Income Taxes as Reciprocal Tariffs - Economic Review, Third Quarter, 1998 - Dallas Fed

Public finance experts have long explored the issue of income taxes making the cost of market transactions higher than nonmarket ones. A 50 percent income tax, for example, requires $20,000 in income to purchase $10,000 of market goods. The tax can be avoided, however, if the same goods can be produced at home. The upshot is that income taxes encourage the home production of goods and services that would otherwise be produced and traded in the market. By restricting trade between individuals, income taxes reduce what Adam Smith considered one of the primary benefits of the marketplace—the gains to specialization. Given that income taxes reduce specialization within an economy, it is easy to see the similarities between the taxing of income within a country and tariff barriers between countries: income taxes encourage individuals to trade less in the marketplace and produce more goods at home; tariffs cause countries to trade less internationally and produce more domestically. Moreover, just as tariffs can redistribute income across countries, flat income tax rates can redistribute income across skill groups. Over a range of positive flat income taxes (tit-for-tat tariffs), raising taxes may actually benefit large groups of similarly skilled individuals (large countries) and hurt the small groups (small countries). Other insights into the effects of income taxation can also be elucidated from tariff theory. As in tariff theory, the costs of income taxes are small only if they succeed in raising revenue; thus, it seriously harms an economy to be on the downward portion of the tax revenue (Laffer) curve. The larger the value of market income (trade) compared with total production (gross domestic product)—that is, the more heterogeneous the society—the higher the income tax rate that maximizes revenue. This article explores the parallel between the standard theory of income taxation and the theory of tariffs in international trade. Indeed, there is no formal difference in economic theory between a tariff war among countries and a flatrate personal income tax within an economy. But although analysts generally consider tariff wars extremely costly to economic activity, they often look on income taxes with complacency. One possible reason for these different reactions is that tariff wars are explicitly used to inflict damage on another country, whereas income taxes are used primarily to finance public spending. This article looks at how insights from the theory of tariffs can help us understand the effects of income taxation. Income Taxes as Reciprocal Tariffs