The Hidden Tax

When the collection of revenue is too convenient, it can lead to consequences that may or may not be intended.
January 1, 2008
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

A canon of good public policy is that the costs of government should be visible so that taxpayers can figure out if they are getting their money's worth. Does the same maxim hold true for paying taxes and the visibility of each of those levies?

Most economists argue that taxes should be collected efficiently so as to minimize the costs of transferring dollars from taxpayer pockets to government coffers. Collection of the federal income tax, for instance, entails a compliance cost for private taxpayers that is estimated to equal 10 percent of the amount of revenue collected. Such collection inefficiencies are viewed as a loss to society.

But some argue against too much tax efficiency. Milton Friedman, for example, regretted the adoption of the withholding of income taxes because it subsequently lessened the visibility of taxes and promoted big government. Lately, the President's Advisory Panel on Federal Tax Reform in 2005 scotched the idea of a value-added tax because, in part, members feared that the tax was too efficient, largely invisible and thereby might serve to increase the size of government. The VAT, which taxes transactions at every level of production through consumption, can raise large sums of money at low rates and is the principal revenue source in all developed countries with the exception of the United States.

When one accounts for all the other things that go into determining the size of the public sector, there appears to be little empirical evidence to indicate that more efficient taxes per se lead to larger government. But, that has not kept folks from trying to find an impact.

Economist Amy Finkelstein, in a recent paper for the National Bureau of Economic Research, studied one aspect of the issue: the adoption of electronic toll collection on the rates charged by toll facilities. ETCs, which go by such names as EZ-Pass and FasTrack, are attractive to drivers in that the tolls are collected by scanning the vehicle as it drives through a tollgate; the toll is then automatically deducted from the driver's credit card. ETCs provide great efficiency in collecting revenue. By the same token, however, drivers lose touch with what individual trips cost.

What Finkelstein found was that adoption of ETC correlated to increases in toll rates. Once the usage rate of ETC on a bridge or highway matured to 60 percent of drivers, tolls went up by 20 to 40 percent. The most-accepted explanation was that, with ETC, the "price" elasticity of driving with respect to toll rates declined, making it easier to raise tolls. In other words, driving around became just another item on the ubiquitous credit card bill, lost amid the multiplicity of charges that get attended to once a month.

The ETC experience raises an important question: Is the taxpayer better off when a service gets delivered more efficiently but with less visibility? Or, can too much efficiency be an enemy to knowing the real cost of government?

The issues of efficient tax policy are a pressing concern. Nowhere is this more evident than in the debate over what to do about global warming. Since there is now nearly universal concurrence that the major culprit is carbon emissions, the issue is how these can best be curtailed. No matter how you cut it, emissions curtailment will require governmental action at the state, national and international level. But how to do it?

Here, economic logic and political rhetoric go head to head. Economists of every political stripe agree that the most efficient way is to tax carbon content. Politicians, on the other hand, flinch when it comes to talk about taxing anything, much less commodities (such as gasoline, heating oil, coal) that have risen steeply in price.

The desire is to find a "costless" regulation. In the case of carbon emissions, the politically preferred route is a "cap and trade" system, which would have governments issuing permits to industries to pollute. Theoretically, the permits would be limited in number and would gradually be tightened. Being tradable, the market values would grow over time. Sounds painless. But the "cap and trade" represents both huge opportunities for manipulation and an inefficient way to impose a hidden tax. That's because, if the system works, carbon-based goods will necessarily carry higher prices in order to reduce their use. Those higher prices will be the "tax."

Now, if we just could figure out a way to tax carbon content using credit cards and monthly statements.