The Limits of Even the Most Powerful Theories, or Why Tax Really Is Different

Alex Raskolnivok, Accepting the Limits of Tax Law and Economics, 99 Cornell L. Rev. 523 (2013).

What are the criteria according to which tax base design should proceed? In Accepting the Limits of Tax Law and Economics, Alex Raskolnikov cogently reminds us not to rely too heavily on the approaches associated with tax law and economics, even if we find the approaches of law and economics in other contexts appealing.

Until early in the last century, there was little room for theory, economic or otherwise, in tax base design. The blunt practicalities of tax collection left little room for taxes that were not focused on highly visible and measurable activities. The development of economic theory, and its application to legal rules in the framework of “law and economics,” has shifted the focus from what can be collected to what should be collected (and from what can fairly be collected given the constraints of politics) to what can efficiently be collected, meaning in general with as little adverse effects on market activities as possible. In Accepting the Limits of Tax Law and Economics, Alex Raskolnikov outlines the reasons tax designers cannot rely solely—and probably not even primarily—on the methods of law and economics.

In its early and most rudimentary forms, the methods of law and economics were congenial to scholars in law schools analyzing tax law and tax policy. Law and economics introduced in a systematic way the idea that legal rules should be developed with consideration not only of the fairness of their ex post application, but their ex ante effect on behavior, given that such rules should only be invoked to constrain rational actors as appropriate to maximize social welfare. It may once have been possible to develop tax laws under the pretense that tax law simply applied to human activity “as the tax law found it.” In reality, however, no one ever really expected that people would not arrange their activities so as to minimize their tax burdens, whether by not finishing the thresholds for their front doors (under a property tax that treated unfinished buildings differently from finished ones), by separately purchasing springs as an add-on to springless carriages (under a carriage tax that increased according to the extravagance of the vehicle) or by investing in municipal bonds (under a federal income tax that was thought incapable of reaching the interest earned on such bonds.) Therefore the mode of analysis that is the hallmark of “law and economics” was early and easily applied to questions of tax policy. The mantra that the goal in tax design was the minimization of distortion in the operation of markets in which only rational actors participate was readily accepted in tax policy analysis, especially during the period when income was regarded as the most politically palatable tax base.

Indeed, in comparison with other administrable tax bases, the income tax was more likely than other taxes to pass muster under the efficiency criteria advocated by the principles of law and economics. If some sources of income were predictably taxed more lightly than others, taxpayers could be expected to pursue those sources of income. Even if all of the private benefit associated with these alterations in taxpayers’ activities were eliminated by changes in the relative costs of engaging in those activities, resources would be misallocated. Articulating tax policy was simply a matter of identifying those places in which tax rules interfered with market outcomes (and reducing that interference) and identifying market failures that could be remedied by alterations in tax rules. The guiding principle for tax policy (or at least income tax policy) for much of the mid-twentieth century was, therefore, the quest for a “comprehensive” tax base.

The problem with these early applications of law and economics to tax design was, of course, the distortions that even the most comprehensive income tax encourages on the labor/leisure and the consumption/savings margins. These distortions soon became the focus of attention, since they can under some assumptions be greater than the distortions that a well-designed income tax avoids (compared to, for instance, a real property tax).

These efforts by those immersed in economic theory to address these shortcomings of the income tax has led to various articulations of “optimal tax theory.” This label is sometimes limited to the particular line of reasoning that concludes that a uniform lump-sum tax is the least distortionary and thus the best of all possible taxes, but is often extended to any theory that insists that minimization of distortion must be the principal goal in tax-base design. Raskolnikov’s discussion is aimed at showing us just how far from anything useful this theoretical approach has proved.

Raskolnikov’s essay articulates the ways in which the task faced by tax theorists invoking “law and economics” is very different from the task faced by theorists of other regulatory regimes relying on such principles. Indeed, one of the clearest take-aways is that tax is not just another regulatory regime. (Raskolnikov’s focus is strictly on “taxes” that are necessary to provide government with revenue, and his analysis does not apply to any use of tax instruments to deliberately affect market behavior (P. 536-37), for which more typical law-and-economics methodologies may be useful.) Therefore its practitioners cannot, as other law-and-economics practitioners can, simply either assume an ideal regulatory regime and propose changes in existing rules to produce such a regime or assume that existing rules approach an ideal solution and identify the ways in which such rules could be altered to produce results even closer to the ideal solution.

Raskolnikov explores three reasons why tax design is different from, and more complex than, simple regulatory design. First, there is “the undeterrability problem.” The simple regulator seeks to set the right balance between an activity that produces both social benefits and social costs such that those activities with excess social cost are deterred. But the primary means of avoiding taxes is likely to be avoiding participating in economic activity (that is, by not working and by not saving). The private benefit to be gained from such a tax avoidance response simply is not a social benefit (in Raskolnikov’s terms, tax avoidance responses are “irredeemably inefficient”)—a condition not present in the problems addressed by simple regulators. It is virtually impossible in any real world to develop sanctions that can effectively deter such tax-avoiding behavior. As long as taxes must be imposed in the absence of information about what actions would have been taken in the absence of taxes, irredeemable tax avoidance behaviors cannot be deterred.

Second, the simple regulator can assume that redistribution is somebody else’s problem (and is encouraged to do so under most standard law and economics analyses). The tax designer cannot, since redistribution is what taxes (as he uses the term) are supposed to be. Third, the simple regulator (or at least the evaluator of the simple regulation) can assume a relatively uncontroversial baseline, and propose changes that move closer to that baseline. The tax designer has no such pre-established baselines on which she can legitimately rely. There is simply too much distance between the tax base we have (and any that we can imagine devising administrable rules for) and the tax base suggested by optimal tax theory (that is, a tax system limited to a nonlinear wage tax) to allow the ordinary methods of law and economics to operate. And, to complicate things further, even the optimal tax base incorporates distortions that would be unacceptable under standard economic theory.

The bottom line for Raskolnikov, especially with respect to the second and third reasons tax design is different, is the familiar conclusion that law-and-economics practitioners who focus on tax base design have little to contribute to a debate that is not essentially economic but is instead political and moral. The difficult choices in tax base design are all those that are assumed away in the typical law and economics approach. The less common feature of Raskolnikov’s discussion is his willingness to accept the typical law and economics framework on its own terms, and his applause for the techniques of law and economics in tax policy analysis when appropriately limited. At times, his approach requires a lot from the reader, since not all of the framework is presented in ways that those not already schooled in it can digest. But regardless of one’s prior knowledge and prior assumptions about law and economics, one cannot help but agree with Raskolnikov’s ultimate conclusion that its framework is inevitably inadequate to the task of the larger problems in tax base design.