Sunday, 25 January 2015

Hourly averaging and taxing the most fortunate

In my recent blogs I have explained why hourly averaging is a very useful method to assist the least fortunate: it provides an earning subsidy that contains a strong incentive for people to work more hours.

Perhaps I have assumed that it is obvious why hourly averaging offers an excellent method to tax the most fortunate at appropriately high rates. Put simply, a lifetime hourly average is the best feasible and measurable gauge of each person’s economic fortune. To show why I will describe eight people, who fit into some fairly simplified but important categories.

Some of the imaginary persons find it easy to do well in the job market. They might earn more because of their natural talents, their connections, or simple good luck. Others, however, are unable to earn high wages because they have not benefited from such good luck. Another dimension of luck is that of family background, people can either come from a rich family which offers them support or a poor family which is unable to assist them in ways that will generate more income and wealth.

All of these people freely choose (with no mitigating factors) to work full or part-time. If we look at some index of their income and wealth against which to tax them we would classify people as follows:

Person
Low or High wage?
Part-time worker or full-time
Rich/Poor family
Income/wealth

Adrianne
L
PT
Poor
Very Low
Brenda
L
FT
Poor
Low
Celine
H
PT
Poor
Low
Daphne
H
FT
Poor
Fairly High
Edith
L
PT
Rich
Middling
Fran
L
FT
Rich
Fairly High
Gina
H
PT
Rich
Fairly High
Hannah
H
FT
Rich
Very high
Table 1 : Fortune and work choice of 8 people

People’s income/wealth generally goes up as we move down the table and those at the bottom of the table are also more fortunate. A progressive tax system (which could capture returns to fortune from family transfers, investment income and earned income) would therefore tax Hannah more than Adrianne, which is the right sort of outcome.

However, taxing income and wealth does not capture the difference between all of the individuals. If we place people on a numeric scale for both their income/wealth rating and the areas in which they have good fortune we can see that in most cases there is a difference (see table 2). This difference tracks their decision to work full or part-time. There is nothing wrong with people making this choice of course. However, the choice does not indicate how economically fortunate they are – they just want to work fewer hours (for example because they want to spend more time on their hobbies).

One way to put the problem is that income and wealth can vary due to numerous factors including the choices that people make. Some of these factors will be examples of fortune, but income and wealth are influenced by other factors as well. The important factor here is the amount of time they work, though another factor could be their tendency to spend or save. This would also influence their level of wealth and investment income, and is reason to be cautious about taxing wealth, as I discussed in a previous blog.

Person
Income/wealth

Fortune in family or job

Difference between the two?
Adrianne
Very Low
Low
Y
Brenda
Low
Low
N
Celine
Low
Middling
Y
Daphne
Fairly High
Middling
Y
Edith
Middling
Middling
N
Fran
Fairly High
Middling
Y
Gina
Fairly High
High
Y
Hannah
Very high
High
N
Table 2 : Problem with tracking fortune on the basis of income and wealth

For progressive taxation on income that tracks fortune, there is a problem. Some full-time workers are taxed at higher rates than their fortune-level would appear to warrant (Fran, Brenda and Daphne) while the part-time workers are taxed at lower rates than their relative fortune level (Celine and Gina). If taxes were made less progressive then less tax revenue would be generated overall, leaving less revenue to assist people like Adrianne and Brenda.

The dilemma continues as well because while higher tax-rates might generate more revenues, they might encourage quite a lot of people to reduce their hours. It might encourage the Daphnes of this world to become like Celines, Frans to be like Ediths and Hannahs to be like Ginas. If people reduce their hours then everyone suffers as a) there are less goods and services available and those that remain will probably be more expensive (prices will rise) and b) there will be smaller tax revenues available to assist the less economically fortunate (particularly when we remember that tax revenues are required for important issues such as administering law, policing, democratic institutions, development, and for providing education, healthcare, support for the disabled and national defence).

Calculating taxation using a lifetime hourly average income enables us to much better tax people in accordance with their economic fortune. As table 3 shows, lifetime hourly average will coincide much better with good fortune.

Person
Income/wealth

Fortune in family or job

Difference between the two?
Lifetime Hourly Average Income
Adrianne
Very Low
Low
Y
Very Low
Brenda
Low
Low
N
Very Low
Celine
Low
Middling
Y
Middling
Daphne
Fairly High
Middling
Y
Low
Edith
Middling
Middling
N
High
Fran
Fairly High
Middling
Y
Middling
Gina
Fairly High
High
Y
Extremely High
Hannah
Very high
High
N
Very High
Table 3 : Lifetime Hourly Average for the eight people

Indeed, lifetime hourly averaging is potentially quite nuanced, and this points to the other major advantage of the system. Taxing people on an hourly basis means that the tax system gives people a strong incentive to work full-time rather than part-time. Adrianne will have a strong tax incentive to work longer like Brenda, Celine like Daphne, Edith like Fran and Gina to do like Hannah. It therefore has the opposite effect to all other tax proposals—instead of reducing the incentive to work this tax system would decrease it. This means that the economy will provide more goods and services (and therefore cheaper prices for these) than we would expect for any other highly progressive tax system.

We want to tax the most economically fortunate without discouraging economically productive activity and lifetime hourly averaging offers the best available means to do so.

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