All About Taxation

I write this blog for folks who are looking to learn more about economics. And if you are in this group, you can’t help but have noticed that there’s been a bit of a brouhaha over taxes, both in the United States of America and in India.

ProPublica has obtained a vast trove of Internal Revenue Service data on the tax returns of thousands of the nation’s wealthiest people, covering more than 15 years. The data provides an unprecedented look inside the financial lives of America’s titans, including Warren Buffett, Bill Gates, Rupert Murdoch and Mark Zuckerberg. It shows not just their income and taxes, but also their investments, stock trades, gambling winnings and even the results of audits.
Taken together, it demolishes the cornerstone myth of the American tax system: that everyone pays their fair share and the richest Americans pay the most. The IRS records show that the wealthiest can — perfectly legally — pay income taxes that are only a tiny fraction of the hundreds of millions, if not billions, their fortunes grow each year.

https://www.propublica.org/article/the-secret-irs-files-trove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax

What exactly is income tax? And what is its history?

Well, the first question is simple to answer (to begin with): it is a tax on your income. Ah, but that then begs the (pardon the puny pun) million dollar question: what is income?

But a question remained: What would count as income and what wouldn’t? In 1916, a woman named Myrtle Macomber received a dividend for her Standard Oil of California shares. She owed taxes, thanks to the new law. The dividend had not come in cash, however. It came in the form of an additional share for every two shares she already held. She paid the taxes and then brought a court challenge: Yes, she’d gotten a bit richer, but she hadn’t received any money. Therefore, she argued, she’d received no “income.”
Four years later, the Supreme Court agreed. In Eisner v. Macomber, the high court ruled that income derived only from proceeds. A person needed to sell an asset — stock, bond or building — and reap some money before it could be taxed.

https://www.propublica.org/article/the-secret-irs-files-trove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax

As the article I have excerpted this from goes on to say, folks were warning us even back then that this was not going to end well (it is nowhere close to ending, and it is not going well). But this talks to us about the difficulty of defining income, about which more in a bit. Here’s a brief snippet about how the idea of income taxes originated:

The universal taxes of ancient times, like the one that brought Mary and Joseph to Bethlehem just before the birth of Jesus, were invariably head taxes, with one fixed sum to be paid by everybody, rather than income taxes. Before about 1800, only two important attempts were made to establish income taxes—one in Florence during the fifteenth century, and the other in France during the eighteenth. Generally speaking, both represented efforts by grasping rulers to mulct their subjects. According to the foremost historian of the income tax, the late Edwin R. A. Seligman, the Florentine effort withered away as a result of corrupt and inefficient administration. The eighteenth-century French tax, in the words of the same authority, “soon became honeycombed with abuses” and degenerated into “a completely unequal and thoroughly arbitrary imposition upon the less well-to-do classes,” and, as such, it undoubtedly played its part in whipping up the murderous fervor that went into the French Revolution.

Brooks, John. Business Adventures: Twelve Classic Tales from the World of Wall Street (p. 93). Hodder & Stoughton. Kindle Edition.

That… is not reassuring.

The chapter on income tax from this excellent, excellent book makes for great reading. As it turns out, it was the (surprise, surprise) Civil War that finally provided the impetus for the imposition of an income tax across the length and breadth of the nation1 And the imposition was celebrated! Well, at least by some:

“I am taxed on my income! This is perfectly gorgeous! I never felt so important in my life before,” Mark Twain wrote in the Virginia City, Nevada, Territorial Enterprise after he had paid his first income-tax bill, for the year 1864—$36.82, including a penalty of $3.12 for being late. Although few other taxpayers were so enthusiastic, the law remained in force until 1872. It was, however, subjected to a succession of rate reductions and amendments, one of them being the elimination, in 1865, of its progressive rates, on the arresting ground that collecting 10 per cent on high incomes and lower rates on lower incomes constituted undue discrimination against wealth.

Brooks, John. Business Adventures: Twelve Classic Tales from the World of Wall Street (p. 96). Hodder & Stoughton. Kindle Edition.

