AN OPTIMAL OR COMPREHENSIVE INCOME TAX?

AN OPTIMAL OR COMPREHENSIVE INCOME TAX?

Graeme S Cooper"

The purpose of this paper is to pose one question - should the Australian income tax system of the twenty-first century belong to the descendants of Henry Simons or to those of Frank Ramsey? Put another way, my topic is whether future tax policy should continue to be framed according to notions of comprehensive income tax1 or, instead, should be directed towards the goal of an optimal income tax.2

It is clear that the Australian Treasury regards the Haig-Simons or comprehensive tax base tradition as the system implemented by the Australian income tax regime.3 It is also reasonably clear that, when allowed to reconstruct a definition of "income" free from the peculiarities of the way the meaning has developed in the Income Tax Assessment Act 1936 (Cth), (the Assessment Act), modem Australian judges understand this to be the concept they are pursuing.4 This is true even though, it has

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Associate Professor, Sydney University Law School. The use of this term springs from the work of Robert Haig as elaborated by Henry Simons. Haig's definition of income as the money value of the net accretion to economic power between two points of time was later elaborated by Simons as the sum of the value of consumption plus net accretion to savings during a period. See R M Haig, "The Concept of Income" in R M Haig (ed), The Federal Income Tax (1921); H C Simons, Personal Income Taxation (1938). For a general discussion of the Haig-Simons tradition, see H M Groves, Tax Philosophers (1974), ch 8; M Mcintyre, "Implications of US Tax Reform for Distributive Justice" (1988) 5 Australian Tax Forum 219 at 234-246. A similar definition of the meaning of optimal tax analysis is difficult to construct. An approximation of a definition will emerge in this paper from a discussion of the principal concerns of the style of analysis. See Australia, Tax Expenditures Statement 1993 (1993) at 1 and 55-60. The best example of this is seen in what is commonly referred to as default assessments where the administrator has to estimate the taxable income of a taxpayer without direct knowledge of the taxpayer's income; the process occurs precisely because the administrator disbelieves the information provided by the taxpayer. See, for example, L'Estrange v Federal Commissioner of Taxation (hereafter FCT) (1978) 78 ATC 4744. The case concerned the calculation of the income of a taxpayer assessed under an "assets betterment assessment". The calculation used by the Commissioner and approved by the judge was to reconstruct the taxpayer's income from his estimated consumption increased by net changes in the value of his assets, reduced by realised capital gains and increased by realised capital losses. Tht! last two adjustments were necessary because of the overlay of the lawyers' notion of income, and the structure of the Assessment Act at that time, which did not include capital gains. Now the similar calculation would require the elimination of fringe benefits and realised capital losses from the employee's income and the inclusion of realised capital gains.

1994 An Optimal or Comprehensivive Income Tax? 415

been argued, the Australian definition of income for tax purposes evident in court decisions can be traced to such unlikely sources as the English trust and proferty law of the nineteenth century and the English schedular system of taxation. Despite important adjustments made for administrative convenience,6 the Haig-Simons model is still the dominant force in tax reforms proposed by the Australian government?

And if one were to look beyond these shores, it is evident internationally as well as in Australia that the comprehensive tax base tradition remains the dominant leitmotiv in tax reform proposals. In the 1960s and 1970s, it influenced the Carter Commission in Canada,8 the Asprey Committee in Australia9 and the Blueprints proposal of the United

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SeeR W Parsons, "Income Taxation: An Institution in Decay" (1991) 13 Sydney L Rev 435. However, while the Australian income tax system may be based on the Haig-Simons concept, many important differences remain when the Haig-Simons net accretion concept of income and the notion of income actually legislated are contrasted. First, the tax base is different. The Haig-Simons definition clearly includes capital gains, gifts and windfalls, a proposition which has been excluded by the schedular approach to income, derived from the English system, at least as it has been interpreted by Australian judges. This approach need not have been taken and is quite contrary to our global income definition - a matter which the High Court acknowledged in State of South Australia v Commonwealth of Australia (1992) 92 ATC 4066, but decided was now too entrenched in Australian tax law to be capable of judicial rectification. See generally R E Krever, "The Ironic Legacy of Eisner v Macomber" (1990) 7 Australian Tax Forum 191. Secondly, the judicial income notion is also linked to a realisation requirement. In fact, so important is our realisation notion that the High Court in FCT v The Myer Emporium (1986) 163 CLR 199 managed to find income from the mere fact of realisation without either flow or gain to the taxpayer. With minor exceptions such as the trading stock valuation rules and depreciation rules, realisation was invariably required under the judicial notion of income, but, as our legislation becomes more sophisticated and Treasury exerts more direct influence over the direction of tax policy formation, realisation is seen as less important and more exceptions to the realisation requirement appear, for example, in the treatment of discounted bonds under Division 16E, the taxation of controlled foreign subsidiaries and portfolio offshore investments and the taxation of financial instruments. Realisation is a relic of the flow concept of income (which requires the severance of income from capital gain), not the accretion concept which is based on gain. Economists in the Haig-Simon tradition concede that it is necessary to have a realisation element in the definition in order for an income tax to be simple to administer, but as Parsons observed (above n 5), if one concedes the realisation requirement it means that the Haig-Simons net accretion tax as defined can never be implemented. Realisation is invariably required before income will be regarded as derived, and although (unlike the position in the United States) a realisation event is not a constitutional requirement, it is still invariably required in Australia. Thirdly, in the treatment of outlays, losses and expenses, it is necessary to exclude net dissavings from the income tax base but to leave consumption expenditure within the base. This means rules are needed to distinguish consumption from dissaving: is a home office, travelling, entertainment, child minding or a business lunch consumption by the taxpayer or an expense of earning income? The treatment of expenses generally gives rise to problems for the judicial notion of income because almost any expense can be related in some way to the derivation of income. These issues are discussed further below at 423-428. See, for example, Australia, Consultative Document, Taxation of Financial Arrangements (1993) at 5. The Document says: "The proposals in this document are directed towards a system for taxing financial arrangements that is more comprehensive ... " Royal Commission on Taxation, Report (1966) (the Carter Commission). Taxation Review Committee, Full Report (1975) (the Asprey Committee).

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States Treasury.l0 More recently, the almost universal tax reform strategy of the 1980s was the widespread reduction in marginal income tax rates accompanied by continued broadening of the income tax base.ll Praise for this strategy emphasised its impact in reducing tax-induced economic distortions on investment and work patterns, reducing the deleterious effects of high inflation rates in tax systems where rates and thresholds were generally unindexed, controlling tax evasion and unproductive investments in tax shelters and reducing pressures on administrators.12 These intended outcomes of the tax reform strategy were those generally attributed to the virtues of the comprehensive tax base tradition.

And in so far as the strategy was criticised, it was generally not because of any doubt about the wisdom of the comprehensive tax base model. Rather, most criticism was of the reductions to tax rates (rather than expansions of the tax base) and concentrated on the deleterious consequences of reduced levels of government revenue - the diminished ability of governments to provide sufficient public goods and to maintain sufficient spending levels in welfare programs, and the implicit accompanying shift in the tax burden away from the wealthy when marginal rates were uniformly reduced.13

Yet, despite its immanence, the comprehensive tax base orthodoxy is currently being challenged. As two commentators have put it: "[L]ess than two decades ago, there was a broad consensus among economists concerned with the design and reform of tax systems. Today this consensus has broken down.''14 The challenge to the existing orthodoxy comes from optimal tax theorists who have expressed quite radical, almost heretical, views on, for example, the desirable shape of the tax rate scale,15 the definition of the tax unit,16 and aspects of the tax base. That challenge has not gone entirely unnoticed. Indeed, it has produced a stout defence of the comprehensive tax

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United States Treasury, Blueprints for Basic Tax Reform (1977). For example, the top marginal income tax rates declined in the United States (50 per cent to 33 per cent), United Kingdom (83 per cent to 40 per cent), Canada (34 per cent to 29 per cent) and Australia (60 per cent to 47 per cent). The trend to reduce income tax worldwide, whether by decreasing marginal rates, increasing exemptions or adjusting thresholds, is discussed in a large literature. See, for example, R M Bird and S M Cnossen, Personal Income Tax: Phoenix From the Ashes (1990); M Boskin, "New Directions in Tax Policy" in M J Boskin and C E McLure (eds), World Tax Reform: Case Studies of Developed and Developing Countries (1990); V Tanzi, "Trends in Tax Policy as Revealed by Recent Developments and Research" (1988) 42 Bulletin for International Fiscal Documentation 97; J M Mintz and J Whalley (eds), The Economic Impacts of Tax Reform (1989). For a general survey of developments in Europe, see F Vanistendael, "Trends of Tax Reform in Europe" (1988) 5 Australian Tax Forum 133. See M Boskin, above n 11 at 3-4; C McLure, "Appraising Tax Reform" in M J Boskin and C E McLure , above n 11 at 282. See F Block et al, The Mean Season: The Attack on the Welfare State (1987); L McQuaig, Behind Closed Doors: How the Rich Won Control of Canada's Tax System (1987). W Hettich and S Winer, "Blueprints and Pathways: The Shifting Foundations of Tax Reform" (1985) 38 National Tax Journal423 at 423. See, for example, J Slemrod, "Do We Know How Progressive the Income Tax System Should Be?" (1983) 36 National Tax Journal 361; J K Seade, "On the Shape of Optimal Tax Schedules" (1977) 7 Journal of Public Economics 203. See, for example, P Apps, "The Tax Unit: An Australian Perspective" in J Head (ed), Taxation Issues of the 1980s (1983) 133.


base orthodoxy.17 Richard Goode, for one, has warned " ... that the most favourable assessment of the optimal tax literature on optimal tax rates that can be supported is that it offers a useful framework for discussion and debate [but he notes that] great caution on the part of writers and scepticism on the part of readers [is] appropriate:•18 Perhaps more cautiously, John Head has concluded that "no optimal tax paradigm has yet emerged which could serve as a really compelling alternative to the ... more general agnosticism of the Haig-Simons approach."19

The topic of this paper is that controversy and, although the question that I wish to discuss is easy to pose, like any question worth asking it is by no means easy to answer. While it may be that difficulties arise in part because it is premature to ask the question, I wi11 be arguing that the insights of the optimal tax literature are already of sufficient importance to provide a significant complement to the comprehensive tax base notion. But I will also argue that the optimal tax approach requires further philosophical grounding and more careful analysis if it is to be considered an adequate replacement for the comprehensive tax base notion. In order to avoid the challenge that "the results are not yet in" - that my question is indeed premature - I will not be concentrating principally on the methodology and outcomes of the optimal tax literature, although they are clearly of interest, but instead on the philosophical and ethical positions which underpin its approach. That is, I will be analysing the values and assumptions which are the foundation for the analysis. Finally, I will also argue that the optimal tax approach is focused on questions which are, on some occasions, so different from those raised by the comprehensive tax base theorists that the two schools are not alternatives which conflict; they are not presenting different answers to the same question, but rather are asking different questions.20

CONSTITUTIONAL CHOICES IN ALLOCATING THE BURDEN OF TAXATION

Before proceeding to analyse each school, it is important to recall that the controversy on which this paper will focus occurs within a framework in western societies which constrains both the comprehensive and the optimal tax analysis. In the popular imagination, taxation is often thought simply to be the way that governments finance their activities. This belief is accurate but incomplete: on the one hand, governments finance their activities by many means, of which taxation is only one,21 and, on the

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See, for example, R Musgrave, "The Nature of Horizontal Equity and the Principle of Broad-based Taxation: A Friendly Critique" in J Head, above n 16 at 27-32; J Head, "Tax Fairness Principles: A Conceptual, Historical and Practical Review" (1992) 9 Australian Tax Forum 65 at 84-99. R Goode, "Changing Views of the Personal Income Tax" in L Eden (ed), Retrospectives on Public Finance (1991) at 104. J Head, above n 17 at 97. Compare W Hettich and S Winer, above n 14 at 423. They say: "Careful analysis reveals elements in each approach that are missing from the competing traditions, but that will have to be part of any successful synthesis to be developed in the future." Governments will often finance particular activities through methods such as user-fees or charges which, some would suggest, do not meet the common definition of a tax even though they are taxes in most senses of the word. See C P Gillette and T D Hopkins, "Federal User Fees: A Legal and Economic Analysis" (1987) 67 Boston University L Rev 795 at 798 footnote 16. They say: "Fees may escape the rubric of taxes where they do not exceed the cost of providing the und~rlying service." A Atkinson and J Stiglitz, Lectures on Public


other, they use taxes for purposes beyond the mere raising of revenue.22 In modem societies, the fiscal system has become the means to many ends.

