Friedrich A. Hayek
It lies in the nature of things that the beginnings
are slight, but unless great care is taken, the rates
will multiply rapidly and finally will reach a point
that no one could have forseen.
F. GUICCIARDINI (ca. 1538)
1. In many ways I wish I could omit this chapter. Its argument
is directed against beliefs so widely held that it is bound to offend many.
Even those who have followed me so far and have perhaps regarded
my position as on the whole reasonable are likely to think my views on
taxation doctrinaire, extremist, and impractical. Many would probably
be willing to restore all
the freedom for which I have been pleading, provided that the injustice that they believe this would cause were corrected by appropriate measures of taxation. Redistribution by progressive taxation has come to be almost universally accepted as just. Yet it would be disingenuous to avoid discussing this issue. Moreover, to do so would mean to ignore what seems to me not only the chief source of irresponsibility of democratic action but the crucial issue on which the whole character of future society will depend. Though it may require considerable effort to free one's self of what has become a dogmatic creed in this matter, it should become evident, once the issue has been clearly stated, that it is here that, more than elsewhere, policy has moved toward arbitrariness.
After a long period in which there was practically no questioning of the principle of progressive taxation and in which little discussion took place that was new, there has lately appeared a much more critical approach to the problem. There is, however, still great need for a more searching review of the whole subject. Unfortunately, we can attempt to present only a brief summary of our objections in this chapter.
It should be said at once that the only progression with which we shall be concerned and which we believe cannot in the long run be reconciled with free institutions is the progression of taxation as a whole, that is, the more than proportionally heavy taxation of the larger incomes when all taxes are considered together. Individual taxes, and especially the income tax, may be graduated for a good reason-that is, so as to compensate for the tendency of many indirect taxes to place a proportionally heavier burden on the smaller incomes. This is the only valid argument in favor of progression. It applies, however, only to particular taxes as part of a given tax structure and cannot be extended to the tax system as a whole. We shall discuss here mainly the effects of a progressive income tax because in recent times it has been used as the main instrument for making taxation as a whole steeply progressive. The question of the appropriate mutual adjustment of the different kinds of taxes within a given system will not concern us.
We shall also not consider separately the problems which arise
from the fact that, though progressive taxation is today the chief instrument
of income redistribution, it is not the only method by which the latter
can be achieved. It is clearly possible to bring about considerable
redistribution under a system of proportional taxation. All that
is necessary is to use a substantial
part of the revenue to provide services which benefit mainly a particular class or to subsidize it directly. One wonders, however, to what extent the people in the lower-income brackets would be prepared to have their freely spendable income reduced by taxation in return for free services. It is also difficult to see how this method could substantially alter the differentials of the higher-income groups. It might well bring about a considerable transfer of income from the rich as a class to the poor as a class. But it would not produce that flattening of the top of the income pyramid which is the chief effect of progressive taxation. For the comparatively well-to-do it would probably mean that, while they would all be taxed proportionately on their whole incomes, the differences in the services they receive would be negligible. It is in this class, however,, that the changes in relative incomes produced by progressive taxation are most significant. Technical progress, the allocation of resources, incentives, social mobility, competition, and investment-the effects of progressive taxation on all these operate mainly through its effects on this class. Whatever may happen in the future, for the present at any rate, progressive taxation is the chief means of redistributing incomes, and, without it, the scope of such a policy would be very limited.
