own limit; which cannot

be exceeded without defeating the end proposed, that is, an extension of the

revenue. When applied to this object, the saying is as just as it is witty, that, “in

political arithmetic, two and two do not always make four.” If duties are too high,

they lessen the consumption; the collection is eluded; and the product to the treasury

is not so great as when they are confined within proper and moderate bounds. This

forms a complete barrier against any material oppression of the citizens by taxes of

this class, and is itself a natural limitation of the power of imposing them.

To illustrate how the apportionment requirement might work, assume that Congress decided

2 ERIK M. JENSEN, THE TAXING POWER: A REFERENCE GUIDE TO THE UNITED STATES CONSTITUTION 17 (2005).