Governments must acquire the resources necessary to provide public services and to make transfer payments. They undoubtedly use taxes to finance these operations, but a government will seek, and must direct its attention to, more than the mere raising of revenue both when a tax is introduced and as it is periodically levied. If governments needed to be concerned solely with raising money to pay expenses, a benevolent government could perform this task simply by printing or borrowing the necessa~ money; a malevolent government could do so simply by confiscation or conscription. 3

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Economics (1980) at 19 observe, while discussing" ... those taxes (benefit taxes) and charges that are closely linked with particular government activity ... " that it " ... is debatable whether we should include gross measures of federal revenue or restrict ourselves to the net profit (or loss)." A definition which excludes user fees may satisfy a philologist and perhaps a lawyer for whom compulsion is of the essence of a tax, but not an economist for whom any leakage from the private sector to the public is the equivalent of a tax. For a discussion of the use of user-fees as a source of financing some government services, see House of Representatives Standing Committee on Finance and Public Administration, Not Dollars Alone: Review of the Financial Management Improvement Program (1990), ch 5. Similarly, much government activity is financed through borrowing. Public debt assumes a large role in financing the activities of government (among other tasks) as evidenced in many western economies currently attempting to deal with significant budget deficits. Many governments derive large amounts of revenue from their trading enterprises, while some receive foreign aid to assist in their general development or to finance specified projects. Finally, governments may simply create new money to buy their resources. It is through this combination of taxation, charges, borrowing, foreign aid, and the creation of new money, that governments finance their activities. See generally, J Stiglitz, Economics of the Public Sector (2nd ed 1988) at 45-59; R A Musgrave and P B Musgrave, Public Finance in Theory and Practice (4th ed 1984) at 219-20; C Shoup, Public Finance (1969) at 1. One may doubt whether, as a matter of history, taxes were ever viewed as mere devices for raising revenue. Certainly the tribute demanded by ancient Rome of its colonies served another function - the reinforcement of the subjugation already effected militarily. As Groves observes: "The taxes paid by the ancient Hebrews at the time of the birth of Christ were levied to take 40 per cent of the national income, most of which was for tribute to Rome. It was not without reason that the Hebrews dreamed of a Messiah who would free them from this load." H Groves, Tax Philosophers: Two Hundred Years of Thought in Great Britain and the United States (1974) at 13. Montesquieu also noted the role of taxes in subjugating conquered peoples while simultaneously spawning resentment against the conquerors. He observed that " ... the provinces were plundered by the knights, who were the framers of the public revenue ... [making] their oppressive extortions." Montesquieu, The Spirit of the Laws (T Nugent tr 1949) at 181 [Bk XI, ch 19]. He quoted from Mithridates who said: "All Asia ... expects me as her deliverer; so great is the hatred which the . rapaciousness of the proconsuls, the confiscations made by the officers of the revenue, and the quirks and cavils of judicial proceedings have excited against the Romans." Ibid. Indeed the similarity between taxation and confiscation is closer and more difficult to distinguish than most would care to admit. W Blum and H Kalven, The Anatomy of Justice in Taxation (1973) at 4 observe: "It is a fundamental proposition of our society, enshrined in constitutions, that private property cannot be taken for public purposes without just compensation; yet these same constitutions explicitly confer the power to tax. The similarity is obvious: there is a taking without just compensation in both cases." Others have also remarked upon the similarities between taxation and confiscation. G Brennan and J Buchanan, The Power to Tax: Analytical Foundations of a Fiscal Constitution (1980) at 8 say: "The power to 'tax' is simply the power to 'take'. If government wishes to obtain a


Instead, a tax is used first, because of the perceived undesirable fiscal and social consequences of adopting these or other practices, and, secondly, because governments recognise that taxes can perform other functions which they may be seeking to achieve.24

Taxes are used, often as blunt instruments, to achieve economic goals: stabilising the economy in order to moderate the consequences of changes in a country's production, encouraging or discouraging increased consumer spending, or stimulating reductions in unemployment and greater business investment.25 The burden of a tax, or the benefit of an exemption from a tax will often be a sufficient incentive to encourage a citizen or firm to undertake desired behaviour or cease other behaviour.26 Finally, governments will interfere with the economy and use taxes, particularly the income tax, to seek the deliberate redistribution of income and wealth.27

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particular piece of property, it is of no account whether it does so by direct appropriation or by purchase together with a tax imposed upon the original owner amounting to the full purchase price." However, seeR Epstein, "Taxation, Regulation, and Confiscation" (1982) 20 Osgoode Hall L J 433 at 453 where he argues that "while all forms of regulation and taxation are subtle forms of taking of private property, they are not necessarily confiscatory in and of themselves." C Allen, The Theory of Taxation (1971) at 23 observes: "Most descriptions of the aims of taxation start by saying that taxation is required to finance government spending. This is misleading. If that were all that was required of taxation, a benevolent government would abolish taxation and finance all its expenditure by printing money or borrowing it ... The aim of taxation is to reduce private consumption and private investment so that the government can provide social goods and merit goods to subsidize the poor without causing inflation or balance-of-payment difficulties ... The basic function of taxation, then, is to reduce the demands made by the private sector on the country's productive capacity." See also C Shoup, above n 21 at 452-454. See generally, J Pechman, Federal Tax Policy (4th ed 1983) at 836. The encouragement of some activity or transaction can be seen in provisions granting special deductions for activities which are perceived to be socially desirable such as the deduction of gifts to certain charities to encourage philanthropy, or accelerating depreciation rates and giving investments credits to encourage capital expenditures. Discouraging certain activity is also sought through taxation. For example, in the 1970s during the so-called "energy crisis" the United States attempted to discourage the waste of fuel through the tax system. See S V Hyatt, "Thermal Efficiency and Taxes: The Residential Energy Conservation Tax Credit" (1977) 14 Harvard Journal of Legislation 281. More commonly, incentives are provided in connection with other policies such as the private provision of retirement income, environmental conservation, and encouraging private investment, to name a few. See, for example, W Klein, Policy Analysis of the Federal Income Tax (1976) at 8. He says: "A strong case can be made for the use of the income tax for purposes of redistribution of income or, if you will, without regard to independent revenue needs." There is nothing particularly new in this use of the income tax. This was the contention of Adolf Wagner who argued that taxation could properly be viewed as an instrument for redistributing wealth within society, but the openness with which he acknowledged this was shocking to many nineteenth century theorists. He wrote: "Taxation can become a regulating factor in the distribution of national income and wealth, generally by modifying the distribution brought about by free competition. I stand firmly by this conception against all polemics. I should even go further now and say that this second, regulatory purpose leads to interference with the uses of individual incomes and wealth. The statement of this second purpose leads to an extended, or if preferred, a second conception of taxation. This is a


When a government has decided which goal or combination of goals it is seeking to achieve through the imposition of the tax, it must then decide how the burden of the tax is to be spread across society. In this respect, a tax system represents part of the constitutional framework of the State. Webber and Wildavsky express the idea as follows:

On the budgetary base ... rest the political pillars of society. An across-the-board attack on the budgetary base is equivalent to a revolution. Breaching the budget is equivalent to opening the boundaries of the social contract to renegotiation. The fundamenta~ priorities of the regime- who will be taxed how much for which purposes- are turned upside down.28

Consequently, the allocation of the burden of a tax is not entirely at the discretion of the government. In addition to substantive and political limitations, the constitutional framework of the state will often also dictate, at least in part, procedural requirements which limit the powers of government.29

And beyond constitutional and quasi-constitutional constraints, the ability of the government to design and impose a tax to achieve its goals fully and efficiently will also be constrained by other criteria on the basis of which others will judge the success of the tax.30 According to the traditional wisdom, the critical analysis of any tax is

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'social welfare' concept besides the 'purely financial' one." See A Wagner, "Three Extracts on Public Finance" in R Musgrave and A Peacock (eds), Classics in the Theory of Public Finance (1958) at 89. See generally, E R A Seligman, Progressive Taxation in Theory and Practice (2nd ed 1908) at 131-32; R A Musgrave, The Theory of Public Finance (1959) at 91-94. Deliberate redistributional goals are now arguably permanently enshrined in the form of the progressive rate structures common in the income tax laws of most western democracies. It should, however, be noted that there is, strictly speaking, usually no redistribution achieved by the income tax at least in so far as a lawyer's definition of "distribution" would require - the only exceptions being in the special cases of a negative income tax or a system of refundable tax credits. The closest that the income tax comes to establishing a distribution or redistribution of wealth is, first, in the way that tax expenditures can reinforce existing wealth distributions by not collecting as much as would otherwise be due from a taxpayer, and, second, in the way that preferential tax treatment afforded to some activities will encourage resources to be used in those activities and will benefit those individuals who undertake them. While it may be appropriate for economists to treat taxation as effecting the equivalent of redistribution of wealth and income, there is clearly a sense in which taxes do not do so. To make too much of the equivalence serves to obscure the fact that by far the more important redistribution occurs through the uses of funds collected through taxes. C Webber and A Wildavsky, A History of Taxation and Expenditure in the Western World (1986) at 31. See also J Head, above n 17 at 65 who says that "the tax system has long been recognised by political scientists as one of the most important economic and political institutions in a liberal democracy. It has a quasi-constitutional character in the sense that it remains in force, usually with only minor changes over a sequence of budgetary decisionmaking periods." See also G Brennan and J Buchanan, above n 23, ch 1. In Australia these manner and form conditions restrict, by procedural rules, the ability of government to enact tax laws which discriminate between States, to introduce tax legislation through the Senate, to impose more than one tax in any taxing Bill, or to impose taxes on subordinate levels of government. They are found in ss 51, 53, 55 and 99 of the Constitution. See, for example, A Smith, An Enquiry into the Nature and Causes of the Wealth of Nations (R Campbell and A Skinner, eds) (1981) Vol 2 at 825-827 [Bk V, ch 2, pt 2]. Smith's


usually undertaken by reference to the recognised canons of taxation- criteria which are usually reduced to three: equity,31 efficiency32 and simplicity,33 though some seek to expand this list to incorporate additional criteria,34 while others challenge the importance to be attached to even this conventional wisdom.35

Although the distinction between goals and constraints may not be clear (influencing economic behaviour, for example, is constructed as both a goal of, and

