Look it up in a dictionary and you will find two basic meanings for the word tax. The concise Thorndike Barnhart pocket dictionary defines it as:
1. money paid by people for the support of the government.
2. a burden, duty, or demand that oppresses.
The first definition needs the qualifier that the money is forcibly extracted from the people. Then the second definition naturally follows from the first.
The alleged purpose of taxation is to provide the money the government "needs" in order to solve national "problems." But taxes have come to consume such a large portion of our income and wealth that they have themselves become a national problem. As Rickenbacker and Uhler pointed out recently (REASON, June 1978), most attempts at tax reform have merely shifted "the burden from one set of productive citizens to another set…while the total burden has kept right on growing." The only hope, as they noted, is fundamental constitutional tax reform.
We can think up many ideal systems to do away with taxes, including total anarchism with no taxes at all. But a more immediate challenge is to find a politically palatable method of "getting from here to there." We need to formulate fundamental tax reforms that will readily appeal to the popular disgust with high taxation and big government and have a good chance of being adopted by the voters. One such method is tax substitution.
A basic problem with many tax-limitation measures is that they usually do not include expenditure limitations as well. Faced with property tax limits, the government may respond with increased sales and income taxes in order to preserve its services and the jobs of public employees. The beauty of tax substitution is that in one fell swoop it eliminates taxes and simultaneously eliminates the associated government expenditures!
There are several possible approaches to tax substitution. The one described here can be defined essentially as the replacement of government services that are paid for by mandatory taxes with similar services freely chosen by the individual, and the corresponding reduction of the individual's tax liability. The rationale behind it is that government services are supposed to fill some "need," and if an individual can fill that need by alternative, nongovernmental means, then he should not have to pay for his share of that government service.
How would such tax substitution work in particular cases?
EDUCATION The educational tax credit now being considered by Congress is a step toward tax substitution, though not quite the same thing. It would allow someone to deduct a certain amount of school tuition from his federal income taxes, reducing part of the burden of sending a student to a private school or college.
Under tax substitution, one would be able to deduct all tuition expense for private education, up to the government's average per capital expense. For education, that would be the average cost per student (hereafter denoted by ACPS, the government's total educational expenditures divided by the number of students).
If someone sends his child to a private school instead of the local public school, he saves the government the cost of educating his child. Thus, under tax substitution, he doesn't have to pay that cost. The tax reduction should not exceed the ACPS, however. Assume that the ACPS is $2,000 per year and the tuition at a high-class academy is $4,000. If someone can deduct only the $2,000, he saves the government $2,000 and transfers the savings to the private academy. But if he could deduct the entire $4,000, that would leave the government with $2,000 less than the savings from one less student (assuming the marginal cost equals the average), and it would have to raise taxes to keep the same ACPS, thus shifting the tax burden to others.
The point of tax substitution is not to shift the tax burden to others but to eliminate it on the individual level One is free under tax substitution to pay more for education than the ACPS, but it comes from one's own pocket.
What if the tuition of a private school is less than the ACPS? If a service can be demonstrated to be the equivalent of the government service, despite its lower cost, then one should be able to deduct the average government cost from one's taxes. In education this is a very tricky and subjective thing to prove. As a rough rule of thumb, perhaps elementary and high school tuition generally ought to be deducted at the ACPS, but college education only by the actual amount of tuition spent, since the type and quality of higher education can vary so much.
Parents with several children in private schools and colleges could find that their total tuition expenses exceed their tax liability. Would the government then have to pay them money under tax substitution? The answer for a proper system is a definite no. The purpose of tax substitution is to eliminate taxes for the individual, not to force others to support his private services. Once a person has substituted all his taxes with private services, he should be on his own.
A basic principle of tax substitution is that the deduction is made from the tax of the agency that is financing the service being substituted. For example, if the tax for education is collected by a school district, the substitution is deducted from the taxes owed to that school district. This is different from the federal tuition tax credit proposal, in which the deduction applies only to the federal income tax.
The complicating factor is that many services, including education, are now being paid for by a combination of local, state, and federal moneys. The tax substitution would only apply to that portion of the expenditure spent by the corresponding agency. For example, if the ACPS was $2,000 but the local school tax only covered $1,000 of that, the local tax deduction would have an upper limit of $1,000 per student. If tax substitution were adopted by the state and federal governments, then the rest of the tuition could be deducted from those taxes. The assumption here is that the school district receives the outside funds on a per-student basis. If it receives a fixed sum, then the full ACPS could well be deducted.
The private school or college should not necessarily have to be located within the taxing government's jurisdiction. The resident is saving his local district or state the expense of educating his child, and therefore the location of the private school is irrelevant.