2. As is true of many similar measures, progressive taxation has assumed its present importance as a result of having been smuggled in under false pretenses. When at the time of the French Revolution and again during the socialist agitation preceding the revolutions of 1848 it was frankly advocated as a means of redistributing incomes, it was decisively rejected. "One ought to execute the author and not the project," was the liberal Turgot's indignant response to some early proposals of this sort. When, in the 1830's they came to be more widely advocated, J. R. McCulloch expressed the chief objection in the often quoted statement: "The moment you abandon the cardinal principle of exacting from all individuals the same proportion of their income or of their property, you are at sea without rudder or compass, and there is no amount of injustice and folly you may not commit." In 1848 Karl Marx and Friedrich Engels frankly proposed "a heavy progressive or graduated income tax" as one of the measures by which, after the first stage of the revolution, "the proletariat will use its political supremacy to wrest, by degrees, all capital from the bourgeois, to centralize all instruments of production in the hands of the state." And these measures they described as "means of despotic inroads on the right of property, and on the condition of bourgeois production ... measures ...which appear economically insufficient and untenable but which, in the course of the movement outstrip themselves, necessitate further inroads upon the old social order and are unavoidable as a means of entirely revolutionizing the mode of production.". But the general attitude was still well summed up in A. Thiers's statement that "proportionality is a principle, but progression is simply hateful arbitrariness,"' or John Stuart Mill's description of progression as "a mild form of robbery."
But after this first onslaught had been repelled, the agitation for
progressive taxation reappeared in a new form. The social reformers,
while generally disavowing any desire to alter the distribution of incomes,
began to contend that the total tax burden, assumed to be determined by
other considerations, should be distributed according to "ability to pay"
in order to secure equality of sacrifice" and that this would be best achieved
by taxing incomes at progressive rates. Of the numerous arguments
advanced in support of this, which still survive in the textbooks on public
finance, one which looked most scientific carried the day in the end.
It requires brief consideration because some still believe that it provides
a kind of scientific justification of
regressive taxation. Its basic conception is that of the decreasing marginal utility of successive acts of consumption. In spite of, or perhaps because of, its abstract character, it has had great influence in making scientifically respectable what before had been admittedly based on arbitrary postulates.
Modern developments within the field of utility analysis itself have, however, completely destroyed the foundations of this argument. It has lost its validity partly because the belief in the possibility of comparing the utilities to different persons has been generally abandoned and partly because it is more than doubtful whether the conception of decreasing marginal utility can legitimately be applied at all to income as a whole, i.e., whether it has meaning if we count as income all the advantages a person derives from the use of his resources. From the now generally accepted view that utility is a purely relative concept ( i.e., that we can only say that a thing has greater, equal, or less utility compared with another and that it is meaningless to speak of the degree of utility of a thing by itself), it follows that we can speak of utility (and of decreasing utility) of income only if we express utility of income in terms of some other desired good, such as leisure (or the avoidance of effort). But if we were to follow up the implications of the contention that the utility of income in terms of effort is decreasing, we would arrive at curious conclusions. It would, in effect, mean that, as a person's income grows,, the incentive in terms of additional income which should be required to induce the same marginal effort would increase. This might lead us to argue for regressive taxation, but certainly not for progressive. It is, however, scarcely worthwhile to follow this line of thought further. There can now be little doubt that the use of utility analysis in the theory of taxation was all a regrettable mistake (in which some of the most distinguished economists of the time shared) and that the sooner we can rid ourselves of the confusion it has caused, the better.
3. Those who advocated progressive taxation during the latter part of the nineteenth century generally stressed that their aim was only to achieve equality of sacrifice and not a redistribution of income; also they generally held that this aim could justify only a "moderate" degree of progression and that its "excessive" use (as in fifteenth-century Florence, where rates had been pushed up to 50 per cent) was, of course, to be condemned. Though all attempts to supply an objective standard for an appropriate rate of progression failed and though no answer was offered when it was objected that, once the principle was accepted, there would be no assignable limit beyond which progression might not be carried with equal justification, the discussion moved entirely in a context of contemplated rates which made any effect on the distribution of income appear negligible. The suggestion that rates would not stay within these limits was treated as a malicious distortion of the argument, betraying a reprehensible lack of confidence in the wisdom of democratic government.
It was in Germany, then the leader in "social reform," that until .the advocates of progressive taxation first overcame the resistance and its modern evolution began. In 1891, Prussia introduced a progressive income tax rising from 0.67 to 4 per cent. In vain did Rudolf von Gneist, the venerable leader of the then recently consummated movement for the Rechtsstaat, protest in the Diet that this meant the abandonment of the fundamental principle of equality before the law, "of the most sacred principle of equality," which provided the only barrier against encroachment on property." The very smallness of the burden involved in the new schemes made ineffective any attempt to oppose it as a matter of principle.
