Much is said and written about the high burden of income taxes on the wealthiest Americans. The top 20% of earners contribute over three-quarters of federal income tax revenues, despite collecting about half of the overall nation’s income. At first blush, this seems markedly unfair. But “fair” depends on perspective.
For example, if I were in a room with Bill Gates, the average net worth of the people in the room would be about $25B. If the only information available was that there were two people in a room with an average net worth of $25B, and you were told that when they left, one would have $50B, and the other would have mere thousandths of a percent as much, that would sound unfair…until you gain the additional perspective of who those people are, and what they brought into the room.
Taxation fairness can be viewed from a few perspectives:
- Collecting the same number of dollars from each person
- Taxing at the same percentage rate, based on the value of something they have (property), or are collecting (earnings)
- Taxing at a rate determined by one’s consumption of government services
- Taxing at the same percentage rate, based on the marginal utility of the value of something they have or are collecting
This last one is the most complex to explain, and thus is unsurprisingly the least well understood. To gain an appreciation for marginal utility, let’s look at the “paradox of water and diamonds,” often associated with Adam Smith but conceptually discussed for centuries before him. Without clean fresh water, we die, yet we as a society value diamonds much more than water (at least for now). The fundamental reason for this is scarcity.
Today, clean fresh water is far more plentiful than diamonds. However, even if one is in possession of the Hope Diamond, if no water is available anywhere in the world save for one person in front of you with a gallon jug, and you are dying of thirst, that gallon jug is easily worth more than the diamond.
Marginal utility is based on a combination of need and scarcity. The greater the need and the greater the scarcity, the greater the corresponding marginal utility.
This concept applies to dollars in the same way that it applies to water or diamonds. The more dollars you have, the less each individual dollar is worth to you.
Intuitively, this should make sense. If all you have for the day is $20, a $15 steak will seem like a lot of money, and you’ll probably opt for something cheaper. If, on the other hand, you have $2,000 for the day, you will feel more inclined to splurge on the $50 steak, let alone the $15 steak. The same dollars provide less marginal utility per dollar. Or, to put it in simpler terms, spending $50 when you have $2,000 is less painful than spending $15 when all you have is $20.
What does this have to do with taxation? As I said before, one fair method of taxation is to tax based on marginal utility. Since each dollar has less marginal utility as you increase the number of dollars you have, in order to tax marginal utility, you must increase the tax rate as the number of dollars rises. This is the basis for progressive taxation.
Of course, all of the above begs an important question: how do you measure that marginal utility? After all, it’s going to be different for different people. To cite one obvious example, someone living in a place with a high cost of living will have lower marginal utility for the same number of dollars as someone living in a place with a low cost of living. But that’s the easy example; there are many other more esoteric ones that are equally valid.
I’m not going to pretend that the answer is easy or obvious. Rather, I suggest that it’s in many ways beside the point. Laws, by necessity, cannot account for all of the subtle nuances that differentiate each of us from the others. We set the age of majority at 18, despite knowing that some people are mature enough at 16 to make adult decisions, while others don’t reach that level of maturity until much later. As a society, we agree that the simplicity of one-size-fits-all rules is superior to the complexity of a more complex, customized set of rules, even though that one size will be ill-fitting for many.
Nonetheless, I wouldn’t object to a more complex set of rules to better fit the progressive tax rate to the marginal utility curve of each taxpayer. It becomes an argument about how to apply a marginal utility tax, rather than whether such a tax is appropriate in the first place.
The concept of “fairness” is pretty slippery. But there’s no more reason to consider a progressive income tax unfair than there is reason to consider unfair any of the other three tax models I outlined above. Rather, it’s an argument over which types of unfairness are the least egregious. And that is entirely a matter of perspective.