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formulation of his maxims of taxation (which were not original) has been followed subsequently by many others concerned with devising proper principles for tax imposition and administration. See generally, Asprey Committee, above n 9; Carter Commission, above n 8. A somewhat different formulation, offered by Sneed, differs from its predecessors by including obviously political concerns, such as reducing economic inequality, compatibility with free market systems, and maintaining the existing political order. See generally, J Sneed, "The Criteria of Federal Income Tax Policy" (1965) 17 Stanford L Rev 567. See also A Wagner, above n 27 at 11-12. The concepts underlying this criterion are two: first, that taxpayers who are in an identical position ought to be treated equally (horizontal equity) and, for those who are not in an identical position, the tax burden should differ, a heavier burden falling on those who meet some second order criterion, such as being better able to bear it (vertical equity). Some attempts have also been made to identify a temporal aspect of equitable tax treatment. See, eg, M F Bravman, "Equalization of Tax on All Individuals with the Same Aggregate Income Over the Same Number of Years" (1950) 50 Columbia L Rev 1; W Vickrey, Agenda for Progressive Taxation (1972) at 172-195; G Bale, "Temporal Equity in Taxation" (1977) 55 Canadian Bar Review 1. The criterion of economic efficiency requires that the base upon which the tax is levied should, unless otherwise intended, be economically neutral so that it does not distort the operation of markets in the private economy by influencing matters such as choices about goods and services to be produced, methods of trading, forms of investment and type of financing. Taxes may affect both allocative and productive efficiency. See A Smith, above n 30 at 825-828. According to Adam Smith, two distinct ideas are involved in the criterion of simplicity. One is that the liability to submit to the tax burden and the amount on which the tax is to be assessed should not be difficult to determine (certainty). The other is that the administrative costs associated with raising each dollar of revenue should be as low as possible. This includes both the taxpayer's compliance costs of providing the information necessary for the assessment to be made as well as the bureaucracy's costs of making the assessment and collecting the revenue. The more modern trend is to treat the problem of administration costs as an issue of efficiency: A Smith, above n 30 at 825-828. Financial stabilisation is often seen as a goal of the tax system, as is maintenance of the dominant political order. See generally, J Sneed, above n 30; C Webber and A Wildavsky, above n 28, ch 1. There has been much recent debate about the precise meaning of the principle of horizontal equity: whether it implies equality in the outcome of the taxing process or, instead, simply in providing rules which offer equal opportunities (or threaten equal costs) to all judged to be equal ex ante. The divergence between equality of opportunity and equality of outcome as a philosophic issue has never been resolved in the tax context. See, eg, G Brennan, "Horizontal Equity: An Extension of an Extension" (1971) 26 Public Finance 437; M Feldstein, "On the Theory of Tax Reform" (1976) 6 Journal of Public Economics 77; A B Atkinson, "Horizontal Equity and the Distribution of the Tax Burden" in H Aaron and M Boskin (eds), The Economics of Taxation (1980) 3; J Stiglitz, "Utilitarianism and Horizontal Equity: the Case for Random Taxation" (1982) 18 Journal of Public Economics 1; L Kaplow, "Horizontal Equity: Measures in Search of a Principle" (1989) 42 National Tax Journal 139; J Head, above n 17.


constraint upon, a government's decision to impose a tax) it is, nevertheless, obviously the case that a government does not impose a tax simply to impose a fair tax or even a simple tax. Rather, it imposes a tax for the many purposes already mentioned - for example, to raise funds for public purposes, to stimulate investment, to redistribute wealth from one group in society to another, or to reduce the advantage that one group enjoys under existing tax arrangements.

Governments ask a great deal of tax systems. It is not a sufficient goal for a tax merely to collect the desired revenue. It must do at least that, but the means adopted by the government will then be expected to conform as much as possible to the constraining criteria described. In other words, the means must be circumscribed- not necessarily to ensure a more effective accomplishment of the ends, but to conform to other criteria, extraneous, in some respects, to the task of raising revenue.

It is within the context defined by this tension between the goals and constraints c:onfronting its fiscal policy, that each government must decide how to answer the fundamental question: how is the burden of taxation to be spread across society?36 Like most important questions, this has received no answer of universal relevance, of eternal application, or one which commands unanimous support. And as we will see, the comprehensive tax base and the optimal tax school each provides insights into answering this question.

In the absence of clear and universal principles scrupulously and meticulously applied, the burden of taxation may, deliberately or accidentally, fall upon some individuals in society and not others, it may fall more heavily upon some than others, or it might happen to be allocated equally among all the citizens. Taxes may fall upon some because of the personal characteristics and abilities they possess, because of their behaviour, or because they own, use or consume, either by choice or through necessity, goods and services which the government has chosen to subject to tax. The polyglot combination of taxes which societies possess, with some falling equally, others unequally, some levied directly on individuals, others attached to various goods and services, reflects different conceptions of the way that the burden of taxation is to be spread across society.37 The proliferation of bases upon which taxes are levied shows

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This is termed a fundamental question because writers from Hobbes to Rawls have considered it one of the first that must be answered after the transition from the state of nature (either actual or mythical) to some form of society. Thus Henry Simons (above n 1) at 3 observed: "So long as poverty and insecurity compel the sovereign to employ every available fiscal device in order to maintain sovereignty, questions of justice are naturally subordinate. Once stable government, and a measure of economic freedom appear, however, considerations of equity are forced to the front. More revenue devices are available than are required. To what extent shall each kind of levy be employed?" It is important to note that the question can also be understood as an absolute or marginal question: how should the total burden of taxation be spread (perhaps including the deadweight loss of the tax), or how should the cost of this additional tax be allocated? See M Feldstein, above n 35 at 90-98 (stressing the distinction in tax analysis between tax policy made in the presence of existing rules as compared to designing a tax system ab initio). Some have argued that absolute principles of distributing tax burdens can never be formulated- the best that can be expected is that a set of principles be formulated which has "relative validity" which would be most likely to dictate different solutions according to whether economic or equity considerations were to be paramount. See A Wagner, above n 27 at 10-14. Edwin Seligman observed: "Our ideals of justice in taxation change with the alteration in social conditions. Not only the actual forms of taxation, but the theories of


the inability of western societies to develop and have confidence in a single base for allocating the burden of taxes. The adherents of the comprehensive and optimal schools offer conflicting arguments and divergent proposals for tax systems in which, they claim, societies can have confidence. Whether either is capable of achieving this is the subject of the remainder of the paper.

THE HAIG-SIMONS INCOME TAX

The theory of an income tax according to the Haig-Simons tradition is well known, but can withstand brief repetition here. The principal insight of the approach is its definition of personal income - it defines as income the net monetised gains accruing to a taxpayer during a tax accounting period.38 This concept is then measured by a further definition in which income (I) is observed as the sum of personal consumption (C) and net accretions to wealth (S) of the taxpaying entity (t), arising during the tax accounting period (p)· In algebraic terms, the equation can be expressed as:

Itp = Ctp + (Stp+ 1 - Stp)·

This is not the only feasible definition of income, nor the only one suggested by economists - other possible definitions had been proposed by Adam Smith, J R Hicks and Irving Fisher, for example,39 although other economists such as Lord Kaldor have lamented that "the problem of defining individual income ... appears in principle insoluble."40 I will return to one alternative conception later, but it is the centrality accorded this definition that makes it the most distinctive feature of the comprehensive tax base tradition.

The Haig-Simons model is used primarily in most Western industrialised countries because it is regarded by governments, and possibly by the populace as well, as a satisfactory indicator of taxable capacity- ability to pay. Whether that is clearly the case is, however, less certain. Indeed, it is one of the most important claims of the optimal tax literature that, when implemented, a tax on observed income as defined by this comprehensive tax base trp.dition can often operate as a poor measure of economic welfare.4l

But it would be a mistake to assume that these reservations about the comprehensive tax base being an accurate measure of ability are new. Even within the comprehensive tax base tradition, there were reservations expressed about its

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taxation as well, vary with the economic basis of society." E Seligman, Essays in Taxation (4th ed 1903) at 1. But the recurrence of the same themes in tax policy literature may suggest that the range of solutions which could have even relative validity is not openended. Compare D Bradford, Untangling the Income Tax (1986) at 148 where he says: "Identifying an improvement in tax equity is difficult because there is no single measure of fairness ... But there is room for reasoned argument on the subject." H Simons, above n 1. Other possible definitions of income are considered in R Goode, "The Economic Definition of Income" in J A Pechman (ed), Comprehensive Income Taxation (1977) 3 at 10. N Kaldor, An Expenditure Tax (1955) at 70. See for example, J Stiglitz, "Pareto-Efficient and Optimal Taxation and the New New Welfare Economics" in A Auerbach and M Feldsten (eds), Handbook of Public Economics, Vol 2 (1988) at 1021.


effectiveness, though perhaps before proceeding to its shortcomings, its strengths should be noted. The definition was clearly effective according to its terms to include as income many items that might otherwise have fallen outside the tax base - gifts, legacies, windfalls, gambling winnings, realised and unrealised capital gains, for example. In Australia, even realised capital gains fell outside the tax base until legislative intervention in 1985. This was the importance of the definition- that:

[N]o distinction is to be made between sources and uses of income. Gains may be factor earnings (e.g., wages, interest, rent) in the economist's sense, or they may be mere transfers (e.g., gifts or gambling); they may be expected or unexrected, irregular or regular, accrued or realized, from business or accident, and so forth.4

The definition also contradicted many deliberate exclusions from the tax base. Many savings and investment incentives would have to be eliminated from the income tax, since they inappropriately narrowed the tax base.43 So too did tax deductions for items of personal consumption such as charitable donations or medical expenses.44

But doubts remained about the feasibility and even the desirability of a truly comprehensive tax base. How should the income tax deal, both in theory and in practice, with less tangible and e':"en less quantifiable increments to net wealth such as the benefits inherent in government expenditure programs, especially those such as social welfare payments, education or health care, that deliver individualised benefits to specific recipients?45 In the prolonged debate conducted in the pages of the Harvard Law Review about the feasibility of implementing a truly comprehensive tax base, it was realised that the definition had many broader implications: for non-specific public services such as roads and national defence, for the repeal of a separate corporate income tax attributing instead all corporate earnings to the shareholders, and for complete accruals accounting for all income.46

Paradoxically, one reason that these doubts survive is probably the very success of the Haig-Simons definition - because it is so familiar and has proved to be so successful and pervasive, we have found it easy both to overstate how well the equation functions in practice as a definition of income, and to ignore its more general theoretical limitations.47 Were it not for the Haig-Simons notion, at a general and

42

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44

45

46

47

R A Musgrave, "In Defense of an Income Concept" (1967) 81 Harvard L Rev 44 at 47. This notion of the "tax expenditure" was elaborated inS Surrey, Pathways to Reform (1973) and S Surrey and P McDaniel, Tax Expenditures (1985). See also V Thuronyi, "Tax Expenditures: A Reassessment" (1988) 55 Duke L J 1155; M Mcintyre, "A Solution to the Problem of Defining a Tax Expenditure" (1980) 14 University of California Davis L Rev 79. See, for example, M Kelman, "Personal Deductions Revisited: Why They Fit Poorly in an 'Ideal' Income Tax and Why They Fit Worse in a Far From Ideal World" (1970) 31 Stanford L Rev 831. Probably the most vocal opponent of the comprehensive tax base tradition was Boris Bittker. See, for example, B Bittker, "A 'Comprehensive Tax Base' as a Goal of Income Tax Reform" (1967) 80 Harvard L Rev 925; B Bittker, "Comprehensive Income Taxation: A Response" (1968) 81 Harvard L Rev 1033. Boris Bittker's original argument was advanced in B Bittker (1967), above n 45. Replies followed from Richard Musgrave, Joseph Pechman and others. See R A Musgrave, above n 42; J Pechman, "Comprehensive Income Taxation: A Comment" (1967) 81 Harvard L Rev 63; C 0 Galvin, "More on Boris Bittker and the Comprehensive Tax Base" (1968) 81 Harvard L Rev 1016. Bittker's rejoinder was published as B Bittker (1968), above n 45. As Head puts it: "[Simons provides] a detailed conceptual and practical discussion of the income concept which has had a truly remarkable influence on practical tax policy analysis


intuitive level, a definition of income might be constructed which expresses an idea about the potential to use economic power, in contrast to the actual use of economic power (which is the idea of consumption).48 One common elaboration of the idea suggests that income is the amount that a taxpayer could consume without diminishing his or her wealth during the period, and perhaps maintaining this level of expected consumption in future periods as well. 49 In other words, income comes to be viewed as the actual product of a taxpayer's investment of his or her labour and capital,SO But what Simons offers is only tangentially related to these kinds of ideas.

48

49 50

Warren puts the difference well and it is worth quoting the passage at some length: Simons' ... concept is simply an arithmetical operation, designed to identify the change in a person's position over the course of an accounting period. It does not provide a standard for deciding whether a given receipt, transaction, event, or whatever is income in some abstract sense. Nor does the idea usefully illuminate the nature of some aggregate tax base, let alone the appropriate taxable unit or period, a limitation not always appreciated by either Simons' disciples or the denigrators of his formulation ... [The] concept is an essential but incomplete perspective on the nature of the income tax base. Specifically, the concept permits the interpersonal allocation or attribution of income to individuals ...