Though some other Continental countries soon followed Prussia, it took nearly twenty years for the movement to reach the great Anglo-Saxon powers. It was only in 1910 and 1913 that Great Britain and the United States adopted graduated income taxes rising to the then spectacular figures of 8.25 and 7 per cent, respectively. Yet within thirty years these figures had risen to 97 and 91 per cent.
Thus :In the space of a single generation what nearly all the supporters of progressive taxation had for half a century asserted could not happen came to pass. This change in the absolute rates, of course, completely changed the character of the problem, making it different not merely in degree but in kind. All attempt to justify these rates on the basis of capacity to pay was, in consequence, soon abandoned, and the supporters reverted to the original, but long avoided, justification of progression as a means of bringing about a more just distribution of income. It has come to be generally accepted once more that the only ground on which a progressive scale of over-all taxation can be defended is the desirability of changing the distribution of income and that this defense cannot be based on any scientific argument but must be recognized as a frankly political postulate, that is, as an attempt to impose upon society a pattern of distribution deter- mined by majority decision.
4. An explanation of this development that is usually offered is that the great increase in public expenditure in the last forty years could not have been met without resort to steep progression, or at least that, without it, an intolerable burden would have had to be placed on the poor and that, once the necessity of relieving the poor was admitted, some degree of progression was inevitable. On examination, however, the explanation dissolves into pure myth. Not only is the revenue derived from the high rates levied on large incomes, particularly in the highest brackets, so small compared with the total revenue as to make hardly any difference to the burden borne by tile rest; but for a long time after the introduction of progression it was not the poorest who benefited from it but entirely the better-off working class and the lower strata of the middle class who provided the largest number of voters. It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off.
How small is the contribution of progressive tax rates (particularly
of the high punitive rates levied on the largest incomes) to total revenue
may be illustrated by a few figures for the United States and for Great
Britain. Concerning the former it has been stated (in 1956) that
"the entire progressive super-structure produces only about 17 per cent
of the total revenue derived from the individual income tax"-or about
8.5 per cent of all federal revenue,-- and that of this “half is taken
from taxable income brackets up through $16,000-$18,000, where the tax
rate approaches 50 per cent (while] the other half comes from the
higher brackets and rates."is As for Great Britain, which has an even steeper
scale of progression and a greater proportional tax burden, it his been
pointed out that "all surtax (on both earned and unearned incomes) only
brings in about 2.5 per cent of all public revenue, and that if we collared
every pound of income over 2,000 pounds per annum. [$5,600], we would
only net an extra 1.5 per cent of revenue....Indeed the massive contribution
to income tax and sur-tax comes from incomes between 750 pounds p.a. and
3,000 pounds per annum [$2,100-$8,400] -i.e. just those which
begin with foremen and end with managers, or begin with public servants
just taking responsibility and end with those at the head of our civil
and other services.
Generally speaking and in terms of the progressive character of the two tax systems as a whole, it would seem that the contribution made by progression in the two countries is between 2.5 and 8.5 per cent of total revenue, or between 0.5 and 2 per cent of gross national income. These figures clearly do not suggest that progression is the only method by which the revenue required can be obtained. It seems at least probable (though nobody can speak on this with certainty) that under progressive taxation the gain to revenue is less than the reduction of real income which it causes.
