wealth and welfare

the more wealth we have, the more we can improve human welfare. this is central to traditional conservative adages like, “a rising tide lifts all boats”.

but the more wealth a given individual has, the less benefit she gets from each additional unit of wealth. we say that wealth has decreasing marginal utility. a reasonable approximation is that utility = log₂(wealth), so a person gets about the same utility improvement from doubling her wealth no matter how much wealth she has.

this decreasing marginal utility means that we can not only improve welfare by increasing wealth, but also by redistributing wealth. that is, we can make people better off by growing the pie, but also by sharing the pie more equally. for instance, imagine a two-person micro-society comprised of alice and bob. if bob and alice both have 5000$, that’s a utility of 24.58. but suppose bob has 1000$ and alice has 19,000$. that’s a utility of 24.18 — a lower net utility despite having double the available wealth. this is why inequality matters, and it’s central to progressive adages like, “tax the rich”.

conflicting goals

but confiscating wealth decreases the incentive to create wealth in the first place. the lost productivity caused by taxing productive behavior is a form of what economists call deadweight loss. the legendary venture capitalist paul graham even penned one of his classic essays on the idea that societies which generate a lot of wealth must by definition have a certain degree of inequality.

and so maximizing human welfare requires a delicate balance between incentivizing wealth creation (which entails, among other things, keeping taxes reasonably low), and redistributing wealth from richer to poorer — which entails making taxes fairly high. we want to maximize something like the product of “amount of pie” and “equal sharing of pie” — in spite of the fact that these two goals seem to be in conflict. so how do we do that?

efficient taxes

the trick is to have as much of our tax base as possible come from taxes which don’t decrease productivity. there are two categories that achieve this.

rents aka windfalls

sometimes people grow richer through pure luck rather than as the result of their productive work. for instance, suppose a large employer opens a new office near your plot of land, sending the rental value of that land through the roof. unlike a real estate project, which requires planning and hard work, this “windfall” comes through pure dumb luck.

the upshot of this is that if the government taxes away that windfall, it by definition won’t decrease your productive output. it cannot affect your incentives, because you didn’t do anything to produce that value. in this case, the appropriation of those earnings is called a land value tax. we ideally want to tax away 100% of the unimproved value of land, to make as much of our tax base as possible free from the destructive effects of deadweight loss.

negative externalities

an arguably even better target for taxation is negative externalities. an example would be a tax on carbon dioxide emissions. the problem of such emissions are that they create a cost that’s paid by society (in the form of drought, fires, higher grocery prices, etc.) rather than by the individual emitting the carbon dioxide. because the individual emitting the carbon doesn’t pay the cost, it feels to them as if they’re being paid to burn more fossil fuels — it literally has the exact same effect as a subsidy. and subsidies lead to overconsumption, which creates another form of deadweight loss.

for example, you might consume 10 dollars worth of gasoline, even though you think it’s only worth 6 dollars, because the lack of a carbon tax makes it cost only 6 dollars. you’re effectively paying 10 dollars for something worth 6 dollars, because the government is picking up the 4 dollar remaining tab. this overconsumption is tantamount to shrinking the pie.

the solution is to “internalize” the negative externality by means of what’s known as a pigovian tax. In this case, we want to charge a carbon tax on emissions of carbon dioxide, and tax other pollutants such as methane as well. this is even better than “rent” taxes like land value tax, because not only does it not add deadweight loss, it actually removes deadweight loss. in other words, it has negative deadweight loss.

taxing productivity

only once we’ve exhausted all possible windfall taxes and pigovian taxes do we want to tax “generated” wealth that arises from productive activity. in this way, we keep taxes on productive activity to a bare minimum.

further, we want these “productivity taxes” to be flat not progressive, due to the simplicity and other advantages. ideally, the rate is 100% of the externalized cost or rental value, in the case of pigovian taxes or land value taxes respectively.

a better way to make the tax system progressive overall is to distribute a flat negative tax amount, a.k.a. a “universal income", rather than have a differential tax rate. a constant universal subsidy combined with a flat marginal tax rate creates a net-progressive tax regime.