Tariffs vs income taxes

Inspired by Don Boudreaux, Tim asks: “If tariffs reduce trade, why does income tax not reduce incomes?”
As one of the many targets of the question - someone who supports free trade and income tax, a perfectly common position - I’d suggest three reasons:
1. There are often more and closer substitutes for imports than there are for earning a wage.
One of the curiosities of international trade is that there’s a very incomplete division of labour, as rich countries often import and produce very similar goods. This generates an ability to substitute away from imports if a tariff is imposed - either to a very close substitute (domestic vs. imported steel) or a near substitute (home-grown apples vs. imported bananas).
By contrast, the substitutes for wage-earning aren’t so close. Yes, some can slip into the black economy, and others can work overseas. But leisure is - as we all know - a very distant substitute for work.
The upshot is that we can’t substitute away from work as easily as we can away from imports.
For this reason, I’m not sure if Tim’s example of NBA stars moving to low-tax states has huge relevance to the UK. Playing basketball in Texas is a close substitute for playing it in California, so we’d expect taxes in the latter to encourage players to move to Texas. But insofar as working in London is a less close substitute for working in Paris, we’d expect a smaller effect of UK taxes on labour supply.
2. Income tax has an income effect as well as a substitution effect. In reducing our post-tax incomes, income tax might encourage us to work harder or longer. It’s difficult to establish this empirically, because one way in which this happens is that we postpone retirement with the result that taxes in one year might raise labour supply decades later.
It’s not obvious that tariffs have an analogous effect in boosting imports.
3. Tariffs often are not just a tax on consumer goods, but upon inputs. And insofar as point 1 doesn’t hold, this introduces another channel in which tariffs reduce imports. In making some activity unprofitable at the margin, firms might shut down.
Again, there’s no analogy with income tax. Companies might kill themselves in response to higher tariffs on imports, but people don‘t kill themselves in response to higher income taxes.
Now, I stress that these are hypotheses that apply generally and with exceptions. It’s entirely possible - nearly certain - that there are some cases where income taxes reduce incomes and where tariffs have relatively benign effects. The question is an empirical one: how common, exactly, are such cases? And the answer is: it’s hard to tell.
Instead, I’m just trying to motivate the Bayesian prior held by many liberalish lefties like me, which is to instinctively oppose tariffs but support income taxes, unless there‘s good empirical evidence to the contrary. And for the tax rates that are relevant, this evidence is, so far at any rate, unconvincing.

Comments

[Andrew]

Apologies if I miss the point here, and you are only instinctively in support of income tax relative to tariffs. However, I don't know why liberal leftiness would predispose to thinking taxing the fruits of labour is a good idea. Surely taxing wealth (particularly land) is much better, for well-rehearsed reasons. It may be mere anecdote, but I don't know anyone in the 40% or 50% bands who doesn't undertake less work than they would were it untaxed.

You haven't mentioned the obvious substitution available to high income earners and capitalists in general: capital appreciation for income.

Thirdly, I suspect you are mistaken about there being no analogy with firms shutting down faced with a tariff on inputs. Since firms must attract labour with NET wage, income taxes are a cost on input (labour) for the firm. Faced with this tax, a firm may well either collapse or decide against creating a paid position.

Income tax, trade tariffs and corporation tax strikes me as an atrocious way organise a tax base. Taxes based on assets would encourage their productive use, seek fairer payment for value-adding public infrastructure projects and provide better incentive for labour.

Your instinct is to tax the poor man who works his arse off and does well for a year and not the noble who inherited Buckinghamshire!

[Jim]

I think its more a case of what is unseen.

Its unlikely that people would reduce their income in response to an increase in income tax (though there could be cases where due to a threshold triggering a higher overall rate say, then the logical response would be to reduce ones income below the threshold).

But its entirely conceivable that in response to higher tax rates people refuse to earn more. Take less overtime, refuse extra work if self employed. I know this is the case for me. I'm self employed and am pushing the 50% rate bracket. I'm not going to bust a gut on a new project only for the tax man to grab over half of the profits. So I don't bother.

But that 'income foregone' doesn't show up in any statistics.

[Jim]

Small businesses often operate just under the VAT threshold because if they go over it they have to be VAT registered and charge VAT. This would result in either higher prices to the customer (and thus most likely less work and profits) or the same price to the customer and an immediate reduction in net income for the business.

That is effectively a tax on income in my view, a somewhat opaque and skewed one, but an income tax in practical effect.

So if that is accepted as the case, why should higher actual income tax rates not depress incomes to lower than they might otherwise be?

[chris]

@ Andrew - I agree, there is a good case for higher land taxes.
@ Jim - I take your point. The question is one of magnitude: how significnt is it? I can believe that some self-employed do make this choice. But these are only a small fraction of the workforce. Is it really the case that many employees in the 50% bracket cease to be ambitious for promotion because of the tax rate?

[Mark Wadsworth]

Well, as Andrew says, least bad tax is tax on land (taxing wealth in a general sense is pointless and probably counter-productive), but failing that, the worst taxes are tarrifs (which includes of course VAT, which is a heavily disguised tax on the income of the producer and his employees). A flat income tax (or corporation tax) does have Laffer negative effects, but these aren't as bad as the impact of VAT.

[anon]

You are neglecting the intensive margin here. The dispersion in incomes is very large, and a clear tradeoff exists between income and leisure, or quality of work. Thus, high income taxes will decrease pre-tax income. The effects will be especially large in the long run, as human capital formation can take years or decades.

The land tax has been mentioned already, but failing that, a tax on consumption is better than an income tax from a pure non-distortion POV, because it taxes present and future incomes at the same rate. However, an income tax may work better in practice, by discouraging envious accumulation of savings.

Similarly, the public finance/optimal redistribution literature suggests that marginal tax rates should be an S-shaped function of income/consumption, tapering off at very high levels. However, if high incomes are envious or result from rent-capturing behaviour, taxing them highly makes sense.

[jean]

The point is that tariffs also reduces incentives to work. Tariffs reduces the purchasing power of one hour of work as effectively as a broadbase work tax (unless the imports are inelastic and that foreign producers are even more inelastic).

The issue was discussed by Tyler Cowen in the context of carbon tax. It shows that if the carbon tax can be a solution to climate change, it is no solution to fiscal problem. The same argument probably applies to tariffs imports (which do nothing for the environment).
http://marginalrevolution.com/marginalrevolution/2009/06/carbon-tax-vs-labor-tax.html

[anon]

jean, you're right about the "tax-interaction effect" of carbon taxes and import tarriffs. However, taxes are still fiscally efficient when compared to alternatives such as carbon mandates and import quotas: the latter measures have the same impact on prices and purchasing power (assuming that they're binding) but yield no government revenue.