If the belief that the high rates levied on the rich make an indispensable
contribution to total revenue is thus illusory, the claim that progression
has served mainly to relieve the poorest classes is belied by what happened
in the democracies during the greater part of the period since progression
was introduced. Independent studies in the United States, Great Britain,
and Prussia agree that, as a rule, it was those of modest income who provided the largest number of voters that were let off most lightly, while not only those who had more income but also those who had less carried a much heavier proportional burden of total taxation. The best illustration of this situation, which appears to have been fairly general until the last war, is provided by the results of a detailed study of conditions in Britain, where in 1936-37 the total burden of taxation on fully earned income of families with two children was 18 per cent for those with an annual income of 100 pounds per annum, which then gradually fell to a minimum of 11 per cent at 350 pounds and then rose again, to reach 19 percent only at 1,000 pounds. What these figures (and the similar data for other countries) clearly show is not only that, once the principle of proportional taxation is abandoned, it is not necessarily those in greatest need but more likely the classes with the greatest voting strength that will profit, but also that all that was obtained by progression could undoubtedly have been obtained by taxing the masses with modest incomes as heavily as the poorest groups. It is true, of course, that developments since the last war in Britain, and probably elsewhere, have so increased the progressive character of the income tax as to make the burden of taxation
progressive throughout and that, through redistributive expenditure on subsidies and services, the income of the very lowest classes has been increased (so far as these things can be meaningfully measured: what can be shown is always only the cost and not the value of the services rendered) by as much as 22 per cent. But the latter development is little dependent on the present high rates of progression but is financed mainly by the contributions of the middle and upper ranges of the middle class.
5. The real reason why all the assurances that progression would remain
moderate have proved false and why its development has gone far beyond
the most pessimistic prognostications of its opponents is that all arguments
in support of progression can be used to justify any degree of progression.
Its advocates may realize that beyond a certain point the adverse effects
on the efficiency of the economic system may become so serious as to make it inexpedient to push it any further. But the argument based on the presumed justice of progression provides for no limitation, as has often been admitted by its supporters, before all incomes above a certain figure are confiscated and those below left untaxed. Unlike proportionality, progression provides no principle which tells us what the relative burden of different persons ought to be. It is no more than a rejection of proportionality in favor of a discrimination against the wealthy without any criterion for limiting the extent of this discrimination. Because there is no ideal rate of progression that can be demonstrated by formula, it is only the newness of the principle that has prevented its being carried at once to punitive rates. But there is no reason why "a little more than before" should not always be represented as just and reasonable. It is no slur on democracy, no ignoble distrust of its wisdom, to maintain that, once it embarks upon such a policy, it is bound to go much further than originally intended. This is not to say that "free and representative institutions are a failure" or that it must lead to "a complete distrust in democratic government,
but that democracy has yet to learn that, in order to be just, it must be guided in its action by general principles. What is true of individual action is equally true of collective action except that a majority is perhaps even less likely to consider explicitly the long-term significance of its decision and therefore is even more in need of guidance by principles. Where, as in the case of progression, the so-called principle adopted is no more than an open invitation to discrimination and, what is worse, an invitation to the majority to discriminate against a minority, the pretended principle, of justice must become the pretext for pure arbitrariness. What is required here is a rule which, while still leaving open the possibility of a majority's taxing itself to assist a minority, does not sanction a majority imposing itself on a minority whatever burden it regards as right. That a majority, merely because it is a majority, should be entitled to apply to a minority a rule which does not apply to itself is an infringement of a principle much more fundamental than democracy itself, a principle on which the justification of democracy rests. We have seen before (in chaps. x and xiv) that if the classifications of persons which the law must employ are to result neither in privilege nor in discrimination, they must rest on distinctions which those inside the group singled out, as well as those outside it, will recognize as relevant.
It is the great merit of proportional taxation that it provides a rule which is likely to be agreed upon by those who will pay absolutely more and those who will pay absolutely less and which, once accepted, raises no problem of a separate rule applying only to a minority. Even if progressive taxation does not name the individuals to be taxed at a higher rate, it discriminates by introducing a distinction which alms at shifting the burden from those who determine the rates onto others. In no sense can a progressive scale of taxation be regarded as a general rule applicable equally to all-in no sense can it be said that a tax of 20 per cent on one person's income and a tax of 75 per cent on the larger income of another person are equal. Progression provides no criterion whatever of what is and what is not to be regarded as just. It indicates no halting point for its application, and the "good judgment" of the people on which its defenders are usually driven to rely as the only safeguard" is nothing more than the current state of opinion shaped by past policy.
