TAXES: A DISCUSSION ON THEIR ROLE IN THE ECONOMY

There are very few things in life from which we as humans cannot escape from. One of them is, paradoxically, the very end of life itself, the other is taxes. Let’s be honest for a moment and concede the fact that nobody likes them. The mere thought of them raises one’s heartbeat, and not in a good way! Regardless, it is a conversation that not enough people are willing to have with themselves to be able to judge whether their respective governments are being efficient enough with what each one of us provides to the system. How much is enough? What should be taxed and how much? These are all valid questions. Perhaps the most common ones pertain to taxes on investments and income.
Why must investors be “punished” for risking their own capital in their quest for returns? After all, this is (in an overly simplified way) one of the main tools governments use to intervene in the economy. When some activity performed by the private sector is deemed harmful to its citizens it’s heavily taxed, take the tobacco industry, for example. On the other hand, to encourage a certain activity deemed beneficial to the nation by the government, it is subsidized, such is the case of green energy initiatives. Furthermore, if anything, governments should encourage people to invest their capital and pursue higher returns on their money. This is what makes the economy go ‘round. The private sector invests its excess capital to fund an activity that creates or increases value in some way. The market itself appreciates it so much that it consumes that value, in the form of goods and services, thus creating the returns the capital providers of that good or service seek. This, in turn, allows the capitalists to use those returns to either invest more in their own (or another) value creating activity seeking even higher returns, and/or simply to finance their own consumption of goods and services (they too are human after all). As I am sure you understand if you have followed me up to this point, it is clear that investing in value creating activities or assets is indeed the axis of growth and economic progress for any nation. So, why tax it? Why risk slowing it down in any way?The philosophy here is, in principle, quite reasonable. The most basic yet crucial public services we all use every day enable us to create value in the economy and are oftentimes taken for granted, like sewage, public roads and so on. These services are, at least in part, provided by governments and are also extremely costly to maintain and expand. Therefore, all of those who benefit from them are expected to “chip-in”. As the great late free market economist, Milton Friedman used to say, “There’s no such thing as a free lunch”. The question now becomes: Who and how will the beneficiaries of such services pay for their use? That of course depends. Some services are easier to allocate to each user (and bill them accordingly) than are others. In fact, the easiest services to allocate are provided by the private sector like in the case of water and power services.
However, it’s not always that easy, as is the case of national defense which is vital for a nation and its citizens. It is best when provided by the democratically elected government that should act in the interest of the citizens it represents without establishing preferences. So, how should governments “bill” for this service specifically? It’s certainly not (or should not be) a profitable activity that could pay for itself. Nevertheless, it’s also an indispensable service from which all benefit. Still, it’s extremely complex to allocate and effectively show its usefulness to the citizens it protects. After all, the best protection is the one that goes unnoticed since it means it is either threatening enough to foreign forces that it avoids conflict altogether, or efficient enough so that its efforts are hard to be perceived and its effects on the economy and general population are very limited. Both are great outcomes that paradoxically make it a “harder sell” on the public because of their perceived lack of usefulness. We humans tend to appreciate more the things we can see in action, which is why countries with huge spending in this area normally “show off” their military capabilities more often. For example, the U.S.A. does it in the form of air shows, whilst many dictatorships do this through huge parades or starting meaningless wars. Different approaches, same end goal.
Whether it’s sewage and rubbish collection or military superiority, everything has its benefit and a cost which is hard to allocate and bill. In these cases, all citizens pay for it equally, without a specific distinction for their use. Some may benefit more than others, but it is way too difficult and expensive to truly figure out how these services should be billed, so it’s more economical and efficient to just bill everyone the same. We could truly go all day discussing the activities that may be crucial but may not be profitable in government. The gist of it is that everything has a cost and it must be paid for in some way, and oftentimes the taxes used to finance these services are collected indirectly. The most common one that most countries implement is sales tax or value added tax which is the government’s way of getting a percentage of a country’s economic activity. So far, so good, it all checks out, we all receive some benefits and pay for their use in some direct or indirect way, but now the truly interesting questions arise.
