Tax Roughening

I said yesterday that the Bush tax cuts are actually tax shifts.  But that was
being kind, once we take into account tax roughening, Bush’s tax
cuts are tax increases.

Deficits caused by tax cuts can reduce the total tax burden if they are used to smooth taxes.  Too see why remember that holding tax revenues constant it’s better to spread taxes across as many goods as possible.  The first penny of apple taxation causes you to stop consuming the marginal apple – the one that was barely worth its price anyway.  Raise apple taxes a bit more and you stop consuming apples whose value far exceeds their price.  Better to lose one marginal apple and one marginal orange than two apples the second one of which was really valuable.

The same thing is true of labor.  The first dollar of wage tax causes you to cut back on the last hour of work, but your wage on that last hour was barely worth the lost leisure time anyway so the first dollar of tax doesn’t create too much waste.  Raise taxes more, however, and you cut into valuable infra-marginal hours.  It’s better, therefore, to spread taxes over time periods – as Arrow taught us, the future is just a different set of goods.

Unfortunately, today’s deficits are tax roughening rather than tax smoothing.  Even with big cuts in Medicare and Social Security, taxes will rise.  Smoothing taxes now requires higher taxes and lower spending.  Unfortunately we have had tax cuts and spending increases and thus the tax stream has become rougher and the total tax burden has increased.