Opinion – Why? Economês in good Portuguese: What does a government program need to contain? Taxes

There has been talk for decades about the inefficiencies of our tax system and the need for tax reform. In the next election, government programs will certainly need to address the issue.

The exact details will depend on each candidate’s political leanings, but some aspects cannot be ignored. Taxes are necessary to keep the state machine running and to produce public services. But they generate costs that go beyond the money that comes out of our pockets – the so-called distortions.

These distortions are inevitable, given that there is no provision of public goods and services without tax collection. The question is whether we can set up a tax system in which they are not too large. An example helps to illustrate this point.

a hypothetical example

Suppose the government of a country decides to tax the production of orange juice to finance its activities. Part of this tax ends up being passed on to consumers in the form of higher prices. But they react, substituting the consumption of orange juice for other goods — for example, grape juice. The result is that both production and consumption of orange juice will be lower.

This movement generates a series of costs for society, which are not exactly the money we spend to pay for these taxes. It is these distortions that reduce the efficiency of the economy.

One sector (orange juice) ends up decreasing in size not because its companies are less productive, but simply because there is a higher taxation in relation to other sectors of the economy. And some economic activities (the production of grape juice) end up benefiting.

Thus, the economy’s scarce resources are not necessarily being directed to those who make the most productive use of them. This is what economists call resource misallocation.

Additionally, taxing few products harms the government’s own tax collection. This is because people and companies change their behavior in response to the higher tax, which allows them to “escape” some of the taxation. I didn’t see tax evasion or evasion, but simply replacing it with other products that became relatively cheaper.

In the hypothetical example, many people would not buy orange juice (instead of grape juice) because it became more expensive because of the higher tax. With this, the consumption of the product and the possibilities of collecting taxes in this way fall.

a real example

There is a proposal that always comes back to discussion in Brazil, and is seen by many as a silver bullet: the single tax. In general, this proposal involves the collection of taxes on financial transactions, along the lines of the former CPMF. There is even talk of eliminating all other taxes from the economy and putting a turbocharged CPMF in place. We will likely see versions of this tax in some government programs.

And here you have to be very careful. As in the hypothetical orange juice example, people are sure to change their behavior to avoid the tax. For example, individuals will use the financial system less to make payments and companies will do more stages of their production in-house (instead of contracting with other companies to carry out part of the production). Check out the discussion in more detail here.

All of this has the potential to reduce the efficiency of the economy. And the amount to be collected will most likely be less than what advocates of the proposal aim for, given the expected reaction of individuals to reduce financial transactions.

So, if you come across miraculous proposals for taxes on few activities financing the state machine, be suspicious!

The benefits of uniform taxation

As we discussed, the tax costs go beyond the money we pay the government. There are social costs, as people and companies change their behavior as a result of taxation. In this sense, systems that are broadly based –that is, that cover various goods and services in the economy– and that have similar rates tend to reduce these distortions.

In the example of orange juice, if the same tax were levied on grape juice, there would be fewer opportunities for substitution, which would reduce the distortions arising from taxation.

The Brazilian tax system, however, is far from this pattern. There are different rates,

This brings additional uncertainty for companies, particularly when introducing a new product, because they don’t know what category the item will fall into (and what tax will be charged). The system is still complex, requiring firms to spend time and resources complying with bureaucratic procedures associated with taxes.

In addition, opportunities are created for the action of business lobbies, in an attempt to pressure politicians and managers to reduce taxes for certain sectors. In the end, entrepreneurs can invest more in creating relationships with politicians to obtain favorable tax treatment, than in innovating, gaining productivity, introducing new products, etc.

A simpler system, with rates common to different products, would have several advantages over the current system. It would reduce the social costs of taxation and signal to entrepreneurs that there are no opportunities to increase profitability by lobbying for lower taxes for their sector.

Questions to candidates

It is always useful to guide the discussion of public policies by a reference. In our case, I believe that this reference should be a uniform taxation system, with rates common to most goods and services in the economy.

If a candidate believes that a particular sector deserves different treatment, it is necessary to justify it. In other words, it must explain why it is necessary to help this sector and harm others, generating social costs. Are there benefits that outweigh these costs?

Often the discussion will be about the jobs to be generated. But it should be noted that the differentiated taxation ends up harming other sectors, which are left with relatively higher taxes. Not only does it trigger the social costs discussed above, but it also makes it difficult to generate employment in other industries that have not been graced.

The argument can also invoke income distribution. One example is charging lower taxes on the products that make up the basic food basket, to benefit the poorest. But it is necessary to consider that the richest will also benefit (albeit to a lesser extent), as they also consume these products, along with entrepreneurs from sectors that produce basic food items (which are probably not among the poorest).

More importantly, the candidate would need to explain why this distributional improvement could not be achieved through income transfer programs, instead of a favorable taxation on basic basket products.

Economists see reasons to “break” the uniform taxation rule when there are externalities. In the case of positive externalities, when a person consumes a good, he generates benefits for third parties that have nothing to do with his action. A very clear example is vaccination, in which the person not only decreases his chances of contracting a disease, but also the chance of transmitting it to others. In these situations, the prescription is that these activities are encouraged, with lower taxes and even subsidies.

Thus, we could question candidates who advocate special treatment for a particular sector if there are positive externalities, and if they are relevant.

On the other hand, there are several cases of negative externalities, when the consumption or production of a good harms others. The classic example is activities that cause pollution and aggression to the environment. Here the recommendation is that these activities be discouraged, that is, have a higher tax rate than other products. In this sense, the eternal discussion of zeroing fuel taxes and even subsidizing this activity goes against any argument of economic efficiency.

Not over yet

The discussion about taxes is complex and certainly does not fit in a single text. Here we basically deal with aspects of economic efficiency related to the tax system. But there are very important issues of income distribution, which we will address in the next opportunity.