The Haig-Simons concept is necessary to identify personal income when a society wishes to implement a tax with personally graduated rates or is too complex to permit collection at source. The arithmetical process of the Haig-Simons definition should not, however, obscure the nature of the aggregate tax base, which is the product of the society's private capital and labor for the accounting period. The Haig-Simons calculation simply identifies how much of that product has ended up in each taxable unit. What is involved here is not merely a quibble about whether an idealized "definition" of income for personal taxation should focus on the required interpersonal accounting or on the product that is accounted for. Rather, both perspectives are necessary to answer properly

over the following half century. At the conceptual level, his net accretions or comprehensive income concept ... has long become accepted as the benchmark in the design of an income tax base." J Head, above n 17 at 75. See Institute for Fiscal Studies, The Structure and Reform of Direct Taxation (1978) (the Meade Committee) at 127-128. See the Meade Committee, above n 48 at 32-33. This definition was the notion underlying the definition of income adopted for the purposes of the United States income tax system by the United States Supreme Court in Eisner v Macomber (1920) 252 US 189. Pitney J at 207 referred to income as "the gain derived from capital, from labor, or from both combined." This definition was subsequently rejected in the 1950s by the Supreme Court as being too narrow in Commissioner v Glenshaw Glass (1955) 348 US 426. That Court decided (at 430) that the earlier definition "was not meant to provide a touchstone to all future gross income questions" and they replaced it with the definition of income as "an undeniable accession to wealth, clearly realised, and over which the taxpayers have full dominion." Despite these prevarications, the United States experience still compares tolerably well with the position in Australia where the first attempted definition expressed by the judiciary was that an amount was income if it was common to call it income. See Scott v Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215 at 219 where the Court said: "The word 'income' is not a term of art, and what receipts are comprehended within it ... must be determined in accordance with the ordinary concepts and usages of mankind."


questions about income measurement in a complex society, with neither concept having primacy over the other. 51

Warren's point is a good one- the comprehensive tax base tradition may serve well as a framework for measuring and allocating income; it serves poorly as a means of defining it.

Apart from its theoretical limitations, other reservations about the definition representing an accurate indicator of ability to pay came from the various concessions and accommodations that must be made in order to render the theoretical definition operable. For example, observed income even under the Haig-Simons sense includes only cash income and some property income- that is, amounts that are monetised and derived from market-based transactions. Welfare from self-provided services, leisure and potential income from assets have to be ignored because they are not separately quantified. Simons requires that there be "gain to someone during a specified period and measured according to objective market standards."52 So, although he concluded that, "if a man raises vegetables in his garden, it seems clearly appropriate to include the value of the product in measuring his income [and that] leisure is itself a major item of consumption,"53 yet he decided against including these items in income. To do so would be to propound an inoperable system. As he put it, while "income per hour of leisure, beyond a certain minimum, might well be imputed to persons according to what they might earn per hour if otherwise engaged ... it is one thing to note that such procedure is appropriate in principle and quite another to propose that it be applied."54

Curiously to a modern audience, Simons would have omitted from the tax base employee fringe benefits (which he referred to as "earned income in kind"). 55 He did so for two reasons, one being the clearly contingent argument of administrative expediency already mentioned. The other is more interesting. He supports the omission of fringe benefits because they largely represent consumption by the recipient - free accommodation, free private use.of a motor vehicle, free meals and so on. Since, he argues, other forms of self-provided consumption, most importantly services provided within the household and leisure, will also escape the tax base, omitting fringe benefits will operate to create a kind of symmetry with these omissions. Taxing only externallygenerated consumption in kind is a greater evil than omitting all consumption in kind. The observation is curious, because in approaching the issue in this way, he appears to be implicitly relying on a notion of second-best, a concept that will later prove to be pivotal in optimal tax analysis. He says:

51

52 53 54 55 56

The measurement of consumption also presents grave difficulties of principle, especially in the case of receipts in kind. These difficulties largely disappear in practice, however, when "earned income in kind" is exempted or disregarded; and the omission of such receipts is defensible not only as a concession to administrative necessity but also as a desirable offset to the disregard of leisure as a form of consumption. The measurement and inclusion of income in kind from consumer capital presents only minor practical difficulties which can be dealt with adequately.56

A Warren, "Would a Consumption Tax be Fairer Than an Income Tax?" (1979) 89 Yale LJ 1081 at 1084-1085. H Simons, above n 1 at 51. Ibid. Ibid at 52. Ibid at 111-12 and 206-208. Ibid at 206-207.


The last sentence shows that his reluctance to impute income from self-provided services and income in kind could be overcome, although he stops short of imputing income in kind from other assets. One of the greatest debates surrounding the comprehensive tax base tradition has been whether owner-occupiers would be taxable on imputed rent. Simons would have included this amount as income, although he goes to some pains to eliminate other types of income in kind from the tax base.

Clearly he now has a problem. One form of income in kind - employee fringe benefits - he has omitted for reasons of equity and administrative expediency, while another form of income in kind - the imputed rent from owner-occupied accommodation - he would include. He tries to reconcile the apparent contradiction by arguing that:

[I]n general terms ... the exemption of "earned income in kind" leads to no serious inequity in the distribution of the tax burden. Such income bulks large only in the case of classes exempt from tax or subject to only the lowest rates. Moreover this element of income probably shows rather little variation within income classes and diminishes in a fairly continuous manner as one ascends the income scale. 57

This is clearly a less than satisfactory basis for distinction. 58

Finally, some hesitancy about the desirability of a comprehensive tax base can be seen in the work of later theorists in the comprehensive tax base tradition who have been less robust than Simons in relation to the treatment of personal expenses. In Simons' theory, allowance would be made for the costs of earning income, but beyond that, most outlays would be allocated to the category of consumption, and therefore remain part of the tax base, although he acknowledged that "a thoroughly precise and objective distinction is inconceivable."59 But intuitively, at least, the differing claims upon a taxpayer's income indicate as much about their relative well-being as do the size of their receipts. Is individual A with $1,000 better or worse off than individual B with $1,500, but where B must spend $500 feeding B's much larger family? Not surprisingly, some subsequent commentators have sought justifications for permitting the exclusion from the base of items such as uninsured losses, medical expenses, and so on.60 A justification for these exclusions, consistent with Simons' firm resolve in relation to income, has proved hard to find.

The requirement that there be a "realisation" event is also an important concession that has to be introduced into the Haig-Simons tradition for reasons of administrative convenience. Simons required that amounts be received or controlled by the taxpayer during the relevant period. In fact, this element is pivotal and changes the nature of the tax fundamentally. It is the realisation proposition that turns an accretion-based notion (increases in wealth) into a transaction-based notion (realised gains) and changes the tax base from accretions to wealth to gains realised during a tax year. Other valuation

57 58

59 60

Ibid at 113. Emphasis in original. Compare B Bittker (1967), above n 45 at 948-949 who argues that the size of the exemption for imputed income in kind from personal property could be as substantial as other special exemptions which would have to be eliminated if a truly comprehensive tax base were to be implemented. H Simons, above n 1 at 54 and 74. See for example, W D Andrews, "Personal Deductions in an Ideal Income Tax" (1972) 86 Harvard L Rev 309.


issues such as changes in the value of money and interest rates also present problems for this definition.

In addition to these difficulties in implementing the ideal, its philosophical ancestry is somewhat difficult to trace. Simons spends a great deal of time discussing the roots of the ability to pay doctrine in traditional utilitarian philosophy, commencing with John Stuart Mill. He notes the various permutations of the theory, but he sneers that ability to pay is "a principle from which, as from a conjurer's hat, anything may be drawn at will."61 Even those most ardently in favour of the ability to pay principle as an adequate principle of equity acknowledge the enormous difficulties with basing the ability to pay principle on utilitarianism. Seligman concedes that the "imposition of equal sacrifice on all taxpayers must remain an ideal impossible of actual realization. "62 Because of those reservations, Simons wants to divorce his notion from traditional utilitarianism and the ability to pay notion.

But there is, in Simons' defence of his concept, the important elements of a theory which can be debated and, more importantly so far as governments are concerned, made operational. His approach emphasises and employs a general definition and then considers how that definition might be made to work. Clearly horizontal equity drives the theory and, as we will later see, also represents one of its major limitations. He seeks the same (or different) nominal dollar contributions as tax payments from equals, with equality of position evaluated according to the number of dollars apparent in either wealth or consumption. While he tries to include as many benefits as possible, treating the form of income as irrelevant for the purpose of differentiating between people, yet there is also the recognition that departures from the definition will be necessary for practicability.63 But Simons is often at his least convincing when describing the circumstances in which it is appropriate to draw these lines to accommodate administrative expediency - administrative expediency now becomes the second conjurer's hat from which justifications may be drawn at will. And it is then, perhaps, that a certain vague sense of scepticism arises and readers realise the apparent certainty and consistency of Simons' rhetoric masks more than a little judgment and opinion.

This brief repetition of some aspects of the comprehensive tax base tradition and some of its problems has, I hope, set the stage for the challenge of the optimal tax school.

OPTIMAL TAXATION

The challenge to the comprehensive tax base orthodoxy in the form of optimal tax theory has only developed in the last twenty years, even though its roots can be traced

61 62

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H Simons, above n 1 at 17. He comes to this conclusion because: "[S]acrifice denotes something psychical, something psychological. A tax takes away commodities which are something material, something tangible. To ascertain the actual relations between something psychical and something material is impossible. No calculus of pain and pleasure can suffice, for no attempt to reduce the heterogeneous to the homogeneous can ever succeed." E Seligman, above n 37 at 222. His subsequent revisiting of the issues in the 1950s was again largely concerned with practical and administrative issues. See H C Simons, Federal Tax Reform (1950).


back much further.64 The attention of the optimal tax approach to tax policy analysis has focused on the efficiency costs of various forms of income and consumption taxes. As a first approximation of its concerns, the optimal tax approach re-directs the nature and focus of tax policy debate away from the definitional and operational problems just discussed and toward generalised conceptions of social welfare of which the efficiency cost of taxes is a vital part. The obligation to pay taxes comes to depend, in this approach, principally on aggregate social goals - maximising social rather than individualised welfare- with social welfare defined and measured in several ways.

To speak of the optimal tax literature as one "school" is perhaps to attribute more coordination -and theoretical uniformity to the literature than is appropriate. Indeed, it might well be the case that the literature is best understood as a collection of papers which analyse a common problem and adopt a common methodology, rather than as papers that express a consistent and shared theory of taxation. One of my purposes in preparing this article is to draw together the themes that emerge from the papers and then to attempt to identify the shared elements of a unified theory of optimal taxation.

Perhaps the best way to commence this search for a unifying theory is to state the problem that the papers have set for solution. The problem is simple to express but enormous in its scope. How should a government act in designing and implementing its tax structures so that these structures best achieve three concurrent but conflicting goals: to produce the desired level of taxation; to collect it from the target groups of taxpayers within society, given that society's preferences about equality and inequality; and to collect the revenue using tax instruments that will minimise the loss in economic efficiency?65 It is the quintessential tax policy dilemma.

The genesis of the optimal tax literature is commonly attributed to the 1927 article by Ramsey modestly titled, "A Contribution to the Theory of Taxation",66 although some have noted that the literature is not quite this modem and owes much to an earlier generation of economists such as Dupuit and Pigou whose contribution has largely been forgottenP Ramsey poses his problem as: "[A] given revenue is raised by proportionate taxes on some or all uses of income, the ta~es on different uses being possibly set at different rates; how should these rates be' adjusted in order that the decrement of utility may be a minimum?"68 The reference to "uses of income" seems curious to a modem reader, but his purpose is actually to describe the optimal differential rates for commodity or consumption taxes, rather than differential rates for

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66 67

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The vast literature on optimal taxation was summarised in A Sandmo, "Optimal Taxation - An Introduction to the Literature" (1976) 6 Journal of Public Economics 37. For a more recent survey, see J Stiglitz, above n 41 and above n 21, ch 20. J Stiglitz, above n 21 at 480 says: "The optimal tax structure is the one that maximizes society's welfare, in which the choice between equity and efficiency best reflects society's attitudes towards these competing goals." F Ramsey, "A Contribution to the Theory of Taxation" (1927) 37 Economics Journal 47. See A Sandmo, above n 64 at 38-39; W Baumol and D Bradford, "Optimal Departures from Marginal-Cost Pricing" (1970) 60 American Economic Review 265; A Auerbach, "The Theory of Excess Burden and Optimal Taxation" in A Auerbach and M Feldstein (eds), Handbook of Public Economics (1988) Vol1, 61 at 61-62; R Musgrave, "A Brief History of Fiscal Doctrine" in A Auet:bach and M Feldstein eds, Handbook of Public Economics (1988) Vol1 at 28. F Ramsey, above n 66 at 47.


an income tax.69 In other words, he is trying to find the rates for consumption taxes at which the deadweight loss to society from the taxes is least.

