Is it possible an optimal tax system that maximizes the welfare of a society?

While research on optimal taxation often focuses on the pure economic implications, it rarely considers the cultural and social differences that can lead to very different results when trying to implement an optimal tax system.

Economic and Cultural Optimization

There are two types of optimization: economic and cultural. Economic optimization asserts that taxes should limit economic distortions and not drastically alter people’s decision-making. From this point of view, taxes must follow clear guidelines, such as the Tax Foundation’s Sound Tax Policy Principles: neutrality, stability, transparency and simplicity.

Cultural optimization, on the other hand, recognizes that countries have different values ​​and suggests that fiscal policy should reflect those values. As a result, the same tax policies can lead to different results in different countries due to cultural variables.

An example of this is an inheritance tax. The importance of equity in income distribution (often called “vertical equity”) differs between countries. Thus, even if the inheritance tax is structured in the most principled way, cultural optimization would vary dramatically between, say, a country that favors social mobility and one that values ​​dynastic wealth. In the former, an inheritance tax is likely to be accepted and complied with; in the second, the chances of taxpayers accepting such a proposal are slim.

Economic and cultural optimization are not mutually exclusive. Rather, cultural factors may inform the implementation of economic principles. When tax policy reforms are discussed, cultural considerations must play a role.

The ugly truth about multilateral agreements

Today, a considerable part of fiscal policy concerns multilateral negotiations. And while countries strive for solutions that all parties can live with, political consensus generally never leads to the economically optimal policy solution.

To structure optimal taxes at the international level, agreements would need to include culture-specific provisions to tailor taxes to the political economy and make policies compatible with the interests of each government agreeing to them. Because multilateral negotiations often end with a compromise, these considerations are rarely represented; one set of cultural preferences usually wins out over the others.

The current negotiations on Pillar One and Pillar Two show this. They ignore cultural differences between countries and instead treat them as if they have the same incentive structures and preferences for higher corporate taxes.

Information as constraint

Any attempt to structure an optimal tax system requires a lot of information. To make the right decisions, policymakers would have to rely on the true preferences of the entire population, or at least a clearly representative sample. Capturing a representative sample is quite difficult; ensuring that your shared views are truthful is even more difficult. When decisions are made under time constraints and are driven by political rather than economic reasons, building an optimal tax system becomes increasingly complicated.

Even if a government could collect all the necessary public information, two key problems remain: costs and interactions. First, the collection and administration costs would likely outweigh the benefits, at least in the short to medium term. This is relevant to most politicians because the economic benefits of an optimal tax system accrue in the long run. The second comes from Hayek’s Criticism of central planning: that policymakers never have enough knowledge to discern the optimal policy during the policymaking process. Interactions between actors and spontaneous order through prices and markets can lead to more efficient outcomes than central planning.

Relying primarily on a mix of taste-based social and economic priorities is, however, not the appropriate shortcut to take in this situation. Many social priorities are inconsistent and harm those who were intended to benefit. One case is capital income taxation, which commonly attempts to redistribute resources from the rich to the poor. Taxes reduce the available wage pool and opportunities for future productive investment, which hurts workers. Instead, focusing on economic growth has been shown to alleviate many problems, including social ones.

In the end, a culturally optimal tax system may be impossible to achieve. But policymakers must not ignore cultural factors when designing and implementing economically optimal policies.

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