- Tax A: Shoes are taxed at $0 per pair.
- Tax B: Shoes are taxed at $100,000 per pair.
Under Tax A, everybody pays zero. Under Tax B, nobody buys shoes and everybody still pays zero. But Tax B is more painful, because it leaves us barefoot.
That’s of course an exceptionally simple example, but the same point arises in much subtler contexts. The pain caused by a tax is measured not just by what you pay, but also by what you do to avoid paying more.
So let’s try something more interesting:
- Tax A: A tax of 50% on all wages.
- Tax B: A tax of 40% on all wages and interest
To make the comparison fair, suppose your total tax bill happens to be the same under either policy.
In class today, I proved to my students that under that assumption, you’ll always prefer Tax A. (Of course someone else with different tax bills might disagree). I fear, however, that I was not my usual crystal clear self. So partly for the benefit of the students and partly for the benefit of anyone following along at home, I’ll reproduce the key diagram here.
Before I show you the diagram, I’ll note that the result follows from the joint application of two principles:
- Principle I: Holding the tax bill fixed, it’s always better for the taxpayer when everything is taxed at the same rate.
- Principle II: Any tax on interest is a double tax.
Principle I says you should never double tax anything, and Principle II says that to avoid double taxes you must avoid interest taxes. This argument, of course, proves nothing, because stating a principle doesn’t make it true. The diagram below, however, proves all. This is an indifference curve diagram of the sort that is standard fare in intermediate-level economics courses. If you’ve never taken such a course, this might not be the diagram for you.