The result he reaches is that "of two commodities, that should be taxed most which has the least elasticity of demand. "70 This proposition is the so-called Ramsey rule of taxes, commodity taxes imposed at rates inversely proportional to the elasticity of demand for the commodity to be taxed. Ramsey also generalised his result to taxes on the supply, rather than the demand, of commodities, such as excises. In this case, he observes, "taxes should be such as to diminish the production of all commodities in the same proportion.''71 The rule derived by Ramsey was a direct contradiction of the conventional wisdom in commodity taxation that a single uniform rate on all commodities is preferable.72

Ramsey's analysis was based on several simplifying assumptions.73 Most importantly for these purposes, he ignored any distributional concerns in framing the problem. That is, he eliminated from consideration the distributional consequences for the individuals who would consume the goods being taxed, and he did not consider how society's total welfare might be affected by the taxes imposed in the manner he suggested - how equity concerns and efficiency goals might be inter-related. Consistent with this, he also assumed that money has a constant marginal utility to all people and at all income levels.

In some senses, therefore, Ramsey's paper proposes the answer to a question that few would be interested in asking, at least as a determinative question. The distributional effects of such an approach were obvious since it implied tax rates on goods which might be considered necessities (say, bread or medicines) higher than those on luxuries (say, imported champagnes or pleasure boats) for which demand was most likely to be highly elastic. Taxes levied in this way might well minimise the efficiency loss, but society may well not attribute cardinal importance to this criterion, especially when it became apparent that the distributional consequences of taxes levied in this manner might be expected to be severely regressive. Not surprisingly, no little attention has since been dev0ted to the modifications of his general principle that would be necessary to make its distributional effects less dramatic.74

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He does, however, offer :,orne comments on the proper treatment of taxing the return to savings under an income tax. See F Ramsey, above n 66 at 58. Ibid at 58. Ibid at 54. It is interesting to observe that, in some quarters, the conventional wisdom has survived largely intact. The policies adopted by the Coalition parties at the 1993 election, described in their policy documents Fightback! (Liberal and National Parties, 1991) and Fightback! Fairness and Jobs (Liberal and National Parties, 1992) focused on a single flat rate VAT-style consumption tax levied at a rate of 15 per cent- precisely the kind of rate structure that Ramsey had criticised. The precise circumstances under which the Ramsey result holds are those in which other strict conditions are met (such as that there are no income effects and that cross-price elasticities are zero). See generally, A Atkinson and J Stiglitz, above n 21 at 366-93; J A Mirrlees, "Optimal Commodity Taxation in a Two-Class Economy" (1975) 4 J Public Economics 27; P A Diamond, "A Many-Person Ramsey Tax Rule" (1975) 4 J Public Economics 335. Compare A Atkinson and J Stiglitz, "The Structure of Indirect Taxation and Economic Efficiency" (1972) 1 J Public Economics 97 at 117 where they say that "the conclusion that


Ramsey's paper lay largely ignored for almost 50 years until two papers were published by Diamond and Mirrlees in 1971 in which they attempted to show the conditions under which both tax instruments and public production could be used as tools to increase social welfare?S In relation to tax structures, they extended Ramsey's analysis by deliberately incorporating the problem of income redistribution - that is, vertical equity concerns - while at the same time retaining Ramsey's concern with trying to minimise the efficiency loss caused by taxes. They stated:

Even in the absence of government revenue requirements, if lump sum redistribution is impossible, the government will want to use its excise tax powers to improve income distribution. It will subsidize and tax different goods so as to alter individual real incomes. The optimal redistribution by this method occurs when there is a balance between the equity improvements and the efficiency losses from further taxation?6

They began their analysis by examining only commodity taxes on consumption and production, but later extended it to consider the other tax instruments that are available to governments to raise revenue, such as income taxes. Rather than proceed laboriously through the succeeding literature, I want at this point to attempt to draw together the threads that emerge from the optimal tax literature in relation to income taxes to construct a view of both its philosophical assumptions and its goals. I realise that this is a teleological process of somewhat doubtful intellectual merit - defining a discipline according to its output - but it serves my present purposes and may be helpful as a heuristic device.

Let me begin by trying to refine the general steps in the analysis. The starting point for optimal tax analysis is the observation that communities and governments have concluded that individuals differ in characteristics which are considered relevant to the determination of their tax burden. Why these particular characteristics and not others are relevant as the basis for discrimination and making distinctions between individuals is not seriously addressed. They simply are treated as relevant, albeit for various unstated ethical reasons, and the unequal possession of these characteristics dictates unequal tax burdens.

In one sense, taxes must be based on such characteristics because there is no alternative. In a truly Panglossian first-best world - in an economic sense, where markets operated perfectly to ensure efficient production and allocation, where everyone had perfect information and there were no externalities in production or consumption and, in a political sense, where all were equal and considered equal -necessary government revenue could be collected by a large lump sum tax exaction imposed unannounced and once only, and collected equally from all, without regard to the characteristics of individual taxpayers. Government policy would be "taxation by surprise"- no-one could plan their affairs with a lump sum tax in mind and so no one would adjust their behaviour to avoid it. The tax would be the economist's ideal non-

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goods with a low income elasticity should be taxed heavily brings out very sharply the conflict between equity and efficiency considerations. The recognition of equity objectives would be expected to lead to important modifications of the conclusion." P A Diamond and J A Mirrlees, "Optimal Taxation and Public Production I: Production Efficiency" (1971) 61 American Economic Review 8; P A Diamond and J A Mirrlees, "Optimal Taxation and Public Production II: Tax Rules" (1971) 61 American Economic Review 261. The seminal paper on optimal taxation of income is J A Mirrlees, "An Exploration in the Theory of Optimum Taxation of Income" (1971) 38 Review of Economic Studies 175. P A Diamond and J A Mirrlees, above n 75 at 9.

432 Federal Law Review Volume22

distortionary tax and the first-best economic environment would be untainted by the effects of the government's need for revenue?7

Unfortunately for the revenue authorities, such a tax system is not possible because the first-best world does not exist in either the economic or political sense alluded to above. Because individuals differ in ways considered relevant by the populace, so must their tax burdens. It is an important limitation for tax design recognised in the literature that taxes which are either too uniform (poll taxes, for example) or are insufficiently uniform (for example, taxes which vary according to genetically determined characteristics) will lack political acceptability. Optimal tax analysis describes these relevant differences - the characteristics with respect to which taxes will vary - as utility. Unlike Simons, who expressed the clear preference for making tax liabilities differ with respect to money, optimal tax analysis prefers the less definable notion of utility. This creates a problem in that utility, unlike money, is not directly observable. Hence, screening methods have to be devised which attempt to identify utility indirectly from other attributes (of which money may be one) which are observable. The important problem for tax policy-makers is that governments cannot easily and without cost recognise all of the relevant characteristics which would allow them to impose a large non-uniform lump sum tax, nor, more realistically, several recurring taxes at different rates for different individuals?B So, alternatives must be found. Stiglitz expresses the problem thus:

It is sometimes assumed that lump-sum taxes are not feasible. Uniform lump-sum taxes are clearly feasible (provided they are not too large). What is not feasible are lump-sum taxes at different rates for individuals of different abilities?9

The non-feasibility of non-uniform and non-distortionary taxes comes from several sources. One is the problem of insufficient readily discernible information to identify utility and the administrative complexity of eliciting further relevant information on which to base the tax. In addition, governments cannot employ a one-off tax exaction to finance all future revenue needs because the current generation would not agree to the imposition of such a tax to finance all future generations. In short, governments face the practical problems of inadequate information, imposed non-uniformity and recurrence.

Having abandoned undifferentiated lump-sum taxes as infeasible, and recognising that surrogates for the target characteristic of utility have to be found as the base for the tax, it is then generally admitted that the use of surrogates is likely to create a deadweight cost to society. That deadweight cost will arise where individuals can control, to some extent, the manifestation of these surrogates and choose to do so in order to avoid the tax. A tax based upon surrogate characteristics will not be neutral where their manifestation is within the control of the individual. It is an exquisite irony

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It is curious to remark in passing the almost universal assumption that any tax that changes behaviour is inefficient and, therefore, to be avoided. Of course, in other contexts such as Pigovian carbon taxes to reduce pollution, taxes are advocated precisely because they change behaviour and increase efficiency. See A Sandmo, above n 64 at 38: "Although lump sum taxes can be envisaged in the context of a once-and-for-all levy, it is much more difficult to imagine such taxes as a permanent system." See J Stiglitz, above n 41 at 1006. Emphasis in original.


that in a first-best world an income tax would not be used, and by using an income tax we guarantee that we do not have a first-best world.80

There is also then the further problem, with both equity and efficiency implications, which arises where the surrogates chosen are only imperfectly correlated with the target characteristics in which the government is most interested. Individuals who possess the surrogate in abundance will be taxed more heavily than those with less, even though both possess the target characteristic in equal measure.

Applying these observations as a background, the optimal tax approach to income taxation emphasises the distortionary effects of defining (and therefore taxing) only observed and monetised accretions as "income". Instead, the question is asked whether other indicators exist which are both more perfectly correlated with the characteristics upon which the decision to impose differentiated tax burdens has been based, and which are also less distortionary when selected as the basis for taxation. As Stiglitz puts it:

[Because] measured income can be viewed as a noisy signal of true income ... it should be possible to show that if it is a noisy enough signal, then it will not be desirable to differentiate among individuals on that basis.81

At this point it is worthwhile pausing to sum up the argument so far. Atkinson and Stiglitz observe:

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The general problem of taxation of individuals may be posed as follows. There are a large number of people in any economy who differ with respect to a number of characteristics, in particular their endowments and tastes. On the basis of certain ethical premises, it is decided that individuals with different characteristics should pay varying amounts of tax. If we could observe these characteristics costlessly and perfectly, that would be the end of the analysis: we would simply impose a lump sum tax on individuals, with the amount differing according to their characteristics. The theory of optimal taxation would then be concerned simply with deriving, on the basis of specified ethical premises, what the relationship between characteristics and taxes "ought to be". It is the difficulties associated with observing characteristics which makes the theory of taxation an interesting and difficult problem. The theory may be seen as being concerned with the choice of certain easily observable characteristics which are related systematically to the characteristics in which we are really interested. It is thus part of what has come to be called the "theory of screening". The use of these surrogate characteristics gives rise to a number of problems ...

(1) Many of the characteristics which may be used for screening are, at least to some extent, under the control of the individual, and basing a tax on these is inevitably distortionary.

(2) Almost all characteristics which may be used for screening are imperfect; that is, the surrogate characteristics employed to determine tax liability are not perfectly correlated with the characteristics with which we are really concerned.

(3) There are costs (e.g. of administration) associated with even non-distortionary screening systems.82

J M Dodge, The Logic of Tax (1989) at 288-89 says: "An income tax simply can't exist in a Pareto-optimal world. Even the broadest-based income tax will distort some economic decisions such as that between working for wages and leisure or self-provided services." J Stiglitz, above n 41 at 1021. A Atkinson and J Stiglitz, "The Design of Tax Structure: Direct Versus Indirect Taxation" (1976) 6 J Public Economics 55 at 56-58.


