Tax Neutrality

Death and taxes—the two certainties of life. While we can’t do much about the former, a well-designed tax system can help minimize its impact on markets by reducing inefficiencies. Economists call this principle tax neutrality, the idea that taxes should allow markets to operate as efficiently as possible, without tipping the scales of competition.

What Is Tax Neutrality?

At its core, tax neutrality ensures that taxes don’t distort consumer or producer choices. Imagine this: red shirts are taxed at 10%, while blue shirts are taxed at 20%. Which color shirt do you think people would buy more of? Clearly, red shirts. But under tax neutrality, both would be taxed equally—say, 15%—so people could choose based on preference, not tax incentives.

This principle may sound simple, but even small violations can create big consequences. In the most recent election cycle, both candidates introduced tax plans that strayed from this ideal. Two key examples—new tariffs and new capital gains taxes—are both violations of tax neutrality and can lead to unintended consequences.

Tariffs: A Clear Violation

Tariffs are perhaps the most obvious offender. By taxing foreign goods more heavily than domestic ones, tariffs disrupt competition in goods markets, steering consumers toward domestic products. While this might sound like a patriotic policy, it’s inherently inefficient. It artificially inflates demand for domestic goods, discourages trade, and creates inefficiencies.

Capital Gains Taxes: A Subtler Violation

Understanding how capital gains taxes violate tax neutrality requires a closer look. Let’s revisit the shirt example. Imagine all shirts are taxed at the same rate—neutrality achieved, right? But now we introduce timing into the equation: what if shirts were taxed at 15% this week but 30% next week? When would people do their shopping? Obviously, they’d stock up before the higher tax kicks in, distorting their natural purchasing patterns.

This is the imbalance capital gains taxes create. Here’s how it works:

Say you have $10 to spend. A red shirt costs $10 today, so you could buy one now. Alternatively, you could invest that money, wait for it to double, and buy two red shirts in the future. Without a capital gains tax, those two shirts would cost you $20. But with a 20% capital gains tax, your investment yields only $18 after taxes— not enough for 2 shirts. You’d have to wait until your investment reached $22.50 to buy those 2 shirts after taxes.

Even though the price of the shirts hasn’t changed, investing your money now makes them more expensive later- simply because of the tax. This creates an artificial incentive to spend money today rather than investing it for future use, disrupting the natural flow of capital and savings.

I should note that I don’t look at this and think “and that’s why we should abolish capital gains tax!” or even tariffs for that matter. However they are facts that cannot be ignored in discussions about the impact of tax policy.

Sources:

Landsburg, Steven E. The Armchair Economist : Economics and Everyday Life. New York, Free Press ; Toronto, 1993.