Income Taxes are Production Taxes
Keith Rankin, 21 April 1998
Income taxes are not taxes on labour, as is often supposed. Rather, income tax revenue arises from the production process. Taxes are, like wages, a cost of production. Wages are one cost, income tax is another cost. Profit and interest are further costs.
These are all "factor costs", which represent the "value added" by firms and non-profit producers. (For convenience, I will call all producers firms; it's just that some, such as government, are regarded as having zero profits.) Factor costs all represent income to households. Factors - eg labour and capital - are owned by households and rented by firms
Firms face other costs - "non-factor costs" - essentially raw materials, capital equipment and other purchases including business services. These represent income to other producers, and represent value-added by other firms.
In this article, it is only factor costs that are of interest. The sum of all factor costs of all producers in any country, represents that country's "GDP at factor cost". To get "GDP at market prices", we must add indirect taxes and deduct government subsidies. 1 A country's gross domestic product is simply the sum of wages (and salaries), taxes, profits and interest. (An exception is interest on consumer credit, but noting that landlords and home owner-occupiers are regarded as producers.)
Income taxes are, this century, accounted for as levies on labour and capital; that is, charges on households whose income derives from employment (labour), from private property (capital), or a combination of the two. Thus, in a contemporary legal sense they are taxes on labour and capital.
The government, like a hairdresser, is seen as a supplier of services to households. (In its modern variant, the government supplies services through subcontracting rather than through direct provision.) Taxes represent payment for those services. The only difference between hairdresser and government is that the former supplies individual services and the latter provides collective services.
Social sciences such as "positive" (ie scientific, value-free) economics have set themselves the task of investigating deeper, hidden truths. Thus economists talk a lot about the "incidence of tax", contrasting the legal "burden" with the actual burden. For example, economists might say that an employee tax is, in some situations, really a tax paid by an employer (who is forced to pay higher gross wages than s/he would in the absence of the tax). Or that a duty paid by an importer is really a consumption tax, borne by the consumer of the imported good rather than by the person who remits the tax to Inland Revenue. The economic incidence may differ from the legal incidence.
Philosophies, such as the various conceptual interpretations of the economy, also yield alternative truths. Thus the perspectives of economic liberalism, Marxism, Keynesianism all represent forms of "normative" economics. Economic liberals have their own alternative story about taxation. They see government more as a big household rather than a big firm. Thus they see taxes as a forced "transfer" from one household to another. This view became prominent in the eighteenth century when governments were in the main corrupt monarchies who consumed public revenue in the form of lavish courts, military campaigns, and bribes of many forms.
Neoclassical positive economics and modern accounting practices are creatures of a particular epoch. They are technical apparatus that necessarily reflect the normative economics of their time; the late 19th and early-mid 20th centuries. Thus 20th century economists continue to regard taxes as a household levy - in particular a levy on labour - rather than as a cost of production.
The most prominent dispute today is whether taxation is demand-driven (the still orthodox Keynesian view of government as producer), or supply-driven (the neoliberal view of kleptocratic government as a form of organised crime). Both views regard tax as a household levy, but only the latter view claims that fewer taxes are necessarily better for society as a whole.
My alternative argument is that all income taxes are really costs of production, and that both the public accounts and the majority of economists are misled in their presumption that income taxes represent a personal or household liability. Thus the sovereign, like labour and capital, is an agent of production. Income taxes, like wages and profits, represent factor costs and an income to the agent of production. The entire income of the sovereign can be called the social wage; and the government, as an agent of the sovereign, distributes the social wage and provides collective services.
As I understand it, this was the orthodox view of sovereignty prior to the emergence of economic liberalism in the 18th century. (Indeed, the term "sovereign" has only recently re-emerged into economic discourse, after a 200 year lay-off. The emphasis in the last 200 years has been on the somewhat different concepts of the "state" and the "government".) The difference today, in an era of democratic sovereignty, is that the owner of the social wage is explicitly the "people" rather than the "monarch".
If income taxes are really a charge on firms imposed by sovereign households - ie a charge by households rather than a charge on households - then does the notion of a progressive income tax have any meaning? The short answer is "no". Under the perspective I am promoting, all income tax is company tax. What we call income tax is really production tax.
Nevertheless, an accounting system that explicitly treats all income tax as company tax need not dispense with the tax benefits that are built into today's progressive tax regimes. Most countries have a range of tax "allowances", tax "rebates", tax "credits", in addition to the ordinary tax concessions that are implicit in any graduated tax scale. All of these are simply benefits - benefits which are higher for people who, by current accounting practice, pay high taxes than for people on low incomes who are regarded as non-taxpayers.
Rather than dispensing with such tax benefits - which, like social welfare benefits, represent allocations of the social wage - a production tax approach suggests that these different benefit types should be integrated and universalised.
At present corporate tax is simply a tax on retained profits, treated as a tax of one component of firms' capital costs. The taxes on interest and dividends, the other forms of capital cost, are still regarded as household liabilities. Likewise PAYE income tax is treated as a household liability, despite the fact that the revenue is generated by the firms which employ the "tax-payers", and is paid by those firms. The firms are the real tax payers. In the case of self-employed persons, their income tax is treated as company tax. Thus they are really taxed as employers of themselves, and not as employees of themselves.
The production tax approach suggests a number of reforms in addition to the introduction of a universal benefit.
The approach means that all private factor payments - ie payments to labour and capital; wages, salaries, dividends and interest - should be always net of tax. (Indeed, to a large extent those reforms have already been made: first there was PAYE, then there was withholding tax on interest and dividends. Next, the IR5 forms are scheduled to disappear.)
And the production tax approach suggests major reforms of our system of national accounts, with explicit accounting for direct (producer) taxes, and the opportunity to integrate direct and indirect taxes as the basis of a single social wage fund to compare with the present funds which are called "compensation of employees" (labour) and "operating surplus" (capital). (The complete social wage fund also includes the profits of state-owned enterprises.)
Finally, the production tax approach to the national accounts enables subsidies to be treated as social wage allocations rather than as deductions from indirect tax. And it enables proper accounting of hidden subsidies, which represent the difference between corporate tax due and corporate tax actually paid.
A production tax approach to public accounting represents both a more realistic interpretation of the economic world as it really is - an advance in positive economics - and an alternative normative perspective on the role of government. Under this perspective, the government is a fund manager for the sovereign; an agent that purchases services - "social wage goods" - for the sovereign people, and that distributes universal benefits as social dividends.
By clarifying the economic relationship between firms, citizens and government, the redefinition of income tax as production tax can lead to reforms that add economic sovereignty (the explicit right of the sovereign to draw an income from productive assets in the public domain) to political sovereignty (the recognition that the people are sovereign citizens).
1. I would argue that indirect taxes should not be netted against subsidies. Subsidies should be treated as a part of the social wage, which represents the allocation of public revenue. A subsidy to a farmer is no different in principle from the cost of running a "crown research institute". Thus GDP is understated in the national accounts, and it is more understated in those countries which have high subsidies. [back]
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