Tax collection is the most efficient department of government, Nick Szabo says; its efficiency rivals that of many private sector institutions:
The tax collector’s incentives are aligned with the other branches of their government in a task that benefits all associated with the government, namely the collection of their revenue. No organization of any type collects more revenue with fewer expenditures than tax collection agencies. Of course, they have the advantage of coercion, but they must overcome measurement problems that are often the same as other users of accounting systems, such as owners of large companies. It is not surprising, then, that tax collectors have sometimes pioneered value measurement techniques, and often have been the first to bring them into large scale use.
Mis-measuring value means taxing various things too much or too little:
On a larger scale, the Laffer curve may be the most important economic law of political history. Adams[2] uses it to explain the rise and fall of empires. The most successful governments have been implicitly guided by their own incentives — both their short-term desire for revenue and their long-term success against other governments — to optimize their revenues according to the Laffer Curve.
Governments that overburdened their taxpayers, such as the Soviet Union and later Roman Empire, ended up on the dust-heap of history, while governments that collected below the optimum were often conquered by their better-funded neighbors.
Democratic governments may maintain high tax revenues over historical time by more peaceful means than conquering underfunded states. They are the first states in history with tax revenues so high relative to external threats that they have the luxury of spending most of the money in non-military areas. Their tax regimes have operated closer to the Laffer optimum than those of most previous kinds of governments. (Alternatively, this luxury may be made possible by the efficiency of nuclear weapons in deterring attack rather than the increased incentives of democracies to optimize to tax collection).
When we apply the Laffer curve to examining the relative impact of tax rules on various industries, we conclude that the desire to optimize tax revenues causes tax collectors to want to accurately measure the income or wealth being taxed. Measuring value is crucial to determining the taxpayer’s incentives to avoid or evade the tax or opt out of the taxed activity.
For their part, taxpayers can and do spoof these measurements in various ways. Most tax shelter schemes, for example, are based on the taxpayer minimizing reported value while optimizing actual, private value. Tax collection involves a measurement game with unaligned incentives, similar to but even more severe than measurement games between owner and employee, investor and management, store and shopper, and plaintiff-defendant (or judge-guilty party).
As with accounting rules, legal damage rules, or contractual terms, the choice of tax rules involves trading off complexity (or, more generally, the costs of measurement) for more accurate measures of value. And worst of all, as with the other rule-making problems, rule choices ultimately ground out on subjective measures of value. Thus a vast number of cases are left where the tax code is unfair or can be avoided. Since tax collectors are not mind readers, tax rules and judgments must substitute for actual subjective values its judgments of what the “reasonable” or “average” person’s preferences would be in the situation.
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The resulting rules often seem arbitrary, but they are not. They are trade-offs, often non-obvious but brilliant, between the costs of measuring more value with greater accuracy and extra revenue extracted thereby. However, the value measurement problem is hardly unique to tax collection. It is endemic when assessing damages in contract and tort law, and when devising fines punishments in administrative and criminal law.Many private sector rules found in contracts, accounting, and other institutions also have the quality that they use highly non-obvious measures of value that turn out, upon close examination, to be brilliant solutions to seemingly intractable problems of mind-reading and the unacceptable complexity of covering all cases or contingencies. Such measurement problems occur in every kind of economic system or relationship. The best solutions civilization has developed to solve them are in most institutions brilliant but highly imperfect. There is vast room for improvement, but failed large-scale experiments in attempts to improve these measures can be devastating.
The Laffer curve and measurement costs can also be used to analyze the relative benefits of various tax collection schemes to government. Prior to the industrial revolution, for example, the income tax was infeasible. Most taxes were on the prices of commodities sold, or on various ad-hoc measures of wealth such as the frontage of one’s house. (This measurement game resulted in the very tall and deep but narrow houses that can still be found in some European cities such as Amsterdam. The stairs are so narrow that even normal furniture has to be hauled up to the upper story and then through a window with a small crane, itself a common feature on these houses).
Prior to the industrial revolution, incomes were often a very private matter. However, starting in England in the early nineteenth century, large firms grew to an increasing proportion of the economy. Broadly speaking, large firms and joint-stock companies were made possible by two phases of accounting advances. The first phase, double-entry bookkeeping, was developed for the trading banks and “super companies” of early fourteenth century Italy. The second phase were accounting and reporting techniques developed for the larger joint stock companies of the Netherlands and England, starting with the India companies in the seventeenth century.
Accounting allowed manager-owners to keep track of employees and (in the second phase) for non-management owners to keep track of managers. These accounting techniques, along with the rise of literacy and numeracy among the workers, provided a new way for tax collectors to measure value. Once these larger companies came to handle a sufficient fraction of an jurisdiction’s value of transactions, it was rational for governments to take advantage of their measurement techniques, and they did so — the result being the most lucrative tax scheme ever, the income tax.
Nazgulnarsil, a commenter, points out that whether or not a society that is taxing below the optimum can survive would seem to depend on the relative costs of offense and defense:
Thus when defense is cheap relative to offense we can expect freer societies since they can afford not to tax at the optimum rate for military expenditures.
Nick goes further:
Nazgulnarsil, since the optimal point for economic growth or wealth is at a tax rate well below the Laffer optimum, one could derive as a corollary that societies with better natural defenses, and thus lower defense costs (in the days before the welfare state) would have higher economic growth (or higher population growth in the Malthusian era before the industrial revolution) per acre of arable land, and perhaps other desirable characteristics as well, such as a more libertarian legal system, and that such societies will be more more likely to conquer than be conquered.
There seems to be some geographical evidence for this: countries with natural barriers of sea or mountain tended to create empires rather than be ruled under them, and tended to have better legal systems and more economic prosperity.