The Myth of Pretax Income

Back in November, I had the opportunity to learn a bit about the sociology of taxes, aka The New Fiscal Sociology, at a workshop organized by Monica Prasad, Isaac Martin, and Ajay Mehrotra (editors of the linked volume). During a discussion of the relative progressivity or regressivity of various tax systems (the US with its somewhat progressive income tax and small sales tax vs. some European countries with high sales taxes but very progressive income taxes), one of the workshop leaders (perhaps Ajay?) referenced a fascinating book review by Lawrence Zelenak. Ok, I know what you’re thinking, a fascinating book review? Huh? But bear with me.

In “The Myth of Pretax Income“, Zelenak reviews a book by Murphy and Nagel entitled The Myth of Ownership. As a caveat, I have only read the review, not the underlying book. Zelenak, drawing on and slightly reworking Murphy and Nagel, argues that, in some fundamental sense, there is no such thing as pre-tax income:

How can my pretax income be a myth, when I can read it on my W-2? Their argument goes as follows: Pretax income means income in the absence of taxes. But in the absence of taxes there would be no government, in the absence of government there would be anarchy, and in a state of anarchy no one would have any income. Pretax income, then, must be zero – or, equivalently, there is no such thing as pretax income. (Zelenak 2003:2261)

Because there is no such thing as pretax income, individuals cannot be “entitled” to that income. Thus, when discussing the relative fairness of different tax systems, we have been asking entirely the wrong questions. We take for granted that people have a pretax income and then ask how much of it is fair to take away in exchange for the services provided by society. But that doesn’t make any sense, becaue pretax income is not “pre” all the services paid for by the taxes. Rather, it depends on them. What matters is the justness of outcomes after all taxes and service provisions, not one of the intermediate steps.

The problem, according to Zelenak’s reading of Murphy and Nagel, is “everyday libertarianism”, the relatively unreflexive assumption “that one earns pretax income without any help from the government, so that the government bears a heavy burden of justification in taxing any of it away” (Zelenak 2003:2262)*. Zelenak connects this everyday libertarianism to the hyperfocus of tax authorities on cheating on the Earned Income Tax Credit (a rebate for poor workers), as compared to cheating on taxes by middle- and upper-income tax-payers, who are cheating in order to “keep” what they’ve earned. Zelenak argues that the success of the current system in part hinges on the withholding system, which to some extent counteracts this everyday libertarianism – the price of government is in some sense paid when you earn your income, not after it’s already in your grasp, for most wage-earners. But it’s not enough, and everyday libertarianism still has a strong hold on how we think and talk about taxes and the financing of government.

Zelenak goes on to discuss various issues relating to the tax system – how progressive it should be, whether it should be used to counteract growing income inequality (no under the old question about tax burdens, perhaps yes with the new questions about outcomes), and so on. Zelenak also notes the paucity of data on after-tax income distribution, and recommends that the analysis of the effects of laws should be instituted on those terms (which makes sense, though poses lots of practical difficulties). It’s very interesting, and I recommend the whole (14p) review. But I want to go in a slightly different direction: what does the myth of pretax income have to do with economic sociology more broadly, and the question of the autonomy of economics and politics?

I think the myth of pretax income is a close relative to the myth of a free market, a market that functions perfectly without the coercive backing of any sort of political authority. Such markets do not exist. Thus, no matter how much “deregulation” happens, markets are still inextricably tied to political systems, and thus deregulation can only be a utopic shibboleth, never a completed reality (cf. Block and Somers on “Free Market Utopianism”). Financial “deregulation” meant the removing of some restrictions on the activities of financial institutions, but in the context of a system where those financial institutions had significant institutional support (the Fed’s discount window, the court system for resolving disputes, the FDIC, and so on). Thus, “removing restrictions” really meant that the government agreed to affirmatively support many new undertakings. This was not the removal of government involvement, but rather a change in who was allowed to do what, and what various state actors promised to various businesses in terms of support. In turn, this “deregulation” led to a change in outcomes – the massive growth in incomes in the financial sector, among other things. Going back to Zelenak, and Murphy and Nagel, we should analyze these regulatory changes in the light of outcomes, not burdens. Just as there cannot be a pretax income (because without taxes, there is no government to produce those services necessary to make the income in the first place), there cannot be a regulation-free market against which to benchmark how much deregulation we’ve done (because without some sets of government regulations, rules, courts, etc. there cannot be a market at all). “Tax relief” is to individuals as “deregulation” is to corporations – powerful myths founded on everyday libertarianism, both of which are appealing, and both of which rest on a fundamentally flawed analysis of the interaction of governments and markets.

