The 'Tax Simplifier' series aims to make the case for a much simpler tax code with practical recommendations for policy change on a regular basis. Blogs are published twice per week, on Monday and Thursday. Read David's previous blog on the tax burden for poor people. You can follow David on Twitter @TaxSimplifier.
Economic efficiency means the maximisation of goods and services that people value most. If taxes, including any incentives built into the tax system, distort an otherwise efficient market, there is a cost which is referred to as the excess burden of taxation. It arises because people do things they would not otherwise have done - or don’t do things they otherwise would have done.
So economic text books tell us that, when people act for tax reasons, economic efficiency is normally impaired, even if they gain a financial advantage for themselves.
Taxes that have a wide base are less likely to create the distortions that reduce efficiency than taxes with a narrow base. So in general taxes applying to all goods and services are less likely to harm efficiency than taxes applied only to some supplies.
But the market does not always operate efficiently - a polluter may not bear the costs of clearing up his pollution, or conversely there may be cases where a person can provide a benefit to the wider community without being paid for it. In such cases the tax system can actually improve efficiency by taxing polluters or by providing incentives for the wider good.
But Governments are justly criticised if they introduce tax incentives because they feel they can spot winners which have not been recognized by the market. Complexity grows and with it the opportunities for avoidance. Incentives are often introduced and then withdrawn after a short time, or left to wither away as the incentive limits are not increased to match inflation.
An incentive is likely to be justified if it appears that we will all better off as a result, not just the lucky person who has his taxes cut. Incentives to attract mobile international business to this country may be an example of this.
But future blogs will examine tax incentives which have been introduced but which are unlikely to be justified.