PUBLIC EDUCATION FEES Under tax substitution, the tuition or fees paid for public (government-operated) colleges should not be deductible from taxes. Why not? Because the student or his parent is paying a direct fee for that service. If that fee could be deducted from one's taxes, it would be the same as getting that service for nothing—or rather, forcing others, through taxes, to subsidize the service.
The tuition for private education, on the other hand, saves the taxpayers from having to subsidize the student's education. Note that the subsidy for public college education is the ACPS minus the tuition charged per student. Therefore it follows that under a proper tax substitution system the amount of private college tuition subject to tax deductions is the tuition paid above that charged by the state colleges.
Let's look at an example. Say that the ACPS for state colleges is $6,000 and their tuition is $1,000 per year per student. If someone spent $7,000 for tuition in a private college, the deduction from his taxes would be $5,000, the amount of subsidy being offered by the state for public college education. If someone's private tuition were only $5,000, the tax deduction would be $4,000—his $5,000 minus the $1,000 charged by the state. So everyone has to pay, without any tax credits, at least the $1,000 minimum charged by the state. In the extreme, if the state charged the full ACPS as tuition and there was no educational subsidy, then there would be no tax substitution for education because there would be no taxes for it! You would simply pay for the school of your choice.
A complicating factor is that the various state colleges and universities may charge different amounts of tuition and have different ACPS's. The private colleges would have to be ranked, for example, as equivalent to either a community college, a state college, or a university, and the amount of tuition subject to tax substitution would be adjusted accordingly.
Tax substitution in education would give parents a free choice about where to educate their children. It would enable them to choose alternative schools without suffering the double burden of also having to support the public schools. The state schools would therefore have to compete on an equal monetary level with the private schools, at least for those families that pay taxes. (A voucher system could be designed for those who do not pay taxes, but that is a subject beyond tax substitution itself.) Tax substitution produces an equitable system, for in a free society we should not be penalized for choosing an education more compatible with our culture and values than that offered by the government.
GOVERNMENT SERVICES Each type of service has its own particular unit of cost, and a general tax-substitution provision has to specify in detail how the costs would be substituted. The following examples illustrate some possible ways of handling various categories of costs.
Garbage collection. For a service like garbage disposal, which is paid for by the household, the substituter would simply pay the alternative service rather than the one sponsored by the government.
If a city garbage service were partially subsidized, then the substituter would also be able to deduct part of his fees from his city taxes. For example, if the city charged $4 per month for refuse pickup, but its average cost per household was actually $8, with the difference paid for by taxes, a resident who paid $7 for a private service would be able to deduct the extra $3 from his city taxes, similar to the system described for education.
Besides the tax deduction, tax substitution necessarily involves a demonopolization of government services. Cities such as San Francisco that have franchises (that is, monopolies) for private garbage companies would have to allow any company or individual to set up in the refuse collection and disposal business as long as the garbage was disposed of in a proper manner—for example, without violating any property rights. The whole purpose of tax substitution is to give the taxpayers a free choice in selecting the service that best fits their needs.
San Francisco uses a cost-plus-five-percent formula for setting garbage rates, which encourages the companies to have high expenses and salaries. Alternative services would try to increase their markets by minimizing their costs and thus would make the cost-plus formulas of guaranteed profits obsolete.
A problem might arise for individuals who wish to dispose of their own garbage personally. How are any freeloaders to be prevented from dumping their garbage in a lake or in their neighbors' garbage cans? Those who do not have receipts for garbage collection might be asked to show some evidence that they are recycling or otherwise disposing of their garbage without invading other people's property rights.
Police. Since the police are supposed to provide for both personal safety and the protection of property, a fair measurement of its cost might be an average of its expenditure per household and per dollar of property. The property value should exclude land, since land cannot usually be stolen or destroyed. In Berkeley, California, for example, the 1978-79 police budget is about $6 million, plus over $1 million in employee benefits, making a total cost of about $7 million. Given approximately 30,000 households, the cost is about $233 per residence. With about $520 million in assessed property (ignoring the land component), the police cost is about $1 per $75 of property. An average of the personal and the property cost would give $117 per household plus $1 per $150 of assessed property value. Someone whose property was assessed at $30,000 would be able to deduct up to $317 ($117 personal plus $200 property) from his taxes for his police substitute. A business would be able to deduct an amount proportional to its property value, exclusive of land.
Unlike garbage collection, police service is not an all-or-nothing proposition. People can use variable amounts of it. No more than the amount of funds actually spent for private police protection would be deductible from the city taxes. This might include the cost of certain goods, such as burglar alarm systems.