* An economist in the audience might helpfully comment on whether or not everyday libertarianism would be a good example of failing to take into account “general equilibrium”. I like the phrase, but I’m not sure I’m using it quite right. “General equilibrium” issues refer to the 2nd order or indirect changes resulting from a specified change – e.g. the change in a tax rate having ripple effects through its incapacitation of the government, say. Does that sound right?

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10 Comments

  1. JeffL

     /  January 13, 2011

    Dan, as always, I’ve got to be a stickler about things.

    Certainly I’m 90% in agreement with the idea behind the “pre-tax myth”. I agree with the argument about the dependency of markets on governments; and the impossibility of a situation where income would remain if taxes were removed. I guess there’s also the possibility that the author is being a bit hyperbolic to drive home the point; which is probably a good tack given the strong entrenchment of “everyday libertarianism”. This is a good thing for undergrads and the general public to read. Finally (the last caveat), I do recognize the fuzziness of the pre-tax income concept, because it’s not like employers are just out there mindless of taxation, negotiating employees’ base rate income. There isn’t a real, hard, pre-government-influence-economy separated from a real, hard, post-government-influence-economy.

    OK, all that being said … STILL, there really is some meaningful distinction between pre- and post-tax income, which makes this distinction a little more solid than a myth. For one, this is how we can even see (fuzzy a view that it is) the difference between Europe and the U.S. Some part of that pre/post-tax stuff is an actual difference in the ability of a government to receive income taxes from its citizens.

    Second, while taxes can’t be removed in the aggregate, it is entirely possible for them to be practically removed in the individual case. Imagine a law that said that 9-11 first responders were exempt from income taxes. They would see a very real difference in their annual purchasing power. Also consider those who are just on the edge of a tax bracket — where you fall on either side of the line gives real meaning to pre- vs. post-tax income.

    Pre-tax income measurement is nowhere near as solid, precise, or accurate as temperature measurement. Nonetheless, like temperature, pre-tax income does not cease to exist simply because it cannot ever reach zero.

    • Jeff, I agree with you that the hyperbole is strategic. And far be it for me to say that an accounting convention doesn’t create exactly the thing it’s measuring – in fact, I routinely argue the opposite! So, I’m with you in agreeing that there is something meaningful in the current concept of “pretax income”. It just doesn’t mean what we theorize it to mean. The review goes on to discuss at some length the importance of the introduction of withholding – once income taxes were withheld, it became harder to think of them as having already been earned and then taken away. “Take home pay” became a real thing. The review argues that withholding should be extended to more kinds of income – dividends and interest income – for similar, let’s call it cultural, reasons.

      To analogize to my own work: the economy does exist, GDP does measure its size, but GDP can’t actually do all the things it tries to do in terms of capturing the value of all goods and services produced. But that doesn’t mean it’s worthless, nor that it doesn’t create a “thing”, rather just that the concept and the object are not identical and there’s a lot of rhetorical fuzziness that goes on in the dance between the two.

  2. Jason Kerwin

     /  January 13, 2011

    *The Myth of Ownership* is a great book in concept and the ideas are provocative but it suffers from a problem I’ve encountered repeatedly in books on economic thought: there really isn’t a book’s worth of ideas in it. The authors spent a lot of time re-making the same points. I don’t think there’s much to it, content-wise, that’s not in the Zelenak review or frankly your summary of his review. I don’t think I ended up finishing it but I recommend the ideas highly and the first couple of chapters are worth looking at.

