A Flat Tax Is Not More ‘Efficient’ Than a Tax System with Loopholes

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.

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.

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.

The economy works exactly this way: owners of resources invest them to satisfy their felt wants and needs. We all do it, all the time. We either do it directly through consumption, such as eating a ham sandwich or driving to a preferred location, or indirectly through production that satisfies our own wants in the future or the wants of others (which then brings income that we can use to satisfy our own). The market consists simply of the exchanges involved in making this happen, and with the price mechanism we can direct resources toward their more valued uses — in order to create more want satisfaction of ourselves.

If the exploitation of tax loopholes were truly economically inefficient, then nobody would voluntarily choose to direct their resources that way. Since they do, this means they value the little money they can keep from the IRS — despite the expense to do so — more than the alternatives available to them.

Closing loopholes, therefore, has only one effect: it strips those who would use it of their most valued course of action. In other words, it makes them worse off. And this is supposedly “efficient” to the new breed of economists.

The only way of making sense of this claim is to think of the economy as a machine rather than organism, and a machine with a specific purpose: to create jobs. Whether those jobs create actual value is apparently beside the point, because what matters is the total spending within the economy that, in turn, create the ability to employ. It’s a Keynesian argument through and through, which completely overlooks whether the economy creates value — as long as money swooshes through the system and people are employed and thus paid to do stuff (such as digging holes to be filled again).

Efficiency, in other words, is here the very opposite of value creation, so destroying valuable alternatives for actors is an “improvement” of the economic system. No wonder Keynesian theory neither includes nor is compatible with the concept of entrepreneurship.