That the rates of progression have, in fact, risen as fast as they have done is, however, also due to a special cause which has been operating during the last forty years, namely, inflation. It is now well understood that a rise in aggregate money incomes tends lift everybody into a higher tax bracket, even though their actual income has remained the same. As a result, members of the majorities have found themselves again and again unexpectedly victims of the discriminatory rates for which they had voted in the belief that they would not be affected.
This effect of progressive taxation is often represented as a merit, because it tends to make inflation (and deflation) in some measure self-correcting. If a budget deficit is the source of inflation, revenue will rise proportionately more than incomes and may thus close the gap; and if a budget surplus has produced deflation, the resulting fall of incomes will soon bring an even greater reduction in revenue and wipe out the surplus. It is very doubtful, however, whether, with the prevailing bias in favor of inflation, this is really an advantage. Even without this effect, budgetary needs have in the past been the main source of recurrent inflations; and it has been only the knowledge that an inflation, once started, is difficult to stop that in some measure has acted as a deterrent. With a tax system under which inflation produces a more than proportional increase in revenue through a disguised increase in taxes which requires no vote of the legislature, this device may become almost irresistibly tempting.
6. It is sometimes contended that proportional taxation is as arbitrary a principle as progressive taxation and that, apart from an apparently greater mathematical neatness, it has little to recommend it. There are, however, other strong arguments in its favor besides the one we have already mentioned-i.e., that it provides a uniform principle on which people paying different amounts are likely to agree. There also is still much to be said for the old argument that, since almost all economic activity benefits from the basic services of government, these services form a more or less constant ingredient of all we consume and enjoy and that, therefore, a person who commands more of the resources of society will also gain proportionately more from what the government has contributed.
More important is the observation that proportional taxation leaves the relations between the net remunerations of different kinds of work unchanged. This is not quite the same as the old maxim, "No tax is a good tax unless it leaves individuals in the same relative position as it finds them. It concerns the effect, not on the relations between individual incomes, but on the relations between the net remunerations for particular services performed, and it is this which is the economically relevant factor. It also does not, as might be said of the old maxim, beg the issue by simply postulating that the proportional size of the different incomes should be left unchanged.
There may be a difference of opinion as to whether the relation between
two incomes remains the same when they are reduced by the same amount or
in the same proportion. There can be no doubt, however, whether or
not the net remunerations for two services which before taxation were equal
still stand in the same relation after taxes have been deducted.
And this is where the effects of progressive taxation are significantly
different from those of proportional taxation. The use that will
be made of particular resources depends on the net reward for services,
and, if the resources are to be used efficiently, it is important that
taxation leave the relative recompenses that will be received for
particular services as the market determines them. Progressive taxation
alters this relation substantially by making net remuneration for a particular
service dependent upon the other earnings of the individual over a certain
period, usually a year. If, before taxation, a surgeon gets as much
for an operation as an architect for planning a house, or a salesman gets
as much for selling ten cars as a photographer for taking forty portraits,
the same relation will still hold if proportional taxes are deducted from
their receipts. But with progressive taxation of incomes this
relation may be greatly changed. Not only may services which before taxation receive the same remuneration bring very different rewards; but a man who receives a relatively large payment for a service may in the end be left with less than another who receives a smaller payment.
This means that progressive taxation necessarily offends against what is probably the only universally recognized principle of economic justice, that of “equal pay for equal work”. If what each of two lawyers will be allowed to retain from his fees for conducting exactly the same kind of case as the, other depends on his other earnings during the year-they will, in fact, often derive very different gains from similar efforts. A man who has worked very hard, or for some reason is in greater demand, may receive a much smaller reward for further effort than one who has been idle or less lucky. Indeed, the more the consumers value a man's services, the less worthwhile will it be for him to exert himself further.