This description of the problem sets the stage for the quest for the optimal tax structure, meaning, the tax or combination of taxes and tax rates which maximise social welfare83 - that is, the tax system "in which the choice between equity and efficiency best reflects society's attitude toward these competing goals."84 This is the optimal tax structure and it depends crucially upon the description of the social welfare function to be maximised which is employed in the analysis.

Social welfare must itself be derived from a logically prior notion - individual welfare. In Mirrlees' original model, an individual's welfare is determined exclusively by utility derived from two items - the amount that an individual consumes (C) and the amount of leisure the individual enjoys (L). Other factors, such as good health, a stable family setting, a rewarding job or enjoying the climate, which might be considered relevant were a more thorough measure of an individual's welfare to be attempted, are ignored.85 The individual's welfare (U) is thus defined:

U= u(C,L)

In other words a person's total utility is a function of the individual utility of each of C and L. Individuals will maximise their individual welfare by choosing the combination of leisure and consumption that yields the highest outcome. For the workaholics of the world, this will be achieved by working long hours (lowering L) in order to have more money with which to consume (increasing C). For beachcombers, greater utility will be achieved by working few hours (increasing L) even if it means having little money to consume (lowering C). Since it is social (rather than individual) welfare that is the object to be maximised, the analysis must then focus on specifying what social welfare means. And there is also the more difficult process of defining how we can move from individual welfare, measured as defined above, to social welfare.

Social welfare is not as easy to define as individual welfare. In one sense, that difficulty arises because social welfare is a normative construct of a different order from individual welfare. By definition, individual welfare will always be increased if individuals have more of both consumption and leisure.86 This is a descriptive observation. Societies, however, are less easy to categorise and we must revert to normative theories about what makes societies better or worse places for their

83 84

85

86

J A Mirrlees, above n 75 at 178. J Stiglitz, above n 21 at 480. Compare A Sandmo, above n 64 at 37, who says that "the optimal tax system is the one which minimises the aggregate deadweight loss for any given tax revenue or level of public expenditure." Stiglitz' definition is a more comprehensive formulation of optimality incorporating equity considerations, while Sandmo's earlier formulation was directed toward the single issue of efficiency. It is also assumed that consumption and leisure have declining marginal utility, that they are both greater than zero and that the U curve is strictly concave. Making the observation that individuals differ in endowments and tastes then creates other problems for the models and welfare functions which are proposed on an assumption that all individuals are identical. The point is often made in the literature that if it is simply assumed that all individuals are identical and have the same welfare function, a government could simply impose uniform lump-sum taxes on individuals with no loss of welfare. The problems arising from the assumption that individuals have the same utility function -that they have identical tastes and preferences - has been remarked upon in the literature. See generally, J A Mirrlees, above n 75 at 176. Although, of course, if more factors were admitted into the definition, the individual might prefer more of something else in preference to either.


citizensP The factors that might be considered relevant would include individual liberty, the level of democracy, the amount and distribution of wealth, the population size, the level of education, and so on. In optimal tax analysis, social welfare is constructed on the assumption that social welfare is determined solely by the individual welfare of the citizens that constitute it and thus social welfare comes to depend indirectly also on consumption and leisure.

But, having determined what items will constitute social welfare, the move from individual welfare functions to the single social welfare function is not obvious. In other words, social welfare might be constructed from individual welfare in many ways. In order to determine the level of social welfare, individual welfare might simply be added, the welfare of some people might be weighted, or the welfare of some might be given absolute priority. In other words, social welfare might be greatest when the sum of the raw numbers is greatest, when the sum of the numbers weighted in a particular way is greatest, when the number for one group is greatest, or when the individual numbers are equal. These possibilities are utilitarian (weighted or unweighted), Rawlsian or egalitarian social welfare functions. A utilitarian social welfare function seeks to maximise the sum of the individual welfare functions of all individuals and may involve ascribing relative weights to the welfare of different individuals. An egalitarian welfare function seeks to minimise the difference in utility between individuals, while a Rawlsian social welfare function would seek to maximise the welfare of the least well-off individuals and groups in preference to all others.88

At this point the analysis embarks upon complex mathematical processes not relevant for this discussion. The hope for those processes is to try to identify tax structures which would produce sufficient revenue to meet government expenditures and then both maximise social welfare using a preferred social welfare function and minimise the deadweight cost to society of the tax, given information about wage levels and assumptions about the rate at which substitution between consumption and leisure will occur.

COMPETING PHILOSOPHIES OF TAXATION

The optimal tax approach to the allocation of the burden of taxation stands in marked contrast to the comprehensive tax base approach in many important respects. In this section I will try to draw out some of these philosophical differences.

At first glance, it might appear in the light of the discussion in the two previous sections that there is little common ground between the two schools. The problems set for solution, the approaches to finding solutions, and the methodology and terminology used seem so dissimilar that finding an area in which both schools have something (and something contradictory) to say might appear impossible. Take, for example, the divergent topics that appear to be the principal focus of attention. As a broad generalisation, the Haig-Simons tradition appears to be concerned with defining an appropriate tax base, while optimal taxation might seem concerned with the appropriate

87

88

See J Bankman and T Griffith, "Social Welfare and the Rate Structure: A New Look at Progressive Taxation" (1987) 75 California L Rev 1905 at 1948-1949; R Dworkin, '"Is Wealth a Value?" (1980) 9 J Legal Studies 191. See generally, J Stiglitz, above n 21 at 405-409; A Atkinson and J Stiglitz, above n 21 at 339-343 and 394-397.


tax rates to be applied to an assumed base. This difference can be seen in Ramsey's initial statement of his goal - to define the proportional tax rates at which the diminution in social welfare is kept to a minimum - which can be contrasted with Simons' goal:

We must now face the task of defining "income" ... Since it is widely agreed that income is a good tax base, its meaning may be sought by inquiring what definition would provide the basis for most nearly equitable levies ... Income must be conceived as something quantitative and objective. It must be measurable; indeed, definition must indicate or clearly imply an actual procedure of measuring.89

In one sense, putting the tension between the two schools as a debate not fought on common ground might suggest that the two schools are not really in conflict at all -because they concentrate on different aspects of implementing an income tax, it might be doubted whether they would actually ever join issue on a common problem so that if any disagreements do emerge, they are perhaps understandable, but are likely to be peripheral to their main concerns. After all, the notion of the tax base and the tax rate, like the definition of the tax unit or the accounting period, are vital issues, but they are not the same issue.

I think, however, that the tension between the two schools is real and it goes rather deeper than this first glance might suggest. That is because the true nature of the disagreement does not appear as long as the focus of each school is constructed as being concerned either with the tax base on the one hand, or tax rates on the other. While the focus of each can be stated reasonably accurately in this way, it is not an exhaustive statement, nor does it disclose why that particular issue is important to each school. In other words, choosing to focus on that aspect of a tax system says something more profound about the eoncerns of the school than its immediate focus would suggest.

Competing Principles of Tax Equity One real tension between the two schools is in relation to equity issues. In the comprehensive tax base, there is very little explicit reference to the problem of vertical equity. Instead, the focus is on the comprehensive tax base as a solution to the problem of horizontal equity. For example, Simons' famous definition is primarily an attempt to measure the relative position of individuals, and it does so by observing their consumption and the net accretions to their wealth. But Simons' analysis does not tell us how to provide different treatment for two individuals who have different incomes. It contains no explicit solution to the issue of vertical equity, although he does have a lot to say, tangentially, about progressivity, redistribution and vertical fairness in the tax system. Indeed, he begins his work with a scathing recital of doctrines he regards as maintaining "a ~retence of rigorous, objective analysis, untinctured by mere ethical considerations"9 - the equal absolute-, equal proportional-, and minimum totalsacrifice doctrines drawn from utilitarianism. Yet, he clearly has little more to offer beyond his own conviction that "the case for drastic progression in taxation must be rested ... on the ethical and aesthetic judgment that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or

89 90

See H Simons, above n 1 at 41-42. Ibid at 1.


unlovely.''91 In so far as Simons' analysis tried to solve the problem of measurin~ and implementing notions of vertical equity, this has to be left to the political process.9

Indeed, even within its own sphere of analysis, the horizontal equity argument advanced through the income definition is what might be regarded as an ex ante, rather than an ex post analysis. That is, there is a fundamental but unaddressed dilemma in seeking to apply a criterion of horizontal equity in a tax context, namely, whether the focus is to be on equality in the outcome of the taxing process or, instead, simply on providing rules which offer equal opportunities (or threaten equal costs) to all judged to be equal (because they possess the same income) ex ante. The distinction I am trying to highlight is the divergence between equality of opportunity and equality of outcome. What Simons provides is a metric of equality of opportunity. Not only has the divergence between equality of opportunity and equality of outcome as a philosophical issue never been successfully resolved in the tax context, it has probably lingered longer and been more deeply submerged in tax analysis than elsewhere.

More modem formulations of the notion of horizontal equity emerging from the optimal tax literature have sought to focus on the outcome of the taxing process: that taxes should leave those who are equal in the absence of the tax still equal after the tax is imposed.93 The comprehensive tax base tradition still seems most concerned with ensuring that equal amounts of tax are collected from those judged equal before the tax is imposed.

The optimal tax analysis has also offered a new critique of the traditional notion of horizontal equity on which the comprehensive tax base rests. As already mentioned, Simons' case for progressive tax rates rested upon a judgment that the distribution of wealth and income in our society showed a level of inequality which was unacceptable ("distinctly evil or unlovely" to use his words.)94 But, as Kaplow has noted, that argument proves too much, since it must also be true that, as between ex ante equals just as for ex ante unequals, the prevailing distribution of wealth and income reveals a degree (and/ or kind) of inequality which is distinctly evil or unlovely.95 In Head's words:

If vertical equity is conceived, following Simons, in terms of a degree or kind of inequality which is entirely arbitrary and lacks any moral justification, how can it follow that pre-tax equals should be treated equally? Their equal incomes could well reflect some type of economic injustice which could in principle be corrected by some appropriate degree or kind of horizontal discrimination in the tax system.96

It was always a major omission of the comprehensive tax base tradition that it had little to say about vertical equity. Indeed, the amount of time Simons spends debunking the utilitarian calculus which had attempted to gamer support for progressive taxation

91 92 93

94 95 96

Ibid at 18-19. Compare W Hettich and S Winer, above n 14 at 424. SeeM Feldstein, above n 35 at 83. CompareD Bradford, above n 37 at 148. Bradford says: "Those with better opportunities than others should be expected to bear relatively more of the tax burden." The resolution of this dilemma between basing taxes on opportunities or outcomes is seen in the optimal tax literature in the emphasis given to trying to tax endowments such as earning potential rather than the outcome of earning in reported wages. See generally, D Bradford, above n 37 at 154-57 and 167-69. H Simons, above n 1 at 19, quoted more fully three paragraphs above. L Kaplow, above n 35. J Head, above n 17 at 87.


undermines his own even more feeble arguments in its support. The formal incorporation of vertical equity into tax analysis overcomes one of the major problems for the comprehensive tax base tradition- to identify how unequally to treat unequals. But by also clouding the horizontal equity notion, the optimal tax critique shows just how tenuous is the apparent certainty of our notions of equity in taxation and Adolf Wagner's scepticism about deriving anything more concrete than culturally contingent and politically-acceptable compromises is vindicated.

Equity and efficiency Further, within most of the comprehensive tax base tradition there is no explicit ordering of priority between equity and efficiency goals. Simons was himself aware of the problem - he noted that "the effect of a higher degree of progression in taxation upon the distribution of income is certain; the effect upon production problematical."97

l11.deed, he goes further and specifically acknowledges that the pursuit of equity will inevitably reduce efficiency. In his judgment, "if reduction in the degree of inequality is a good, then the optimum degree of progression must involve a distinctly adverse effect upon the size of the national income. "98 But there is no concerted attempt within the comprehensive tax base tradition to resolve the competing demands of equity and efficiency.

