Proportional and progressive income taxation with utility-maximizing governments

Abstract

In the Constitution of Liberty (1960), F.A. Hayek suggested that proportional taxation of personal incomes is compatible with a social order in which individual liberties are preserved whereas progressive taxation is not.1 He argued that proportional taxation, in itself, would exert a sufficiently constraining influence on the behavior of government in exploiting its inherent fiscal authority. We may infer from his discussion that Hayek would support a constitutional limit on the taxing power that would allow the levy of proportional income taxation but that would prohibit the imposition of progressive rates. To our knowledge, the precise effects of such a constraint on the fiscal authority of government have not been fully analyzed. This paper is aimed at partially filling the gap. In highly simplified models, we shall examine the behavior of government under proportionality constraints and we shall compare this behavior with that predicted under progressive taxation. We shall analyze the effects of maximal rate constraints under both proportionality and progression. In the first part of the paper we shall ignore the effects of taxation on incentives to produce taxable income; incentive effects are introduced in the second part of the analysis. Before we can make the analysis meaningful, some model of governmental decision-making is required, along with some specification of the nontax constraints on fiscal authority. We shall model governmental behavior in very general terms. We assume only that governmental fiscal decisions are made by some subset of the taxpaying citizenry, some less than all-inclusive coalition of the whole polity. The decision-making group may be conceived as a majority coalition representing one of two major political parties, with the total group of taxpayers being divided into members of this majority and members of the minority. Alternatively, we might consider the setting to be one where a ruling clique or committee (in the limit of one