What Does a Fair Tax Code Look Like?

What does a fair tax code look like?

That’s a more difficult question to answer than you might think because it requires balancing trade-offs between efficiency and equity.

It's relatively easy for economists to measure the efficiency of the tax code, but the debate gets complicated when it comes to fairness. That is because fairness is a subjective concept, making it to determine without a specific social welfare function. In other words, there isn’t a clear maximization formula for fairness that everyone agrees upon.

For example, many people believe that Nordic countries like Denmark, Sweden, and Finland have a fairer tax system that provides a more comprehensive social safety net and more public services. However, the differences between the Nordic and US tax systems at the top are not that large, with one notable exception. The average Nordic top marginal tax rate kicks in at 1.4 times the average wage in the country, while in the US, it kicks in at 8.5 times the average wage.

In practice, this means the average personal income tax rate for a typical one-earner married couple with two children in the Nordic countries, including cash transfers, was 21.7 percent. In contrast, that same family in the United States paid just 11.9 percent in 2019 (and it was 1 percent in 2021 due to a temporary expansion of the child tax credit). Additionally, the average sales or value-added tax in the Nordic countries is 24.6 percent, while it is only 6 percent in the United States.

Is the Nordic tax system more fair? There is no definitive answer to this question. While the Nordic system provides more benefits, such as socialized healthcare, it also requires lower and middle-class families to pay higher taxes to finance these benefits. If the US were to finance Nordic-style social programs with Nordic-style taxes, the top marginal tax rate would need to kick in at a much lower income level—around $88,000 instead of $535,000 like it does now—and sales tax rates would have to increase significantly.

The real question to ask in this debate is: What is the trade-off between fairness and efficiency that is being optimized for? When a tax cut benefits everyone, including the wealthy, why is it considered unfair?

For instance, in 2017 the Tax Cuts and Jobs Act reduced the tax rate on corporate income, leading to opposition and criticism from the academic community because of its perceived unfairness. And yet it resulted in higher gains in both income and wealth for the bottom percent of the income and wealth distributions than it did for the top.

This confusion surrounding the social welfare maximization debate may stem from a lack of distinction between the statutory incidence and the economic incidence of a tax. Statutory incidence determines who legally pays the tax, while economic incidence shows who actually bears the burden of the tax. 

For example, when a corporation experiences a tax increase, the burden of the tax often falls on lower-skilled workers, even though the tax was imposed on the corporation. A recent study by Siegler found that workers bear about half of the total burden of corporate income taxation.

Therefore, it's important to understand that just because a tax is increased against a well-off group does not mean that it benefits the less well-off. Similarly, just because a tax might benefit those who are well-off does not mean that it comes at the expense of the less well-off.

When discussing tax fairness, it is crucial to understand the trade-off between fairness and efficiency. The use of relative terms like “fairness” muddies the discourse on taxes, leading people to reject absolutely efficient gains that they perceive as unfair—even though they may make everyone better off.