The one notable exception to this statement appears in the report of the Carter Commission which directed a strict sequential ordering of equity and efficiency concerns- that equity issues were always to be given first priority, so that no trade-off between equity and efficiency was possible. The report stated:

[W]hen faced with these hard choices [between competing equity and efficiency goals] we have consistently given- the greatest weight to the equity objectives ... We are convinced that scrupulous fairness in taxation must override all other objectives where there is a conflict among objectives.99

But with this exception, under the comprehensive tax base tradition, it is not too great a simplification to suggest that efficiency was largely subsumed by other aspects of the analysis. Perhaps it is more accurate to say that, in so far as efficiency concerns were elaborated, they were based on a neutrality notion that was largely unsophisticated from an economic perspective, but made some sense as a statement of political neutrality. The efficiency notion of the comprehensive income tax base was that of allocative neutrality. The simplest analogy is with the single rate consumption tax- if everything is taxed at 15 per cent there is no incentive to shift resources to an untaxed option because no such alternative exists. It was not the Ramsey efficiency notion. As noted above, his point was that a tax at a uniform rate which applied to everything is likely to be more rather than less distortionary because firms or individuals still produce (or consume) goods with low and high supply (or demand) elasticities. Even if we are operating within a world where no non-taxable alternatives exist, which was the goal of comprehensivity, the latter group will be more greatly, affected by the flat rate tax than the former group.

By concentrating on issues of horizontal equity, and one version of horizontal equity at that, the comprehensive tax base tradition has had little to say formally and from

97 98 99

H Simons, above n 1 at 19. Ibid. Carter Commission, above n 8, Vol1 at 4.


within the confines of the theory about another major element of tax design - how to integrate and deal with the equity-efficiency trade-off. It is precisely this omission that optimal tax analysis takes seriously. In relation to the integration of both equity and efficiency issues, much attention is focused in the optimal tax literature on the appropriate social welfare function to be used and the incorporation of substitution possibilities is explicitly included to attempt to quantify the efficiency-equity trade-off.

Identifying taxable capacity

Another fundamental difference between the two schools, and one that is related to the notion of the tax base in each, is the description of how taxable capacity is to be understood and measured. Consider, for example, the observation of Atkinson and Stiglitz that "the necessity for any form of taxation other than a uniform lump-sum tax arises from the fact that individuals have differing characteristics (endowments or tastes ).''100 The analysis assumes unequal tax burdens, with the inequality being based upon differences in certain as yet unidentified characteristics, endowments and tastes. And as they tellingly observe "the treatment of, say, optimal excise taxation in a world where individuals are assumed to be identical is at best of limited relevance."101

Clearly according to our political traditions, individuals do differ and in ways that are considered relevant for tax purposes, but optimal tax analysis does not offer any justification for the importance of differences based on particular endowments nor help in identifying when endowments are relevantly different. Nor does the literature explain convincingly which differences are relevant to the determination of an individual's tax liability and how relevant differences are made operative. Try answering the questions using, as an example, the tax advantages given in some countries for people who suffer visual impairments. Why is suffering visual impairment relevant to utility when genetic differences such as Bright's disease are not? Where is the sighted/visual impairment border to be drawn for tax purposes? More fundamentally, why is suffering visual impairment considered relevant for tax purposes? And should suffering visual impairment entitle a person to a deduction or credit and of how much? Optimal tax offers no answers to these definitional questions from within the confines of the theory.

In this respect, optimal tax analysis resembles the ability to pay calculus of all utilitarian theories, dependent upon ethical precepts corning from outside the scope of the theory itsel£.102 In order to know why we think someone with Bright's disease is better off than someone who is blind (as a society implicitly does if it only gives tax relief to the latter) we need views about rights/ entitlements/merits/ deserts of individuals. Optimal tax theory does not give us this information. It just assumes that society makes these decisions somehow and the analysis then proceeds from that ~oint. Indeed, there is a general silence on what is often referred to as "admissible taxes" 03 -

100 . 101

102

103

A Atkinson and J Stiglitz, above n 82 at 74 . Ibid at 57. It is also not self-evident why tastes should be considered relevant to the determination of relative tax shares. Compare B Bradford, above n 37 at 148 (admitting only endowments, or "opportunities" as he puts it, as relevant to determining the individual's tax share). See, eg, J Stiglitz, above n 41 at 1011. Stiglitz says: "There is no agreement about how to define the set of admissible tax structures." Interestingly, Stiglitz goes on to define the constraints on admissibility as coming from technological and administrative limitations, not from notions of social equality.


that is, which taxes are within the boundaries set by constitutional, political, administrative and other constraints. Of course, the solution adopted by the comprehensive tax base tradition is not really a solution- its decision is to ignore such issues and opt instead for the more "general agnosticism"104 described below.

The comprehensive tax base tradition stems instead from classical liberalism with its emphasis on equality, not difference, and personal liberty. Indeed, Simons himself went to great pains to try to make a case for equality in the application of the tax process, rather than equality in its outcome. He claims that he is cEromoting "fairness between and among persons of similar economic circumstances."1 This is clearly emphasising horizontal equity and his famous definition is best understood as an attempt to provide a more thorough measure to identify similarly placed individuals.

Optimal tax analysis is thus concerned to assert exactly what Simons tried to deny - the use of a generalised notion of utility as the basis for imposing taxes with the concomitant issues of defining utility and, in particular, which endowments, tastes and characteristics go to make up utility. Simons was instead in favour of a vastly more pragmatic approach which concerned itself only with money. If a tax is to be levied it must be based on something much more concrete than well-being - as Simons has intimated, personal income has nothing to do with sensations.l06 Remember that he was not even prepared to include employee fringe benefits in his tax base, partly because they were not monetised. And while he was prepared to concede that money is only an imperfect measure of an individual's income because of fluctuations in the value of money, he was not prepared to abandon its foundational role. For Simons, monetised income alone was the best measure of taxable capacity for an income tax.

And this is clearly where the debates fundamentally part company. Simons took a tax on income as a self-evident good and then tried to propound a definition that would identify exactly what constituted the base of that tax. Optimal tax analysis accepts no such limiting assumptidhs. For its purposes, there are a variety of possible tax bases (some of which go by the generic name income tax) and the ones that are to be used are chosen because of their ability to meet generalised conceptions such as utility and to deliver enhanced social welfare outcomes. The optimal tax inquiry is therefore much more wide-ranging than Simons' own task. It is clearly not concerned predominantly with attaching meaning to labels such as "income". Rather, optimal tax is perhaps better described as being concerned with establishing a "utility tax" and this implies the survey of a variety of tax bases and tax rates which individually or in combination will lead to the greatest social welfare. The difference is well summed up by Head:

In stark contrast to the comprehensive tax approach of the Haig-Simons school ... the practical ideal which emerges from optimal tax analysis is clearly one of selectivity and non-uniformity.1°7

And how would the utility tax differ from Simons' income tax in identifying taxable capacity? The optimal tax might include non-monetised amounts (such as amounts . received in kind); the base of Simons' tax would not. The base of an optimal tax might include non-market or self-generated transactions (such as imputing income from

104 105 106 107

J Head, above n 17 at 97. H Simons, above n 1 at 205. Ibid at 49. J Head, above n 17 at 88.


leisure); the base of a Haig-Simons tax generally would not. The base of an optimal tax would include potential income amounts; the base of a Haig-Simons tax would generally not (requiring actual derivation).

And underlying all these decisions would be the question, requiring a unique answer for each situation and on each occasion, whether a tax on this possible base to be levied at this possible rate, would enhance social welfare. Should labour and capital income be taxed in preference to (or in combination with) consumption? Should labour income be taxed differently from capital income? Should male labour income be taxed differently from female labour income? Should male labour income be measured by reference to wages actually received or an hourly wage rate which might be earned? Should male income, measured by an hourly rate, include hours spent in leisure? This is a long voyage from the concerted reductivism of Simons.

The politics of taxation Finally, I want to look a little more closely at the implications of the discourse of each school for what might be termed the politics of taxation. That is, how would the constitutional tax debate be conducted under an optimal tax rubric? I have already noted that the importance to be attributed to efficiency concerns clearly differs under each school and even the emphasis in defining efficiency differs, with the efficiency notion of the comprehensive income tax base being allocative neutrality rather than the Ramsey efficiency notion of total deadweight cost. As a description of a method of achieving allocative or consumption efficiency, the comprehensive tax notion of neutrality was only ever a poor approximation elevated beyond its merits. But understood as a political statement about not favouring certain individuals, at least in terms of the money (rather than the deadweight) cost of a tax, this kind of neutrality made greater sense.

This kind of efficiency notion states many important political propositions to citizens. It indicates that, in the taxing process at least, the government does not want to distinguish between individuals to the extent that their welfare takes the form of cash receipts. It says further that the government does not want to distinguish between individuals whose welfare, in the form of cash receipts, is derived in one form rather than another. It also says ·that the government does not recognise losses of nonmonetised welfare as possessing the same weight· as losses of monetised welfare. The implication of the last point is that the government will, therefore, discriminate between individuals according to whether they suffer the imposition of a tax in cash or some other form. Equal dollar contributions will be expected from all who are similarly placed; unequal welfare costs, unless they are monetised, will be ignored.

The repetition of the word "money" in the previous paragraph serves, of course, to highlight one of the principal insights of optimal tax analysis- that monetised income may be a poor indicator of individual welfare. But this observation raises a more general problem when optimal tax analysis argues that a surrogate (such as wages) is a poor indicator of the characteristic actually being sought. It is not a problem that optimal tax analysis actually addresses. The analysis generally assumes which is the true characteristic (utility) and which the surrogate (wages).

But it may be the case that the income tax base as designed by a particular government is not intended to tax economic welfare but only to tax the base specifically chosen as the tax has been implemented. In other words, Stiglitz' "noisy signal" may be


a clear signal for what is intended to be subject to the tax. Hence, the discrimination between individuals according to whether they suffer the imposition of a tax in cash or some other form referred to in the last paragraph may be entirely apt - optimal tax analysis is simply missing the point to suggest that there are other non-monetised and superior indicators of welfare. Wages might have been chosen as the tax base for many primarily political reasons and any reflection about actual welfare is purely fortuitous. I do not press these points to suggest that the comprehensive tax notion of neutrality promoted efficiency. Rather, my point is that it may still be valid if it is understood as not proposing an efficiency argument at all.

I will try to make the same point in another way. The point was made above that, since the main purpose of the comprehensive tax base analysis was to provide a more thorough measure for determining horizontal equity, more complex measures of efficiency were not formally integrated into the analysis. And the omissions concerning efficiency costs went even further. In so far as the conflict, and potential for trade-offs, between equity and efficiency were addressed at all in the comprehensive tax base tradition, the conflict was generally resolved by imposing a lexicographic ordering between the two competitors - equity is generally considered first, and only then are efficiency concerns relevant.108

In contrast, the optimal tax approach explicitly included efficiency concerns and then went on to recognise the equity-efficiency trade-off by making both equity concerns and efficiency costs elements in a single social welfare function. This is an important change of focus and one which fundamentally differentiates the two schools. If equity and efficiency concerns are of the same order of magnitude in political decision-making, obviously the comprehensive tax base tradition is flawed - it can only give an answer to one aspect of the government's dilemma. But if the lexicographic ordering suggested by the Carter Commission, for example, is the "correct" way to approach tax policy debate given our political preferences- that is to say, that ensuring fairness betwe~ individuals should be more important to policymakers than making the individuals better off when considered collectively - then optimal tax confuses the initial problem for the government. Sen, for example, has argued that the optimal tax style of analysis - one in which individuals are asked to trade individual entitlements in return for the promise of greater collective returns- is inconsistent with absolute rights for individuals.109

And when one moves to consider the responses of each school to equity issues in isolation from efficiency concerns, it has already been mentioned that the policy implications of optimal taxation analysis can raise serious distributional concerns. This concern with distributional issues has been important in optimal tax analysis, but, again, not really explained by it. It is an apparent matter of concern to analysts if a policy prescription leads to mal-distribution but the reason for the concern is to be found in ethical precepts outside the body of the theory.l10 It does not remove this gap

108 109 110

Carter Commission, above n 8. A Sen, "The Impossibility of a Paretian Liberal" (1970) 78 J Political Economics 152. See, for example, J Stiglitz, above n 41 at 1038: "Popular views of fairness seem inconsistent with these results produced by the utilitarian calculus." A Atkinson and J Stiglitz, above n 74 at 117 say that "the conclusion that goods with a low income elasticity should be taxed heavily brings out very sharply the conflict between equity and efficiency considerations. The recognition of equity objectives would be expected to lead to important modifications of the conclusion."


in the theory to say that concerns about wealth and income distribution form part of the social welfare function - while true, the form that the function should take is not universally accepted nor is the source of those preferences explained.

