The Wedge

What are taxes, anyway?

Governments have to collect taxes to pay for their services. They also collect taxes to encourage or discourage various activities. For example, the mortgage interest deduction and homestead property tax exemption are designed to encourage people to own their own homes. Our governments have tax policies that affect our actions.

But taxes also act as a wedge between economic actors, distorting prices and changing behavior in unforeseen ways. For example, a tax on luxury goods has the effect of increasing the price to the consumer (depressing demand) while decreasing the price received by the producer (depressing supply). With lower demand and lower supply, the price stays the same, but less is sold. So governments never get as much in tax revenue as they expect.

When you look for them, there are tax wedges everywhere. Social security taxes are a wedge between workers and their employers. Income taxes create a wedge between the value of someone’s labor and what she receives. Capital gain and dividend taxes are a wedge between what investors earn and how much an investment returns.

The larger the rate, the bigger the wedge. That’s why many see that having a broad tax base and low tax rates as the most effective way to raise money for the government. A lower rate distorts the economy less and provides less drag.

Which raises a question: can you think of a tax that’s not a wedge? I can. I don’t like it. But it may just be the best way to go.

Douglas R. Tengdin, CFA
Chief Investment Officer
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