Back, as it were, to the future. Anand Giridharadas wrote an article in the New York Times about the ProPublica report:

Mr. Buffett is almost the perfectly made billionaire for this moment in which, at last, many Americans are beginning to question not only corruptions of the system but the matter of whether billionaires should exist at all. He doesn’t do the things the worst of them do. He isn’t in it for what they’re in it for. He clearly must care about money, but he also kind of doesn’t care about money. Even in his generosity, he has avoided the imperial lording over that others cannot resist.
And this is what makes him so troubling, because through him we are tempted into believing that a system can be defended that allows a man to accumulate more than $100 billion while people are sleeping, in hock to him, in his mobile homes, shortening their lives with the beverages he’s invested in, scampering around the warehouses whose nonunion status has redounded to his money pile.
It can’t. And who keeps us from seeing that simple, stark truth more effectively, more perniciously, than the Good Billionaire?

https://www.nytimes.com/2021/06/13/opinion/warren-buffett-billionaire-taxes.html

The second card in my three card trick is a response to this essay, from V Ananta Nageswaran2:

So, notwithstanding Anand Giridhardas, we can still think about the manner in which incomes and capital gains & dividends are taxed. I see three issues, at my level.
There needs to be a discussion on unrealised capital gains and dividends. Dividends are avoided and companies buy stocks back to avoid dividend tax. What if the tax policies take away that choice?
Second, even if we accept that only realised capital gains are to be taxed, why are they taxed at much lower rates than tax on wages?
Third, even if we accept this logic (which, in addition to the above arguments, is also a reflection of who made those laws, their incomes and wealth status, etc., over time and across the world) of the primacy of capital, for the sake of argument and hence accept the conclusion that capital gains will be treated differently from regular labour income, then the question is one of defining short-term and long-term. Why should short-term be just one year? In economics, anyone’s definition of short-term is not one year but a business cycle, i.e., minimum three years. Extending the definition of ‘short-term’ to 36 months from 12 months will earn more revenues.

https://thegoldstandardsite.wordpress.com/2021/06/19/the-inequity-of-the-tax-system/

That is, the author is saying that that are indeed problems with capital being taxed the way it is, but (as he points out elsewhere in the blog) the way forward is evolution, not revolution.

Which brings me to the third card: TALISMAN.

The truth, as always, lies somewhere in the middle – and that, of course, is the point of the excerpt above too. On the spectrum of Current System Bad:::Current System Good, reasonable people can and should argue about the “sweet spot”.


And if you are a student of economics (and especially public finances), where do you go to learn more before trying to figure out where you should be on this spectrum?

  1. Please read the chapter on income taxes from the book Business Adventures
  2. Read this essay by Tim Taylor (and note that it was written before the ProPublica report came out!)
  3. Farhad Manjoo, a while ago, on abolishing billionaires (and the response to that essay)
  4. Gulzar Natarajan on this issue
  5. And for a theoretical understanding – always a good idea for an issue as complex and important as this one – Chapters 20 and 21 from Stiglitz’ Economics of the Public Sector.
  1. do read the entire chapter, though. The snippet about the experiment in Rhode Island is fascinating.[]
  2. note that I am excerpting the outline of the argument, please visit the blog to read it in full[]

Links for 22nd February, 2019

  1. “We seem somehow bored with thinking. We want to instantly know. There’s this epidemic of listicles. Why think about what constitutes a great work of art when you can skim “The 20 Most Expensive Paintings in History?”I’m very guided by this desire to counter that in myself because I am, like everybody else, a product of my time and my culture. I remember, there’s a really beautiful commencement address that Adrienne Rich gave in 1977 in which she said that an education is not something that you get but something that you claim.

    I think that’s very much true of knowledge itself. The reason we’re so increasingly intolerant of long articles and why we skim them, why we skip forward even in a short video that reduces a 300-page book into a three-minute animation — even in that we skip forward — is that we’ve been infected with this kind of pathological impatience that makes us want to have the knowledge but not do the work of claiming it.”
    Have you heard of Maria Popova? This interview helps you understand who she is, and her importance in combating what I linked to a couple of days ago – David Perell’s article about the Never Ending Now.