    Your definition of GE effects is spot on but your usage is stretching the concept a bit. Usually we think of GE effects are pertaining strictly to market transactions; think of a drop in the real price of movie tickets when a substitute like DVDs gets cheaper. What you’re describing generally falls under the label of “political economy” issues, although economists are often happy to put the entire world into their models and hence subsume politics into the models’ general equilibria.

    • Jason,

      Thanks for the clarification. Makes sense re: GE being restricted to markets. I guess I was being cynical and assuming more economic imperialism than was warranted!

  3. Isaac

     /  January 13, 2011

    The question of what you owe to society and what society owes to you is interesting. It is analogous to the question of how do you do compensation in a team when the team size is 4, the first person adds $10 in value, the second $5, the third $2 and the last $1. However, it is the order of adding that matters and not identity (so person 1 could be the 4th or 1st person). Econ 101 would say that you compensate people by their marginal product so that each adds $1 and is paid accordingly; but that leaves lots of money on the table!

    by Jonathan Weinstein gets at this using some pseudo-philosophical game theory. Its interesting.

  4. Isaac

     /  January 13, 2011

    (And I screwed up my html; that should read: “This essay by…”)

  5. The argument really rests on two assumptions which may or may not be theoretically or empirically valid.

    1.) In the absense of a state, there would be no markets. Theoretically, this doesn’t hold up and there’s no lack of empirical evidence that markets can thrive in the absence of a state (See Powell and Stringham 2009 for a survey). Markets existed before states. I have no doubt that markets need institutions and organizations to work effectively, but this is very different from saying that a state is necessary.
    2.) You seem to be saying that because the state is so pervasive in our lives, we cannot (conceptually or empirically) disentangle the effect of state actions from nonstate actions. If this is the case, I would disagree. I think you’re talking about what I would call the dynamics of intervention. Not all interventions are created equal and they will have different effects in different combinations. This is indeed a very interesting question, but its no reason to get rid of the state/nonstate distinction used by “everyday libertarians.”

    • Damien RS

       /  January 20, 2011

      Strictly speaking, “there is no income in anarchy” is wrong; people can certainly scrape by, though their income would not be measured by state-denominated currencies. But hunting and gathering is income.

      But I think it’s fair to say that the income absent good governments would be vastly less.

      I’ve had my own version of this argument, that while taxes can be simple theft by those in charge, ideally especially under democratic government they are dividends owed to public capital, rent owed for use of environmental or natural capital, and premiums owed to government as insurer of last resort. Measuring exactly what is owed is difficult, but the estimates I’ve seen are huge: Herbert Simon thought (perhaps glibly) a 90% tax rate was fair, and more conservatively a World Bank report said 56% of US income came from strong law and order, alone. Never mind transportation infrastructure helping stuff get around or the National Weather Service providing free information about risks to crops and transportation and so on.

  6. Ernestine Gross

     /  January 18, 2011

    I am fascinated by “The Myth of Pretax Income“ argument. My question is, would the argument hold if the proponents were to treat the words ‘pretax income’ as simply a label in a financial recording system? Specifically, would the argument hold if the words ‘pretax income’ would be replaced with another label, say ‘lucy’? If the argument does not hold then I’d say there is a little problem somewhere.

    Regarding ‘general equilibrium’. There are two interpretations known to me. One, the more popular one, is the verbal expression of the belief that an economic system where agents are free to interact with each other in ‘markets’ is self-regulating. Two, there are precise theoretical models of economic systems (the most studied system is a market system but it is not the only one). In these models, the term ‘general equilibrium’ refers to a solution concept.

  7. For my part, the effort is to build a typology for comparison sub-sectoral, to highlight distinct subtypes of neoliberalism. This view allows us to account for the relative displacement of the neoliberal project in the sense that it has different nuances depending on the sector. So, although the initial project was a Unitarian (even this is debatable as the national cases), however, is dynamic filtering by sector, that have to do with the other variables in the sector rather political agenda (there I Political scientist left).
    It is a work in progress on which I do not want to have him expound more before more refined, but surely we will have the chance to discuss it.