Once the basics are all paid for, where do we go from here? How involved should the government be in the life of its citizens? To which extent should indirect taxes be used to finance programs and initiatives that don’t necessarily concern all citizens but are financed by all citizens? How much is too much? All these questions are extremely controversial for the same reason since they are the important ones to ask. The saving grace for many informed citizens is that, thanks to capitalism and strong globalization, we live in an age of virtually limitless availability of information and travel. This allows ordinary people to judge what their elected officials are doing with the resources they are given and compare them with their fellow citizens from other countries. Once again, free market economics saves the day and even in government, at least in theory, market forces allow free states to compete in virtually all areas. The winners will naturally be the ones that get the most “bang for their buck” and are able to maintain a high standard of living for their citizens whilst not hindering the economy to do so. The most efficient spenders will inevitably win. If one country is more efficient, the citizens of the comparatively speaking less efficient one would, in theory, move to the former given no other barriers of entry like culture, language, legal framework, etc. This in turn, as you could expect, has massive effects, economic and not, for both countries. It’s easy to understand why taxes are an integral part of any country’s economic policy, its effects can be of great magnitude. Let us just recall one of the motives that sparked the U.S. independence from the UK back in the 1770’s, that’s right, taxes. “No taxation without representation” American revolutionaries chanted, a mere 2% tax on tea set the stage for what would become one of the most powerful nations in world history.
We don’t need to go that far away, or that far back for that matter, to see the effects of different approaches to taxation. Let’s make a comparison between two neighboring European countries with drastically different tax systems. Take Italy on one hand, known for its great culture and exceptional climate and resources, and Switzerland on the other, a small landlocked country with barely any strategic natural resources to exploit, at least compared to its neighbors. Even though this might be true, we all know the numbers don’t lie. Just a quick glance at the latest available data from both countries is enough to realize how far apart these two economies are from each other. Even though Italy’s GDP is more than double that of the alpine country, when we look at the GDP per capita matters change dramatically. Switzerland’s GDP per capita is more than double that of Italy’s. Interesting, isn’t it? But let’s not stop there, the debt numbers are even more impressive, as a percentage of GDP Switzerland’s debt is at around 33%, whilst Italy’s is at over 134%, so slight difference there. But what about the topics we’ve been discussing so far like spending and taxes? Here, the trend continues. As far as spending is concerned, for the mediterranean country that translates to about 53% of its GDP, whilst our Swiss friends only spend about 33% of their GDP. These numbers become more shocking when we start analyzing taxes, things as simple as VAT or sales tax differ massively. Italy’s average VAT rate is about 22% whilst Switzerland’s’ just shy of 8%. Furthermore, the highest income tax rate in Italy sits at 43%, Switzerland’s’? 0%. Pretty cool right? This is somewhat deceiving though, since income taxes are dealt with at a local level and these can vary significantly. However, even the canton with the highest tax of this type, Zurich, only gets as high as 11.5%, which is laughable in comparison with Italy. The advantage of devising a tax system that’s more focused on the local level than it is at the federal level means that each canton can compete with one another to attract more residents using what are essentially market forces. The canton that provides more to its citizens for less, wins. Simple enough, right? Efficiency is the key to economic progress in modern economies, the free market at it again. The best part about applying this kind of tax system isn’t some magic trick that only works in small countries. The biggest economy in the world also has its own version of this. Although there are more federal taxes, a lot of them are local in order to take advantage of this phenomenon of competition amongst different states. This is something so efficient that, for example, the president of Argentina, Javier Milei, has recently announced in a press conference his intention to apply this very tax system to complement his great efforts to save a nation that has suffered for decades from an extreme lack of government efficiency, corruption, and high taxes.
Lastly, let’s talk about the controversial capital gains tax. Switzerland is one of the few countries in the world where there are no capital gains taxes at all (except for few specific cases). This, of course, attracts a lot of wealthy individuals and, in turn, translates into consumption in their own country. It also works as a way to prevent an exodus of its own citizens. By not taxing capital gains, their residents are more inclined to want to produce more value since they know they get to keep more of it. Just in case you were wondering, Italy’s capital gains tax is around 26%. But how does all of this translate in terms of quality of life for its citizens? Are they getting what they pay for? Let the figures do the talking. According to the IMD world competitiveness ranking for 2023, which ranks countries based on several factors such as government efficiency and infrastructure, Switzerland ranked 3rd overall and Italy 41st. Also, the world happiness report which considers a great number of factors such as GDP and so on, ranked Switzerland 9th this past year, Italy was 41st.
It is clear, then, that although tax rates and government efficiency might not be the “end be alll” when it comes to the economic progress and prosperity of a given country, it is clearly intimately correlated with it. The good news is that, even though it might not seem like it at the start, making some subtle changes in this area can meaningfully and positively affect a countries’ economy and standard of living. Argentina is a current and undeniable example of this. Under the new administration and Milei’s leadership, they are proving all their naysayers wrong. In just over a year in office, they have achieved what many insisted couldn’t be done, all through a simple yet proven strategy, free market economics, increased government efficiency, and low taxation.