  2. “Thanks to government backing, the state-owned company building the bridge is unlikely to default or go bankrupt. But bridges like Chishi leave local governments and developers struggling with debt, and those who live below nonplused.“If you don’t build roads, there can’t be prosperity,” said Huang Sanliang, a 56-year-old farmer who lives under the bridge. “But this is an expressway, not a second- or third-grade road. One of those might be better for us here.””
    The New York Times on bridges in China – and how there might be one too many of them. Economists have worried for many years now about how China’s economy will slowdown in the years to come, and also about how China’s economy has masked it’s imminent slowdown by building bridges, roads and entire cities when the immediate need is not apparent.
  3. “Turns out the reason was likely the same as the one behind every one of my life choices: it involved the least effort. As Frankie Huang, a writer and strategist based in Shanghai, told me over email, numbers are far easier to type for purposes like websites’ names, as compared to pinyin, the Romanised system for Chinese characters.”
    …speaking of China, Mithila Phadka explains why the Chinese prefer using numbers evreywhere possible – even preferring to use numbers rather than text for URL’s. 12306.cn is preferred to ChinaRail.com, for example.
  4. “In Study the Great Nation, you can catch up on the latest state media reports on Mr. Xi’s decisions, savor a quote of the day from Mr. Xi or brush up on “Xi Jinping Thought.” You can quiz yourself on Mr. Xi’s policies and pronouncements, or take in a television show called “Xi Time,” which is … well, you get the picture.Doing each of these activities can reward users with “study points,” which can be redeemed for gifts in future versions of the app.”
    I worry that China won’t be the only country doing this for very long – far too many leaders in far too many countries are likely to be tempted to be, um, inspired.
  5. “This conclusion, if it withstands open-minded analysis in India, does not mean that India lacks ways to punish Pakistan and motivate it to demobilize groups that threaten to perpetrate terrorism in India. Rather, it suggests that more symmetrical and covert operations would yield a better ratio of risk to effectiveness for India. There are many ways to make Pakistani military leaders conclude that the cohesion, security, and progress of their own country will be further jeopardized if they fail to act vigorously to prevent terrorism against India. Limited, precision air strikes are not India’s best option now or for the foreseeable future.”
    This is from 2015 – but as of that point, this rather well researched article points out that India may not be able to carry out precision air strikes against Pakistan – because of the threat of escalation, because of the technology available with Pakistan today, and because other ground based options may be more operationally feasible.

Small economies, big economies

Here’s a fun thought experiment.

What if Sachin Tendulkar agreed to give you a one-on-one batting masterclass for an hour? One hour with the Little Master, who will carefully observe your technique, our shots and your overall batting, and then proceed to tell you how he thinks you can become better. It’d be fairly safe to assume that you’ll be a much better batsman at the end of that session, right?

Now, what if Sachin also did a one-one-one masterclass with Virat Kohli? Here’s a batsman who’s at the peak of his game, and who is, in his own right, a very accomplished batsman indeed. Here’s the question: will it be equally safe to assume that Kohli will be a much better batsman at the end of that session?

Hopefully, all of you agree that Kohli was already a very good batsman That masterclass won’t hurt him, but the rate of improvement won’t be all that much, because he was so very good already.

But you? Your rate of improvement will be stratospheric, because you are a novice in batting compared to Kohli.

Similarly, what will be the impact of a spanking new expressway connecting two cities in America? Marginal, because they already have a pretty good network of highways. What will be the impact of a spanking new expressway connecting two cities in India? Much larger, because in all likelihood, this will be the first such road between these cities.

The flow of commerce between these cities will be higher than earlier, the measurement of which will show up as an increase in GDP. This is a central prediction of the Solow model.

Countries with a low level of capital will, other things kept aside, grow faster than countries with a high level of capital. America will not grow at anything in excess of 3% per year, while India will consider it a tragedy if we grow at less than 5% a year.

That doesn’t mean America is somehow worse than India when it comes to economic performance. Of course America will grow slower, because she has seen so much growth already. We, on the other hand, are just about beginning our growth story. Villages in India will see electricity for the first time, and many Indians will travel in a car, on a national highway, for the first time in their lives. These indicators of progress will all be registered in our GDP measurements as growth, and so India will (or at least ought to) grow faster than America in the years to come.

So countries with a low capital stock tend to grow faster. Tend to, unfortunately, isn’t a guarantee of growth. In other words, not all countries with a low capital stock grow rapidly – some don’t.

