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Tax policy colloquium session on horizontal equity

By Daniel Shaviro

Yesterday at the colloquium, Brian Galle of FSU Law School presented his paper, "Tax Fairness," arguing that rumors in the recent tax policy literature of the death of horizontal equity (HE) as a tax policy norm are greatly exaggerated. I was not persuaded, but unfortunately there was a bit of a ships passing in the night quality to the session.

There's a bit of a generational aspect to this, I suppose, just as with Sarah Lawsky last week, in that my peer group is the one that purported to throw out HE with the trash.

Brian mainly argues for HE on grounds concerning procedural norms that may improve decisions in an imperfect political setting, rather than as something that (like welfare-based norms) matters for its own sake. So I would compare the argument he is making to support for, say, a takings compensation rule like that in the U.S. Constitution, or the constraint barring nominally retroactive changes (e.g., raising the income tax rate with retroactive application to the last 20 years) that I discussed in my transitions book, When Rules Change. But I couldn't entirely get a handle on exactly how the argument goes.

In terms of HE for its own sake, I made a point that I think a lot of people in the tax policy literature have missed (though Kaplow, Auerbach, and Hassett get it) concerning the potential irrelevance of whether one subscribes to HE or not, and the resulting purely semantic character of many HE debates. Consider David Bradford's argument that a consumption tax is fairer than an income tax because it doesn't overtax savers relative to immediate consumers when the two have the same budget lines but different inter-temporal consumption preferences. David posed this as an HE argument, and many responses said: So what, if we don't like HE.

But David's argument was relevant, whether one agrees with it or not, even wholly without HE. To accomplish vertical equity (VE) or suitable progressive redistribution, you need to rank people on a vertical scale from best-off to worst-off, so that you know how much everyone should pay or get. ("Vertical" and "better or worse off" may be misnomers insofar as the scale depends on factors, such as the number of children in the household, that affect the marginal utility of a dollar, and thus distributive desert in a utilitarian framework, without regard to whether they systematically affect how well-off one is deemed to be.) HE concerns equal treatment of two people at the same point on the scale but, as Kaplow has repeatedly argued, you need to do this for purposes of VE whether you separately care about HE or not. So even if you don't care about HE, Bradford's argument, that a consumption tax measure gets the vertical scale right while an income tax gets it wrong, remains completely pertinent.

Why does subscribing or not to HE matter at all in this framework? Borrowing from the idea behind an Auerbach-Hassett paper from some years back, I put it this way. Suppose a person who is otherwise a utilitarian, but hasn't decided yet whether or not to differentially weight utility gains or losses under the influence of HE, is considering two wealth transfers, each bad in itself but leading to an efficiency gain that increases other people's utility. The first would violate HE (but also VE, as Kaplow notes) by transferring a certain number of dollars from A to B, who previously were equally well off, leading to a utility loss from the redistribution (because as A gets poorer her marginal utility of a dollar increases) in the amount of X utiles. The second would only violate VE, by transferring dollars from C to D, where C was already poorer, also leading to a utility loss from the redistribution of X utiles. If you nonetheless weight the first utility loss more than the second utility loss in your social welfare function, thereby departing from strict utilitarianism, by reason of the fact that A and B started out as equal, then you are relying on horizontal equity, albeit consistently with welfarism.

Suppose the utility consequences of the efficiency gains that accompanied the wealth transfers from A to B and from C to D were equal to each other (and greater than X). A welfarist who believed in HE, but not a strict utilitarian, might oppose the former transfer and support only the latter one, solely by reason of using HE in her social welfare function. (I ignore here the question of how the HE proponent might need to think about the utility gains from the efficiency enhancement.) So we have a theoretical case - albeit a painfully abstract and bloodless one - in which subscribing or not to HE actually does matter.

When Kevin presented the Auerbach-Hassett paper at the colloquium many years ago, I responded by quoting the Jeff Goldblum character in Jurassic Park, who says: "You did it because you could! You never bothered to ask whether you should!" In other words, I complained that while it worked logically, and showed that HE can be reconciled with a welfare framework (contrary to what Kaplow had argued), it remained unmotivated, at least for me.

But given how abstract and third-hand the example where HE matters turns out to be, perhaps the real lesson is that it doesn't matter so much. When people make HE arguments that are not just status quo bias or simplistic takes either on transition issues or on how market prices respond to tax preferences, they often are arguing about the correct vertical scale, an issue that anyone interested in the fiscal system's effect on distribution must take seriously.

Full post as published by Start Making Sense on February 22, 2008 (boomark / email).