Review of Austrian Economics - The Ludwig von Mises Institute

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Tabarrok: Preferred Tax Type 109 Herbener's second critique of the preferred tax theorem is that the proof requires a certain sequence of events: (1) the excise tax is placed on good X, (2) the amount of tax revenue is measured, (3) an equal-revenue income tax is levied. He argues that the sequence cannot begin with an income tax followed by an equal-revenue excise tax because the government does not know the preferences of individuals and therefore cannot compute the equal-revenue excise tax. According to Herbener the first scheme is the one that is presented "because only it allows the government to conduct the postulated experiment." But as Herbener himself notes, the neoclassical method (at least the part required to prove the theorem) is axiomatic and deductive. The theorem is a conclusion of theory and not a description of how to conduct an experiment. 7 For a theory to be correct it need not be experimentally testable. But it must have true premises and sound reasoning. The preferred tax theory is presented the way it is because this is the only method which guarantees that one of the implied premises is true. The implied premise which must be true for the theory to hold is that there exists an excise tax capable of generating revenue equal to that of an income tax. The sequence of the first proof guarantees that this premise is true because the excise tax is placed first followed by an equal-revenue income tax. 8 The alternate sequence, proposed by Herbener, cannot guarantee that this statement is true. No excise tax on toothpicks could raise the same amount of revenue as does the present income tax of the United States. This is the problem which the first sequence avoids. If we make the implied premise explicit, then the proof follows as before. Referring to figure 1, AA is the original budget constraint, BB is the budget constraint after an income tax. Let us assume, so as not to clutter the diagram, that the consumer chooses bundle F. We now assume that an excise tax exists which raises revenue equal to that of the income tax. In general we do not know exactly how high this tax must be but this is irrelevant as far as the theory is concerned. 9 We do know by assumption that such a tax exists; assume that it is AC. If AC is the equal revenue excise tax then we know that the 7 There is no reason it could not be both, but this is unimportant for present purposes. 8 As a matter of logic, ceterius paribus, it must be true that an income tax can always raise as much money as an excise tax. The situation is equivalent to knowing that demand curves slope downward yet being unable to a priori predict by how much quantity demand increases when price falls by 10 percent.
110 The Review of Austrian Economics, Vol. 5, No. 2 consumer must be consuming at point D (any other point along AC would raise to much or to little revenue). But point D was available to our consumer before the excise tax was imposed and he chose not to consume at that point. His action demonstrated that he preferred to consume at point F. We therefore know that this consumer's utility has been unambiguously decreased by the switch from an income tax to an excise tax. Concluding Comments It has been shown without the use of indifference curves and using either sequence that an income tax is preferred to an equal-revenue excise tax. As Herbener notes, and is widely recognized, this type of analysis is only partial in nature. Taxes also have effects on the production side of the economy. References Herbener, Jeffrey M. "Austrian Methodology: The Preferred Tax Type." Review of Austrian Economics 2 (1988): 97-111. Hicks, J. R. [1939] 1946. Value and Capital, 2nd ed. Oxford: Clarendon Press. Rothbard, Murray N. 1956. "Toward a Reconstruction of Utility and Welfare Economics," in Sennholz, Mary, ed. On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises. Princeton, N.J.: Van Nostrand, pp. 224—49. Samuelson, Paul A. 1948. Foundations of Economic Analysis. Cambridge, Mass.: Harvard University Press.
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