What holds countries back is institutions – and that’s what we will be looking at next.

Thinking about capital

You’re reading this post, right here and right now, using capital. You’re using some sort of electronic machine – maybe a computer, maybe a phone, maybe a tablet – in order to read these words. I used a laptop to write them.

Would it have been possible for me to write these words without any machine whatsoever? No computer, no paper, no pen, no nothing. In theory, yes. I could have used my foot to etch some words in the sand. But not only would that have been tedious and impractical, it would also have required you to be there in order to read it. But with my laptop, and its internet connection, I could put this post up on the internet, and anybody could read it, including you. So I could produce something of value (and you could consume it) much more easily because of the presence of capital.

And in general, that holds true for almost everything. Most goods and services are far easier to produce, and turn out to be of far better quality, when produced with the aid of machines. This is true of something as simple as haircuts (scissors), or classes (computers and projectors), and something as complicated as a rocket launch. Machines (that is, capital) help us grow faster.

So a growth in the amount of capital we possess (what economists refer to as capital stock) is almost a prerequisite for economic growth. Now, if this is true, we can make a series of predictions. I have outlined them below.

One, countries that have a low level of capital stock will be poor, and countries that have a high level of capital stock will be rich. Also, countries that are in the process of adding to their capital stock will be growing more rapidly than others.

Are these claims true? Nothing is ever completely true in economics. It is, after all, a social science, and you’ll always have a bit of error. But most economists would agree with the claims made above.

And without getting into the data and the charts, it is possible to see that the claim makes sense. Which country, do you think, has more roads, airports, seaports and power plants – India or the United States of America (USA)? Which country is richer?

Has China added, in the last three decades, an enormous number of airports, seaports and power plants (besides much else)? Has China grown rapidly?

Long story short, if we want India to grow rapidly, we have to add to India’s capital stock. We have to, in the years to come, build more roads, more dams, more solar farms – more everything, really. This will raise, to use a bit of jargon, our productivity. That is to say, it will raise our ability to produce more goods and services in the future – and that is what we mean by growth.

And this is the first intuition behind a model that we will be fleshing out now. The model is called the Solow model, and the intuition is painfully obvious in hindsight: adding to the capital stock helps a nation grow.

Thinking About Long Term Growth

We now know what GDP is, and why it is important to measure growth using GDP. We know what statistical adjustments are made over time so that growth is made truly comparable. We also know the difference between long term and short term growth.

Armed with the answers to all of these questions, we now ask the million dollar question:

What makes a nation grow over time?

That is, if we are to transform India into a developed nation by increasing her growth rate in a sustained, sustainable fashion, then what, specifically, needs to happen? Well, lots of things, is the easy answer. And a true answer, too.

Here’s a better question. What are the things without which this growth story absolutely can not happen?  What are the indispensable factors?

Answering this question takes us into the realm of growth, or development economics. Nomenclature aside, it is the area that lies at the heart of all economic policy-making. What we are looking for is the framework, the core, around which everything else can be built, added and embellished. Just as a truly great dish looks good and tastes better with more accompaniments, but can’t really work without the core ingredients – similarly, our growth story needs some core ingredients, around which we’ll add more stuff later.

And our core ingredients are labor, and capital. Turns out, India’s growth story cannot happen, without first possessing (and growing) capital and labor.

What is capital, and what is labor?

Capital is machinery. You’re almost certainly reading this post on an electronic device, and that device is your capital. The ladle with which a dosa-wala flips a dosa is capital. The pushcart that a chaiwala uses as his makeshift shop is capital. An assembly line in a Tesla factory is capital.

And the effort that I put in to type out this article is labor. The hands that use the ladle to flip the dosa is labor, as is the chaiwala himself and the worker on the factory floor of that Tesla factory. That is all labor.

And any production, anywhere in the world, of any good at all, can only be done with some combination of labor and capital. In order to produce something – anything – you need capital and labor.

The more you produce, the more you grow. The faster you produce, the faster you grow. And so in order to grow more, and grow fast, you need more capital, and you need more labor. So any story about the long term growth prospects of a nation need to start from capital, and labor.

Economists call these the factors of production, and without them, our story can’t start. But with them, we encounter another question: how do you get capital and labor to grow?