This effect on incentive, in the usual sense of the term, though important and frequently stressed, is by no means the most harmful effect of progressive taxation. Even here the objection is not so much that people may, as a result, not work as hard as they otherwise would, as it is that the change in the net remunerations for different activities will often divert their energies to activities where they are less useful than they might be. The fact that with progressive taxation the net remuneration for any service will vary with the time rate at which the earning accrues thus becomes a source not only of injustice but also of a misdirection of resources.
There is no need to dwell here on the familiar and insoluble difficulties which progressive taxation creates in all instances where effort (or outlay) and reward are not approximately coincident in time, i.e., where effort is expended in expectation of a distant and uncertain result-in short, in all instances where human effort takes the form of a long and risky investment. No practicable scheme of averaging incomes can do justice to the author or inventor, the artist or actor, who reaps the rewards of perhaps decades of effort in a few years. Nor should it be necessary to elaborate further on the effects of steeply progressive taxation on the willingness to undertake risky capital investments. It is obvious that such taxation discriminates against those risky ventures which are worthwhile only because, in case of success, they will bring a return big enough to compensate for the great risk of total loss. It is more than likely that what truth there is in the alleged "exhaustion of investment opportunities" is due largely to a fiscal policy which effectively eliminates a wide range of ventures that private capital might profitably undertaken
We must pass rapidly over these harmful effects on incentive and on
investment, 'not because they are unimportant but because they are on the
whole well enough known. We shall devote our limited space, then
to other effects which are less understood but at least equally important.
Of these, one which perhaps still deserves emphasis is the frequent restriction
or reduction of the
division of labor. This effect is particularly noticeable where professional work is not organized on business lines and much of the outlay that in fact would tend to increase a man's productivity is not counted as part of the cost. The tendency to "do it yourself" comes to produce the most absurd results when, for instance, a man who wishes to devote himself to more productive activities may have to earn in an hour twenty or even forty times as much in order to be able to pay another whose time is less valuable for an hour's services.
We can also only briefly mention the very serious effect of progressive
taxation on the supply of savings. If twenty-five years ago the argument
that savings were too high and should be reduced may have had some degree
of plausibility, few responsible persons today will doubt that, if we are
to achieve even part of the tasks we have set ourselves, we want as high
a rate of saving as people are prepared to supply. The socialist
answer to those who are concerned about this effect on savings is, in fact,
no longer that these savings are not needed but that they should be supplied
by the community, i.e., out of funds raised from taxation. This,
however, can be justified only if the long-term aim is socialism of the
old kind, namely, government ownership of the means of production.
7. One of the chief reasons why progressive taxation has come to be so widely accepted is that the great majority of people have come to think of an appropriate income as the only legitimate and socially desirable form of reward. They think of income not as related to the value of the services rendered but as conferring what is regarded as an appropriate status in society. This is shown very clearly in the argument, frequently used in support of progressive taxation, that "no man is worth 10,000 pounds a year, and, in our present state of poverty, with the great majority of people earning less than 6 pounds a week, only a few very exceptional men deserve to exceed 2,000 pounds a year. That this contention lacks all foundation and appeals only to emotion and prejudice will be at once obvious when we see that what it means is that no act that any individual can perform in a year or., for that matter., in an hour can be worth more to society than 10,000 pounds ($28,000). Of course, it can and sometimes will have many times that value. There is no necessary relation between the time an action takes and the benefit that society will derive from it.
The whole attitude which regards large gains as unnecessary and socially undesirable springs from the state of mind of people who arc used to selling their time for a fixed salary or fixed wages and who consequently regard a remuneration of so much per unit of time as the normal thing. But though this method of remuneration has become predominant in an increasing number of fields, it is appropriate only where people sell their time to be used at another's direction or at least act on behalf of and in fulfillment of the will of others. It is meaningless for men whose task is to administer resources at their own risk and responsibility and whose main aim is to increase the resources under their control out of their own earnings. For them the control of resources is a condition for practicing their vocation,'just as the acquisition of certain skills or of particular knowledge is such a condition in the professions. Profits and losses are mainly a mechanism for redistributing capital among these men rather than a means of providing their current sustenance. The conception that current net receipts are normally intended for current consumption, though natural to the salaried man, is alien to the thinking of those whose aim is to build up a business. Even the conception of income itself is in their case largely an abstraction forced upon them by the income tax. It is no more than an estimate of what, in view of their expectations and plans, they can afford to spend without bringing their prospective power of expenditure below the present level. I doubt whether a society consisting mainly of "self-employed" individuals would ever have come to take the concept of income so much for granted as we do or would ever have thought of taxing the earnings from a certain service according to the rate at which they accrued in time.