Tax substitution for the police should be limited to criminal investigations and the protection against violence, theft, and other types of coercion. Private guards and investigators are already being used by businesses and individuals. They perform the "front end" of police protection—guarding banks and stores from theft, keeping watch on who enters and leaves, and investigating crimes. A guard may detain a shoplifter or use force to stop a criminal from harming someone, but the "back end" of law enforcement, arraigning the suspects and punishing the convicts, is still the exclusive realm of the government's police, district attorneys, courts, and penal institutions. As long as the "back end" remains the exclusive jurisdiction of the government, tax substitution for the police would have to be limited to the "front end" jobs of guarding and investigating.
If a thief broke into your house, triggering a silent alarm that alerted your protection agency's patrol car, and they rushed to your house and caught the culprit, they would then hand him over to the city police and the district attorney to try and convict. Since tax substitution should not be a free lunch, those who substitute private protection or investigation for the public service would no longer be eligible for free "front end" protection. The substitute laws could include a provision that if a person has subscribed to a private service he could still use the city police if he paid a fee each time he needed their assistance.
For many people, the local police simply do not provide good protection. Law enforcement authorities often refuse to interfere in "labor disputes" even when they include threats and violence against small companies that don't want to sign union contracts. Many people—political rebels, drug users, ethnic minorities—have been victims of police aggression. Under tax substitution people would be able to pay private guards to help protect themselves from violence instead of being forced to pay for an unresponsive or even hostile government police force.
Instead of paying the police to chase after prostitutes, investigate bingo games for gambling offenses, and bust marijuana parties, many people might prefer to pay guards to protect their homes and streets. In order to stay in business and prevent a massive drain of city funds to private protection agencies, the police might well have to deemphasize victimless acts and concentrate on real crime! Tax substitution could compel the police to be more responsive to their true purpose—the protection of lives and property from violence and theft.
Charity. The biggest tax burden is at the national level, and much of this is used for welfare transfer payments. Could welfare, such as aid to the poor and sick, be tax substituted? Certainly! In fact, welfare is an excellent candidate for it. Aside from the inherent wrongs of our welfare programs, their inefficiency and abuse is beyond all hope unless something better can be substituted for them.
In his book Libertarianism John Hospers describes a company that provided scholarships for needy students as well as summer camps for underprivileged youths. The company continued the programs even though its taxes kept increasing. Then the president of the company learned that the government was spending $13,000 per year per student on the Job Corps. He could have trained them himself at one-tenth the cost. That was the unfortunate demise of the company's voluntary charity. If the government was taxing the company and forcing it to provide for these wasteful programs, then the company would give up its own projects.
But under tax substitution, the story would have had a different ending. The company would have been able to deduct its voluntary charity directly from its taxes. Not only would it have continued its "welfare" programs, it would have most likely been outraged enough by the gross costs of the Job Corps to start its own training program at a fraction of the cost and deduct that cost from its taxes too. The candidates would have received better, more practical training and, if the company could have done the job at one-tenth the government cost, the taxpayers would have saved $11,700 for each candidate transferred from public to private training.
Under tax substitution people could also deduct their contributions, for example, to cancer research directly from their taxes (instead of from their gross income) and could support programs such as nutritional research instead of the government's cancer establishment.
For services that the taxpayers can actually use, such as the police, the amount of substitutable taxes should be limited to the government's average cost per unit of service. Welfare transfer payments, though, is one "service" that taxpayers generally do not consume themselves. By definition it is a "service" that is paid for the benefit of others. The upper limit of welfare substitution should therefore be the proportion of one's tax bill that is spent for welfare. For example, if 40 percent of the federal budget is devoted to aiding the poor and the sick, then up to 40 percent of one's taxes would be substitutable for similar private welfare programs. If 5 percent of the budget goes to health research programs, then up to 5 percent of one's federal taxes could be substituted for private cancer research and other such programs.
There should also be a second limitation: the average cost per welfare recipient. For example, if the Job Corps has an average cost of $13,000 per trainee, then a similar private job program may only receive tax-substitutable donations of up to $13,000 per trainee. If for some odd reason it was spending $26,000 per candidate, then only half of one's donation to that organization could be tax-substituted.
Only charities that replace government programs should be eligible for tax substitution. Donations to the Girl Scouts and Boy Scouts would not be eligible, since these are not devoted to aiding the "needy," but if the Girl Scouts had a special project that aided underprivileged girls, that would be eligible. Donations to local neighborhood free clinics or emergency food projects should certainly be eligible, and tax substitution would encourage these small, home-town charities that are so much more effective than the federal behemoths.
