Tax Policy, Writ Large

From Louis Kaplow, an integrated theory of taxation and public economics


Credit: Harry Campbell

“Most work on issues of taxation and related questions in public economics is inevitably specialized,” writes Harvard Law Professor Louis Kaplow ’81. “On occasion, there is value in stepping back and considering explicitly the relationships among the parts. What is learned can then be used to refocus, redirect, or even realign subsequent research on particular subjects.”

That is what Kaplow has done in a newly published book—“The Theory of Taxation and Public Economics” (Princeton 2008)—that stands to secure him a place in the firmament of public economists and scholars in public finance.
The book, more than a decade in the making, has its origins in Kaplow’s early training in economics, under such luminaries and mentors as Hugo Sonnenschein, Michael Spence, Martin Feldstein, Lawrence Summers and Richard Musgrave. The latter, one of the great pioneers in the field of modern public finance, taught at Harvard Law School from 1965 until his retirement in 1981, and died last year at the age of 96.

The purpose of his book, Kaplow writes, is not to champion particular policies or analytical results but rather to urge a new way of thinking. “This book develops and applies a unifying framework for the analysis of taxation and related subjects in public economics,” he writes.

To that end, Kaplow offers what he calls “an integrated view” of how tax policy can best be analyzed. Ideally, he writes, policy analysis attempts to consider completely specified policies, take a comprehensive view of the problem at hand with regard to potentially useful instruments, and present and assess alternatives in a comparable manner.

“Together, completeness, comprehensiveness, and comparability are essential aspects of an integrated view of taxation, government expenditures, and redistribution. One can only understand each policy instrument—each piece of the puzzle—if the others are also on the table and the relationships among them are understood.”

It is the case for more “comparability,” in particular, that occupies Kaplow most. The “notion of comparability has received too little attention in the theory of taxation,” he writes. “Comparability is in fact an extremely powerful idea.”

The Theory of Taxation and Public EconomicsThe most successful methods of policy analysis are those “that enable apples-to-apples comparisons, thereby permitting separate examination of each dimension of a policy, which in turn allows identification of the policy’s intrinsic features,” Kaplow writes. Here, he notes, traditional analysis is usually muddled by the distributive (and redistributive) effects of the policies being analyzed. Every tax has distributive effects, and those effects inevitably complicate analysis by creating additional dimensions, reverberations and distortions. Ideally, Kaplow says, any proposed tax or instrument can be better studied and evaluated in isolation from those effects—in what he calls a “distribution-neutral” manner. “Distribution-neutral analysis avoids these problems, and uniquely so,” he writes.

To that end, he offers a technique—in many ways, the nucleus of his integrated approach to tax analysis—designed to isolate and study any given tax in a way that isn’t clouded by its distributive effects or certain other complications. He suggests that for analytical purposes, it is most helpful to study the utility of a particular tax—say, a proposed tax on luxury goods—by postulating a corresponding, proportionate reduction in the income tax burden of the group that will be most affected (e.g., higher-income earners who can afford to buy luxury goods).

“This income tax adjustment … mirrors the distribution of the policy under consideration so that the net distributive incidence of the complete package is nil,” Kaplow explains.

Analyzing a proposed tax—which is distributive by nature—in a distribution-neutral fashion seems counterintuitive. But as Kaplow answers, his method “does not disregard distributive effects but instead isolates them from other effects so that each may be brought into sharper focus.”

Applying his distribution-neutral formula to a number of tax policy and revenue-raising scenarios, Kaplow arrives at (perhaps “confirms” is more accurate) his view that “it is not generally sensible to use various indirect forms of taxation, expenditure policies, or regulations to redistribute income if an income tax is available.” And: “Among the many policy instruments typically thought of in distributive or revenue-raising terms, the income tax has a special place, and because of this role the others need to be analyzed differently from how they often are.”

Policy tools other than the income tax system, he finds, tend to be advantageous in pursuing distributive and revenue objectives only when they are able to address particular shortcomings of a more direct approach, such as by mitigating evasion or reducing the labor-leisure distortion in subtle ways.

These broad conclusions aside, Kaplow’s purpose in writing the book was less about advancing a particular view of tax policy than about reframing the way tax policy is analyzed. As economists Feldstein and Peter Diamond have acknowleged, he has done just that.