It is questionable whether a society which will recognize no reward other than what appears to its majority as an appropriate income, and which does not regard the acquisition of a fortune in a relatively short time as a legitimate form of remuneration for certain kinds of activities, can in the long run preserve a system of private enterprise. Though there may be no difficulty in widely dispersing ownership of well-established enterprises among a large number of small owners and in having them run by managers in a position intermediate between that of an entrepreneur and that of a salaried employee, the building-up of new enterprises is still and probably always will be done mainly by individuals controlling considerable resources. New developments, as a rule, will still have to be backed by a few persons intimately acquainted with particular opportunities; and it is certainly not to be wished that all future evolution should be dependent on the established financial and industrial corporations.
Closely connected with this problem is the effect of progressive taxation on an aspect of capital formation which is different from that already discussed, namely, the place of formation. It is one of the advantages of a competitive system that successful new ventures are likely for a short time to bring very large profits and that thus the capital needed for development will be formed by the persons who have the best opportunity of using it. The large gains of the successful innovator meant in the past that, having shown the capacity for profitably employing capital in new ventures, he would soon be able to back his judgment with larger means. Much of the individual formation of new capital, since it is offset by capital losses of others, should be realistically seen as part of a continuous process of redistribution of capital among the entrepreneurs. The taxation of such profits, at more or less confiscatory rates, amounts to a heavy tax on that turnover of capital which is part of the driving force of a progressive society.
The most serious consequence, however, of the discouragement of individual capital formation where there are temporary opportunities for large profits is the restriction of competition. The system tends generally to favor corporate as against individual saving and particularly to strengthen the position of the established corporations against newcomers. It thus assists to create quasi- monopolistic situations. Because taxes today absorb the greater part of the newcomer's “excessive" profits, he cannot, as has been well said, "accumulate capital; he cannot expand his own business; he will never become big business and a match for the vested interests. The old firms do not need to fear his competition: they are sheltered by the tax collector. They may with impunity indulge in routine, they may defy the wishes of the public and become conservative. It is true, the income tax prevents them, too, from accumulating new capital. But what is more important for them is that it prevents the dangerous newcomer from accumulating any capital. They are virtually privileged by the tax system. In this sense progressive taxation checks economic progress and makes for rigidity.
An even more paradoxical and socially grave effect of progressive taxation is that, though intended to reduce inequality, it in fact helps to perpetuate existing inequalities and eliminates the most important compensation for that inequality which is inevitable in a free-enterprise society. It used to be the redeeming feature of such a system that the rich were not a closed group and that the successful man might in a comparatively short time acquire large resources .Today, however, the chances of rising into the class are probably already smaller in some countries, such as Great Britain, than they have been at any time since the beginning of the modern era. One significant effect of this is that the administration of more and more of the world's capital is coming under the control of men who, though they enjoy very large incomes and all the amenities that this secures, have never on their own account and at their personal risk controlled substantial property. Whether this is altogether a gain remains to be seen.
It is also true that the less possible it becomes for a man to acquire a new fortune, the more must the existing fortunes appear as privileges for which there is no justification. Policy is then certain to aim at taking these fortunes out of private hands, either by the slow process of heavy taxation of inheritance or by the quicker one of outright confiscation. A system based on private property and control of the means of production presupposes that such property and control can be acquired by any successful man. If this is made impossible, even the men who otherwise would have been the most eminent capitalists of the new generation are bound to become the enemies of the established rich.
