Market and state must complement one another

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by Hans Dembowski

In praise of taxes

The Paradise Papers and US President Donald Trump’s tax reform plans have generated lots of headlines internationally in recent weeks. Taxes are also high on the agenda of the negotiations that are meant to forge a new coalition government in Germany. All over the world, some commentators pretend that taxes are something evil, and that taxpayers are always overburdened. The idea that cutting taxes is always good is closely related to the idea that markets are always superior to state action.

Both ideas are distorted. Markets are different from states. Both need to complement one another, cannot replace one another. In this blog contribution, I’d like to list a few things that state agencies tend to be better at than markets. This list will not be complete, it merely emphasises some important points. Their implication is that taxes are indispensable because states cannot function well unless they are properly funded. I’m not suggesting that any fixed level of state revenue is necessary, but only arguing that we do indeed need taxes. Important points are:

  • Law enforcement and the judiciary cannot be left to market forces, unless we want judges and the police to decide in favour of the highest bidders. Indeed, the better off are privileged when it comes to legal action. One, though not the only, reason is that they can afford to pay the best lawyers, and hire many of them.
  • State institutions are more effective and cheaper when it comes to social protection. This is the reason why many wealthy countries have pension systems and health-care systems that rely on payroll taxes (which are called social protection contributions in Germany). These systems spend the money they collect on providing social services to all those who have paid their due share. They do not build a capital stock, but spend the revenue. That has several advantages. For example, the funding cannot be eroded by inflation, and indeed the pay-as-you-go systems were typically established after serious bouts of inflation. Health-care systems, moreover, tend to be cheaper if government-run institutions are the main buyer of services, because they have a stronger bargaining position vis-à-vis pharmaceutical corporations, for example.
  • State-run schools are essential for ensuring share opportunities. Yes, it is true that private schools tend to have a better reputation. It is equally true, however, that private schools cater, in particular, to a wealthy clientele. They ensure that the offspring of rich families have a head start before the competition for good jobs and careers even begins. Any society that wants to ensure equal opportunities, therefore needs a strong public education sector to level the playing field to a reasonable extent.
  • Markets are at risk of being monopolised. Where that happens, the competition that normally ensures market efficiency no longer exists. In those cases, state agencies are preferable, because they are designed to serve the common good rather than to maximise individual profits. In some sectors, there are natural monopolies, moreover. The reason is that they depend on expensive infrastructure. Water pipes, train tracks and power grids are examples. These sectors need to be either run or thoroughly regulated by state agencies.
  • Market dynamics in themselves do not lead to environmental protection. On the contrary, they typically result in pollution. The reason is that neither the buyer nor the seller of a product worry about the environmental impacts of that product. The impacts concern society in general. Markets are good at maximising individual benefits, but they are not designed to promote the public good when and where individual interests have a negative bearing on society. The legitimate representatives of society in general are our elected legislators and governments. Regulation is needed to control pollution.

It is sometimes argued, that industries should be allowed to regulate themselves, but this approach often does not work out convincingly. In some cases, it does. One example is the way that formal skills training is regulated in Germany, where the local Chambers of Commerce are in charge of the matter. Germany’s Chambers of Commerce however, are parastatal institutions. All private sector companies must join them, and the Chambers’ management is elected by the members. The Chambers, moreover, charge fees. Basically, they are serving a function that would normally be a government agency’s, and they are constituted in a way that resembles state institutions.

Paying taxes is actually quite similar to paying membership fees to one’s nation. It is an empirical fact, that sound tax systems contribute to good governance and foster democratic attitudes. A core issue of democracy, after all, is to hold governments accountable for what they do with taxpayers’ money. It is unsurprising that countries that hardly collect taxes tend to be unable to provide the essential services and build the indispensable infrastructure their nations need.

The long-term viability of any state depends on proper taxation. It is an issue of sustainability. It is no coincidence, that the Nordic countries, which have a history of intelligently balancing the state and the market, collect high levels of taxes. They also enjoy high standard of living, and have strong, highly competitive economies.

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