More importantly, the comprehensive tax base tradition emphasises individual qualities, and makes judgments about tax liabilities based on the position of a particular citizen - the receipt of unequal amounts of income is relied upon to sustain the imposition of an unequal tax burden. Instead, optimal tax theories emphasise collective goals- the effect of this tax regime on aggregate social welfare, of which the welfare of any particular individual forms only a small part. Social welfare is the principal yardstick against which the effects of a tax are evaluated, rather than individualised conceptions of obligation.lll Certainly, individual tastes and endowments are taken as given, and they form a background against which tax obligations are ultimately constructed, but they are not determinative in any primary sense as the basis for imposing tax liabilities.

While maximising social welfare is the principal object of analysis, the social welfare concept is not generally viewed within the optimal tax school as an appropriate subject for study in itself. That is odd and ignores the warnings surrounding tax as a majoritarian process, an issue dealt with more recently in the public choice literature of Brennan and Buchanan.112 A Rawlsian welfare function can prevent some of the implications of optimal taxation based on utilitarian calculus from becoming pure expropriation by a majority from a political minority, but insisting on such a welfare function makes reform more difficult to achieve and, by definition, the benefits of reform are more narrowly distributed.

And there is a further implication for our society where income can be imputed in the absence of cash. Solvency limitations may require individuals to work in order to pay tax. Warren has argued that this type of expropriation offends fundamental values, such as personal liberty, which are given paramount importance in the traditions of western societies:

The idea of any tax on earning capacity is inconsistent with widely accepted concepts of individual liberty because it would disregard such choices as which career to pursue, the amount of time to devote to work as opposed to leisure, and so on .... Like other capital human capital embodies a capacity for production, but for reasons of liberty we distinguish human capital with regard to forced production.113

I began this paper by elaborating taxation as a process which occurs, and which must be resolved, within a constitutional framework. I want to return to this problem briefly. If selectivity and non-uniformity are implemented in the pursuit of enhanced social welfare, the political process must be sufficiently strong to defeat partisan claims for favouritism and then to be able to defend itself against claims of apparent favouritism. Head leaves us with a clear warning:

111

112 113

Once the quasi-constitutional principle of comprehensiveness and uniformity is surrendered, and in the absence of any really well defined alternative, the way is open under democratic political decision-making for wholesale departures from uniformity

This is taken to an extreme in a suggestion that, in certain circumstances, taxation should be designed to be random. See J Stiglitz, above n 35 and above n 41 at 1011-1014. G Brennan and J Buchanan, above n 23. A Warren, above n 51 at 1114-1115.


based on sectional interest rather than on probabilistic calculations of efficiency or horizontal equity gains.114

CONCLUSION- AN EXAMPLE

An example at this point may help to make clear the political and philosophical differences that I have been trying to elucidate and serve as a satisfactory way of trying to ground a long elaboration in something more tangible. The example concerns a tax on wages. Our society consists of many individuals but I will pick just two- referred to generically as John and Jane. They both have jobs and earn a weekly salary and work an additional hour as overtime each week for which they are paid $20 per hour. They wish to undertake a project that will bring benefits to them both exceeding the costs of the project and decide that they have to raise a tax on themselves to finance the additional expenditure. They need to raise $10 per week through the tax for an extended period. They decide that they will use a tax on overtime wages imposed at a rate of 25 per cent to finance the project. The initial expectation of the parties would appear to be that, since they earn equal amounts, and they will enjoy the benefits of the project jointly, they will also be sharing its costs equally.

After some reflection, however, John decides he would prefer to spend his extra hour playing golf if he only keeps $15 of his overtime salary, even if it means that the project cannot continue or will proceed more slowly. He works no overtime and pays no tax. Jane continues to work overtime and pays $5 in tax.115 What presented itself as a tax threatening equal burdens on each, has resulted in unequal burdens, at least in so far as the cash paid by each is concerned.

Now we may have little sympathy for John's position in this situation and both an optimal and a comprehensive tax analysis might suggest that in this case, we should try to collect some tax from John. Using the terms of comprehensive tax analysis, and despite Simons' own misgivings, our tax base is insufficiently comprehensive because it incorporates only paid labour and John pays no tax if he spends his time in some other way- in other words, it is possible to substitute an untaxed alternative. In the terms of optimal tax analysis, observed wages are too noisy a signal for real welfare- John gets more welfare from an extra hour playing golf than from $15 (after tax) but pays no tax when cash received is the only indicator of his welfare. We need to impose a tax on something else that would be a better indicator of his true welfare.

They are still $5 short of their revenue needs and Jane faces the prospect of an increase in the tax rate to 50 per cent if they are to raise $10. What are they to do? The problem arises because of the differing marginal elasticities in their labour supply -Jane is happy to work overtime if she keeps $15 per hour, while John is not. One solution would be to change the tax base to take this difference into account. They might agree to substitute a different tax base, such as their wage rate, for the tax on overtime wages that they began with. Now John and Jane would both pay $5 as tax regardless of the fact that John was not earning any cash with which to pay the tax. Again there would be a happy coincidence between comprehensive and optimal tax analyses. Our base has become more comprehensive; we have employed a less noisy signal. We might

114 J Head, above n 17 at 89. 115 Why she might prefer this position is rarely a serious matter for analysis in economics. It

falls into the "black hole" for analysis called values, tastes and preferences.


ignore Warren's views about forcing John to work in order to pay tax because this is a tax on his overtime wages- he will have other cash.

In fact, we might expect there to be a productivity bonus- John, knowing that he must find the cash with which to pay the tax from somewhere, may now decide he has little choice but to give up his extra golf game and stay on at work. If he really wants to enjoy this new jointly-financed benefit, he, like Jane, is going to have to work a little bit more to pay for it.

But do we really want this to occur? Is this a better tax base? If, in my example, John did not play golf, but was instead using the extra hour to perform domestic chores, how would we view the outcome? Do we want John to stay at home and perform these tasks or to work to pay the tax? Under the initial tax on wages, he could either play golf or get the benefit of services by providing them for himself, but in either case he paid no tax. The solution to the problem of differing marginal elasticities of labour supply was to change the tax base to a tax imposed on the wage rate in order to prevent him from switching to leisure and so tax was paid whether he chose to work in his job or to play golf. But he would also be taxed if he stays home to look after his children, cook meals, clean the bathroom and so on. If it is impossible cheaply to distinguish between an hour spent playing golf and one spent in home duties, John and Jane now have to ask whether they want to impose a tax on time spent on domestic duties, because by shifting to this base, they will end up taxing both.

If we pause at this point, so far, we have seen that a rule threatening equal costs will result in "unequal" cash outcomes. And we have seen it under both taxes. Under the tax on wages, John pays less tax than Jane. But he also has less cash because he works no overtime. Under the tax on wage rates, John pays the same tax as Jane, but he still has less cash from his wages with which to pay it if he worked no overtime. If they both start from an after-tax salary of $400, the outcomes of each tax base would be:

TAXON WAGES TAXON WAGE RATE John Jane John Jane

Salary 400 400 400 400 Overtime 0 20 0 20 Tax 0 (5) (5) (5)

TOTAL 400 415 395 415

The point, of course, is that in both cases John has another non-monetised item which does not appear in the table - either a game of golf or the time spent looking after his house. But the question whether these are both ''benefits" and contribute to John's welfare is, at least in my opinion, not obvious. We might suspect that golf does, but do we view performing housework as an enhancement of his welfare or a reduction of it? If it is the latter, we might also suspect that there is a similar item affecting Jane's welfare - the extra hour spent doing her job, which may or may not give her extra


pleasure independent of the cash it pays. There is also a lost opportunity to do her housework. In other words, the cash outcome for each is going to be different but so are the non-cash elements of their welfare.

If we are to take into account both the cash and the non-cash elements of their welfare, we need to be reasonably assured that we know which individual is better off. Only then can we ask which tax system is the better at selecting that one. Is it Jane who is better off because she has more cash at her command albeit by doing more of a job she increasingly dislikes? If so, she should pay more tax than John as in the first tax case. Or is John better off because, although he has less cash, he does enjoy a game of golf? If so, he should pay more tax, a result which neither system reaches. Or are they equally well off and so they should pay equal tax as in the second tax base?

The problem, of course, is that neither tax system can accurately (or cheaply) pick leisure. The first system treats all time away from paid work as tax-exempt; the second treats it all as taxable. Neither can distinguish leisure from "unpaid work". But the issue is more fundamental than the limitations of administrative instruments. The underlying question is whether potential income is an appropriate tax base at all.

John and Jane may decide to try another strategy. They might agree to leave the initial tax base (overtime wages) intact but to employ different tax rates. They might decide to do this because they know that the benefits of the project will exceed its costs, and so it is desirable for the project to proceed. They might also be convinced by the argument that it is more efficient for John to be working- his output at work is worth $20 per hour but his services as a cook, cleaner and childminder might be replaced for only, say, $16 per hour. Because of the tax payment, it is, nevertheless, not worth his while to work. If the tax base is left untouched, the only way to advance the project is to utilise a low enough tax rate so that John will now think it in his best interests to work (and pay a cleaner) and so pay some tax. There will, however, have to be a corresponding increase in the tax rate on Jane (though not so high that she now decides that it is not worth working either).

Assume that they were to adjust the tax rates to take into account the marginal elasticity in their respective labour supply functions. In essence, they are now trying to adjust for the differential impact of the tax on overtime on their respective cash and non-cash positions. Now John and Jane would pay unequal amounts with John paying less tax than Jane - say, $3.50 for John and $6.50 for Jane. The project can now proceed.

Again, we might wonder whether this is really a satisfactory outcome. John and Jane were in an identical position (except for their tastes and preferences about working) before the tax was threatened, but the tax has been designed to differentiate between them according to their responses to the tax. In this respect, it is like a "Ramsey tax" with the tax rate inverse to the marginal elasticity of supply. A higher rate can be imposed on Jane because she will continue to work even at this rate. Conversely, because John is more deterred from working by the tax than Jane, John pays a lower rate and they decide this in order to facilitate the implementation of a value-enhancing program. Jane has clearly abandoned her "right" to equal treatment with John, at least in terms of the cash cost of the tax, in favour of an earlier delivery on the government program.

If she chose this outcome, we might have little quarrel with the result, but if she were an unwilling participant in this proposal or were not consulted about it at all, how


would we react? Is it appropriate for tax systems to differentiate between individuals on the basis of the elasticity of their labour supply, with lower taxes being offered to the group with the highest marginal elasticity? It is in John's interests, of course, to dislike work greatly but should this society be influenced by that? To do so gives a substantial role in tax policy-making to John's values and tastes in regard to work, values which the society might wish to change, rather than affirm through its tax system.

And is it appropriate to permit Jane to trade-off her entitlement to equal treatment in return for quicker delivery on the program, or some other benefit? And would the answer be any different if we were to require her (as is the way with taxes in the real world) to trade-off her entitlement to equal treatment in return for quicker delivery on the program? It is true that the society (including Jane) is better off with John working since his services are more efficiently allocated if he is at work rather than at home, but it is not inevitable that Jane will get much of the benefit from this outcome. John will appropriate some of it personally and the balance will go to the government as tax which will then be used to fund the project, but she may be less than pleased with this outcome.

This example is, of course, too simplistic for any purpose other than a heuristic device, but I think it serves to highlight the important political and philosophical questions which will have to be answered as Australia chooses between the comprehensive and optimal tax schools.

Date post:	29-Oct-2021
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AN OPTIMAL OR COMPREHENSIVE INCOME TAX?

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