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A Flat Tax Is Not More “Efficient” Than a Tax System with Loopholes

Economists say an Inescapable Tax is more Efficient

A frequently repeated claim is that loopholes in the tax code are “inefficient.” A more efficient tax, economists say, is a flat and all-encompassing tax that is inescapable. Why? Because this means no one will waste resources on tax planning and thus tax avoidance. In other words, more resources will be used in production, which is better for the “economy.”

Leaving the moral and ethical argument about tax avoidance aside, the efficiency argument too is completely wrong. It shows how much economists have deviated from understanding what they supposedly try to learn about: the market.

Tax loopholes

The loophole inefficiency argument is based on the view that seemingly unproductive uses of resources are a waste because they don’t contribute to the overall economy. But this is a backward argument, and in fact the same argument as that against “hoarding” of funds. And it assumes that people (or, more specifically, their owned resources) are for the economy, rather than the economy for people.

Loopholes in the Tax System

It seems intuitive, however, that resources used not to produce or buy goods and services would contribute little to the economic machine. After all, if someone uses a part of his or her income

to pay accountants and tax lawyers to figure out how to pay less in taxes, then this money could have been used productively to either increase supply of goods (through investment/production) or increase demand for the same (by buying and spending). Instead, this money is redirected to become income for people massaging numbers and creating artificial legal structures that exploit loopholes.

This intuition is wrong because it misunderstands what economy is about, and completely does away with the functioning of the market process.

Just like hoarding supposedly keeps money away from society by being kept “idle” rather than used in production, “investing” in finding and exploiting loopholes does not create anything useful. Except that it does. The intuition that resources that are not used in production is somehow a waste is wrong. The owner of the resources necessarily chose (what appeared to be) the most valuable course of action available, which is hardly wasteful. Rather, it is by definition value maximizing — from the point of view of the owner.