Rational majoritarian taxation of the rich: with increasing returns and capital accumulation.

• Author: Buchanan, James M.

1. Introduction

   In the United States political setting of 1993, the dominant majority coalition effectively excluded high income recipients (the rich) from participation in fiscal decisions and sought to increase the differentially high taxation of members of this group under a rhetoric of "fair shares." This real-world fiscal environment motivates our analysis in this paper. We address the question: What rate of taxation should the political majority rationally impose on high-income recipients if this majority is motivated strictly in the interest of its members?

   We shall use highly abstracted models of the political economy that incorporate several simplifying assumptions. We suggest, however, that the results attained are relevant for the decision calculus of the leaders of the majority coalition. And in particular, we suggest that the possible presence of generalized or economy-wide increasing returns along with saving and the accumulation of capital make such decision calculus more difficult than that which would be implied in modern normative tax analysis that may involve maximization of a specific social welfare function. More specifically, our analysis indicates that the rational fiscal exploitation of the rich may involve lower tax extraction than orthodox fiscal theory would suggest. Or, in summary terms, the middle and low income members of the dominating majority may secure both more fiscal gains as well as non-fiscal benefits from the income-producing behavior of the rich than is recognized in the traditional analyses, and these benefits should be taken into account in any comprehensive reckoning. One implication involves the strengthening of the case for expenditure based taxation, even from the perspective of members of non-saving classes.

   We shall proceed as follows: we shall first, in section II, summarize the straightforward response to the question posed in a simple model that assumes all income is derived from current labor supply and that the economy operates under universalized constant returns. In section III, the constant returns assumption is replaced by one of generalized increasing returns. A central contribution in the paper is that of tracing out the effects of this change in the model. In section IV, we include income from capital, which adds complexity to the analysis of both earlier models, and introduces implications of its own that are challenging quite independently of the presence of increasing returns. In section V, we examine the prospects for an expenditure tax rather than an income tax. Finally, in section VI we discuss some extensions and qualifications on the analysis.

2. The Political Economy under Constant Returns: The Benchmark Model

   Consider an economy in which production is specialized and in which exchanges of goods and services are made through an interlinked set of markets. Politically, the community has a "democratic" constitution, and government adequately meets its protective state obligations to protect property and contract against private predation. There is universal franchise and majority voting. There are no restrictions on the fiscal authority of the majority coalition, either in$imposing taxes or in allocating benefits from government spending, including direct transfers. All taxes are levied against an income base, and persons cannot be taxed on their potential rather than their observed income receipts. Leisure, as such, cannot be taxed.

   For initial simplicity in exposition, we assume that all income is derived from current supplies of labor services. There are no capital goods that yield income, and labor, itself, cannot be made more productive of income by investment in either general or specific skills. The community is made up of three distinct groups of individuals, classified by value productivity. There are no non-producers in the economy. For simplicity, assume that, within each of the three groups, all persons are equivalent. We designate the groups as R (rich), M (middle), and P (poor), and individual members of these groups as r, m, and p. The economy, which we assume to be closed, is characterized by constant returns, in each industry, in each industrial category, and for the inclusive size of the network of production-exchange.

   Given the parameters of the basic or benchmark model as described, we now assume that a majority coalition emerges that is made up of all members from the middle and low income classes or groups, from M and P. Members of the high income group, R, are relegated to minority status and are unable to influence political decisions. We assume that members of the dominant coalition are motivated only by their own economic interest; they are not altruistic toward members of R.

   More restrictively, we also assume that members of the majority are not concerned about possible defections in the coalition membership through a series of subsequent electoral periods. We explicitly abstract from issues of potential instability in the majority coalition due to the defection of members in response to possible side-payments from non-coalition members. This assumption allows us to avoid discussion of the whole set of problems that involve rotating sequential majorities and cycles.

   Since, by assumption, all members of R are identical, little could be gained by differential taxation among separate members of the exploited minority. The tax rate structure confronting each person may take many forms. Initially, consider proportional taxation. What rate will the majority coalition impose on all members of the high-income group? Note that this question may be analyzed independently of whether or not members of the majority find it advantageous to impose taxes on themselves. If revenues sufficient to meet collective purposes can be raised from the rich, no residual taxes will be accepted by members of M and P. And if revenues raised from R are more than sufficient to meet collective goods demands, as determined by members of M and P, the taxation of members of R will still be used to finance direct transfers to those persons in M and P.(1)

   The rate of tax that will be imposed on all members of the high-income group, R, will depend on the predicted responses of members of this group to differing rates. If no response at all is predicted to occur, that is, if income-producing behavior of the rich is not predicted to change as a result of changes in tax rates, the majority will impose confiscatory taxes on all incomes of the group over some subsistence minimum.(2)

   If any behavioral response to taxation on the part of the taxed persons is anticipated to occur, the optimal levy for the majority to impose will be that rate that maximizes total revenue extraction. Under the simplifying assumptions here, where all income is from currently supplied labor services, and further, where the coalition is not concerned about voter defections from its own ranks, there will be a uniquely determinate solution to this maximization problem. This will be attained at the extremum of the "Laffer curve" or function that relates tax rates directly with revenue totals.

   More formally, and stated in terms of the taxation of a single member of R, the majority's problem is to maximize:

   [V.sub.r] = t[y.sub.r] (1)

   subject to

   [y.sub.r] = f(t) (2)

   where t denotes the tax rate and [V.sub.r] revenue extraction from a single member of R. The income of a minority member [y.sub.r] = f(t) in (2) is determined by utility maximization: given tax rate t, work effort is chosen to maximize

   v(c, L)

   subject to

   c = (1 - t)[y.sub.r]

   [y.sub.r] = F(e - L) (3)

   where c is consumption, L leisure, and v is the utility function of member r; e is member r's input endowment, and F is the production function the individual member r faces. The first order condition for the majority's solution is met when

   d[V.sub.r](t)/dt = 0 (4)

   and the maximum tax revenue can be extracted at the tax rate at which income [y.sub.r] = f(t) attains unit elasticity.(3)

   We want to call attention to one feature of this model. There is no non-fiscal interest on the part of the members of the majority in the incomes of the rich. These incomes matter to the members of the majority only as potential sources of tax revenue. The contribution to national income made by the rich in earning high incomes is totally irrelevant to the majority except through the fiscal interdependence described.

3. The Political Economy under Generalized Increasing Returns: The Effect of Non-fiscal Interdependence

   We now change only one element in the basic model outlined in section II. We drop the assumption that the economy operates under constant returns and replace this with the assumption that there are increasing returns to the size of the network of market production and exchange. For our purposes it is sufficient to assume that as the size of the economy increases, the value productivity of inputs increases as measured in units of output.

   This assumption of generalized mncreasing returns is not a radical departure from the central idea of economic theory. Adam Smith's widely cited principle...