8. In those countries where taxation of incomes reaches very high
rates, greater equality is, in effect, brought about by setting a limit
to the net income that anybody can earn. (In Great Britain during
the last war, the largest net income after taxation was approximately 5,000
pounds, or $14,000-though this was partly tempered by the fact that capital
gains were not treated as in-
come.) We have seen that, considering the insignificant contribution which progressive taxation of the higher brackets makes to revenue, it can be justified only by the view that nobody should command a large income. But what a large income is depends on the views of the particular community and, in the last resort, on its average wealth. The poorer a country, therefore, the lower will its permissible maximum incomes be, and the more difficult for any of its inhabitants to reach income levels that in wealthier countries are considered only moderate. Where this may lead is illustrated by a recent proposal, only narrowly defeated, of the National Planning Commission of India, according to which a ceiling of $6,300 per annum was to be fixed for all incomes (and a ceiling of $4,300 for salary incomes). One need only to think of the same principle being applied to the different regions of any one country, or internationally, to see its implications. These consequences certainly are a commentary on the moral basis of the belief that the majority of a particular group should be entitled to decide on the appropriate limit of incomes and on the wisdom of those who believe that in this manner they will assist the well-being of the masses. Can there be much doubt that poor countries, by preventing individuals from getting rich, will also slow down the general growth of wealth? And does not what applies to the poor countries apply equally to the rich?
In the last resort, the problem of progressive taxation is, of course, an ethical problem, and in a democracy the real problem is whether the support that the principle now receives would continue if the people fully understood how it operates. It is probable that the practice is based on ideas which most people would not approve if they were stated abstractly. That a majority should be free to impose a discriminatory tax burden on a minority; that, in consequence, equal services should be remunerated differently; and that for a whole class, merely because its incomes are not in line with those of the rest, the normal incentives should be practically made ineffective-all these are principles which cannot be defended on grounds of justice. If, in addition, we consider the waste of energy and effort which progressive taxation in so many ways leads to, it should not be impossible to convince reasonable people of its undesirability. Yet experience in this field shows how rapidly habit blunts the sense of justice and even elevates into a principle what in fact has no better basis than envy.
If a reasonable system of taxation is to be achieved, people must recognize as a principle that the majority which determines what the total amount of taxation should be must also bear it at the maximum rate. There can be no justified objection to the same majority deciding to grant to an economically weak minority some relief in the form of a proportionately lower taxation. The task of erecting a barrier against abuse of progression .is complicated by the fact that, as we have seen, some progression in personal income taxation is probably justified as a way of compensating for the effects of indirect taxation. Is there a principle which has any prospect of being accepted and which would effectively prevent those temptations inherent in progressive taxation from getting out of hand? Personally, I do not believe that setting an upper limit which progression is not to exceed would achieve its purpose. Such a percentage figure would be as arbitrary as the principle of progression and would be as readily altered when the need for additional revenue seemed to require it.
What is needed is a principle that will limit the maximum rate of direct taxation in some relation to the total burden of taxation. The most reasonable rule of the kind would seem to be one that fixed the maximum admissible (marginal) rate of direct taxation at that percentage of the total national income which the government takes in taxation. This would mean that if the government took 25 per cent of the national income, 25 per cent would also be the maximum rate of direct taxation of any part of individual incomes. If a national emergency made it necessary to raise this proportion, the maximum admissible rate would be raised to the same figure; and it would be correspondingly reduced when the over-all tax burden was reduced. This would still leave taxation somewhat progressive, since those paying the maxmum rate on their incomes would also pay some indirect taxes which could bring their total proportional burden above the national average. Adherence to this principle would have the salutary consequence that every budget would have to be prefaced by an estimate of the share of national income which the government proposed to take as taxes. This percentage would provide the standard rate of direct taxation of incomes which, for the lower incomes, would be reduced in proportion as they were taxed indirectly. The net result would be a slight over-all progression in which, however, the marginal rate of taxation of the largest incomes could never exceed the rate at which incomes were taxed on the average by more than the amount of indirect taxation.
1. Hayek, F. A. The Constitution of Liberty. University of Chicago Press, 1960 pp 306-323