National defense. Even in national defense there is room for tax substitution! Here the cost unit would be the proportion of federal funds devoted to defense and the military. If 25 percent of the budget goes to national defense, then up to 25 percent of one's federal income taxes could be substituted for one's own military defenses. But what kind of personal expenditure would that be?
Bomb shelters, for one thing. Clearly civil defense is a part of national defense. The Soviets are certainly making it part of their military strategy. Just because the US government has chosen to deemphasize civil defense does not mean that a citizen or a community should not provide for its own defense from attack. The cost of building and maintaining a bomb shelter would be deductible from federal income taxes, although the cost of storing food would not, since it would eventually be used for personal consumption.
Intergovernmental substitution. Tax substitution can also be used by governments themselves. The city of Berkeley likes to run its own health department even though Alameda County also has one. The taxpayers of Berkeley have to support two health departments, even though they don't use the county's program. Since Berkeley is substituting its own health programs for those of the county, under tax substitution the Berkeley residents would be able to deduct the average per capita cost of the Alameda system from their county taxes, or else Berkeley would receive the equivalent funds from the county. The same method would apply to a state that chooses to substitute its own services for those of the federal government.
ADMINISTRATION The catch in tax substitution is that someone has to decide which private schools or voluntary charities qualify as genuine substitutes for government programs. Otherwise, phony organizations would spring up, and the substitutes would simply be used to evade taxes. Some kind of organization has to be set up to safeguard the taxpayers and legitimate substitutes against fraud.
This could be accomplished in much the same way as the government currently handles tax-exempt nonprofit organizations. A company's records could be examined to verify that it was indeed performing as a substitute for government services. Under a good tax-substitute system the burden of proving the ineligibility of a purchased alternative would rest with the government rather than the tax substitute. If the government challenged an agency but failed to prove that the agent was not eligible, it would have to pay for the defendant's expenses. This would minimize the harassment of tax substitutes.
There could also be special boards or commissions to administer tax substitution independently of the rest of the government. They would be able to conduct audits of government agencies to determine their true costs. (Generally the average unit cost of a government program would simply be its total budget divided by the number of beneficiaries, such as households, students, or welfare recipients.) Though this would add one more body to our menagerie of government, it would be a board uniquely dedicated to a method for reducing government programs rather than increasing them.
PARTIAL REFORM Tax substitution is itself not a replacement for comprehensive tax reforms and limitations on government spending. Many taxes and government "services" should be abolished entirely rather than merely substituted. Some of these "services," such as poisoning marijuana plants (and Americans) with paraquat, are really the grossest disservices.
The fact that tax substitution allows taxpayers to exchange their own programs for those of the government does not mean that the latter are in any way justified. Tax substitution does not imply any moral judgment concerning any particular government service. It is simply a means of demonopolizing these services and giving individuals the choice of substituting their own education, police, charity, etc., instead of being forced to pay for and use inefficient, unresponsive, and corrupted government programs. The moral position inherent in tax substitution is that education, welfare, and other services should not be government monopolies and that the taxpayers should not be forced to support them as such if they can buy the same product through other channels.
Tax substitution is a bridge between the ideal of giving each individual more control over his own life and the growing popular resentment against taxes and big government. Politicians always pledge to cut taxes and control spending, yet once in office they find it difficult to resist the appeals of special interests, including their own. But tax substitution lets the individual cut his own taxes and automatically reduces the government's role in that program. Thus it should appeal to the taxpayers as a whole. The main special interest that would oppose it is government officialdom and the public employees, but even they might appreciate the job opportunities of the private alternatives as well as the tax benefits to themselves.
In some fields, such as welfare, tax substitution would most likely reduce spending more than it would reduce taxes, producing a net saving in government costs. In other areas, such as education, where some people are already supporting nongovernment alternatives, it would probably reduce taxes more than the expenditures . This would place the burden of supporting these services on the general taxpayers, who supposedly benefit from them, and away from the tax substituters, who are not using them.
We can hardly expect the government to implement tax substitution. The voters, through initiatives and constitutional conventions, will have to adopt it themselves. Tax substitution could act as a complement to other tax reforms and efforts to reduce the scope of government.
Ultimately, tax substitution could result in a massive shift from government-mandated services to those individually chosen from a wide range of free-market alternatives, with much of education, welfare, and other services in private hands. Some government expenditures, though, cannot be substituted away. In particular, the public debt is something that simply has to be paid.
Tax substitution has a major role to play in the quest for tax limitation and reform. It is not a panacea, but it is a path toward economic freedom.
Fred Foldvary has a background in economics and computer science and is a systems analyst for the Educational Testing Service and a freelance writer.