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Pareto Principle and Taxes

By Van Leaming
Published: 06/08/2024

The Pareto Principle and Taxes

You might have heard of the Pareto Principle1, also known as the 80/20 rule. It’s often thrown around in business and economics, but what does it actually mean, and how does it relate to taxes?

Understanding how a 19th-century botanist, tax collector, and economist named Vilfredo Pareto2 observed that a small percentage of the population controlled the majority of wealth might seem like it has little to do with today’s tax systems. Yet, his insights laid the groundwork for modern progressive tax policies.

Vilfredo Pareto, born in 1848, was initially known for his work in economics and sociology. But here’s a fun fact: he also dabbled in botany. Pareto’s most famous contribution is the Pareto Principle, which he formulated after observing that 20% of the pea pods in his garden produced 80% of the peas3. This observation led him to notice similar patterns in wealth distribution in Italy—namely, that 20% of the population owned 80% of the wealth4.

Pareto Principle Usage

This principle, now a staple in economic and business analysis, suggests that a small percentage of causes often lead to a large percentage of effects. It’s a widely used, and very useful concept in business, as all businesses strive for efficiency and effectiveness. The principle allows businesses of all kinds to focus limited resources for the biggest possible outcomes knowing that the top salespeople produce much higher sales, and the largest customers are larger but orders of magnitude, and that 20% of the marketing effort will net 80% of the results. So, whether it was taxes, the number of flowers on a plant, fruit on a tree, developer productivity, sales, marketing etc. a small percentage of each group delivers a much higher outcome. When applied to taxation, it reveals a lot about how wealth is accumulated, and how our progressive tax system is designed with a similar distribution as the Pareto rule.

The Pareto Principle in Taxation

In the context of taxes, Pareto’s principle can be seen in the structure of progressive tax systems. In such systems, the tax rate increases as income increases. This means that the wealthy, who make up a smaller percentage of the population, end up paying a much larger portion of the total tax revenue. It reflects the 80/20 rule where 20% of the people (the wealthy) pay 80% of the taxes. The United States closely reflects the 80/20 rule being slightly more progressive with the Top 10% paying 75.8% of the US income taxes, and the Top 25% paying 89.2% of income taxes.5

Why It Matters

Understanding Pareto’s principle helps explain why progressive taxes are structured the way they are. They aim to shift the economic burden on those who can more likely afford to pay more and shoulder the additional burden, thus supporting public services and infrastructure that benefit society as a whole.

Is this Fair? Well that depends on who you are and which side of the income spectrum you belong to. (See our Article on Fair Share) What is clear is that our Government cost structure, and the services that it provides are extremely dependent on this model (uneven distribution of tax burden). In fact, the Bottom 50% of Americans pay less than 3% of Income taxes while the Top 25% pay more than 89%.5 If citizens were to pay anything close to equal amounts in income taxes, like was required by law before the passing of the 16th Amendment to the US Constitution in 1913, it is all but assured we would have nowhere near the size, scope, and services that we do from our Federal Government today. 

“Taxes are the price we pay for a civilized society.”

Oliver Wendell Holmes Jr.

Progressive Taxation: Balancing Needs and Responsibilities

Oliver Wendell Holmes Jr. famously observed that taxes are necessary for a civilized society. This quote encapsulates the role of Government. (See our Article on Social Contracts) Governments provide the basics that help create the structure that brings order to the chaos, and the environment where all can thrive. It brings safety in the protection in the form of our national sovereignty, and rule of law protecting our persons and property. It supports the general welfare of the people and promotes the commerce of a nation. 

“I can’t imagine an alternative to the American system. We’ve got the goose that lays the golden eggs.”

Warren Buffet

Warren Buffet’s statement that those living in America are fortunate for the system of Government that we have in place, and the ability to thrive like very few other places on Earth.

Pros: 

Proponents of progressive taxation often point to the 80/20 Pareto principle, which suggests that a small portion of the population receives a large share of the income and should contribute a commensurate amount in taxes. A progressive system ensures that this wealthier segment shoulders a larger tax burden, enabling the government to act as a distribution mechanism to redistribute resources and provide essential services for the broader population. 

  • Equal Society, Reduction in Poverty
  • Educated Society
  • Civil Society 
  • More Social Services

“The art of taxation is the art of plucking the goose so as to get the most feathers with the least hissing.”

Jean-Baptiste Colbert

Cons:

Opponents argue that progressive taxation discourages hard work and investment, potentially hindering economic growth. They may also feel it infringes on individual liberties and freedoms. In extreme cases, you have a tyranny of the masses where a majority votes the public coffer for more services, and the authorization of the taking of more of the income and wealth of higher wealth individuals. Additionally, some critics point out that government spending, especially when fueled by easy access to tax revenue, can become excessive, wasteful, and inefficient.

  • Infringes on Personal Liberties
  • Limits Growth and Removes Incentives
  • Discourages Risk and Innovation
  • Waste and Inefficiency

Balancing the Principle

This quote reflects the core tension in taxation: the need to raise the most revenue to fund public services against the individual’s liberties and the right to keep the fruit of their labor. (See our Article on The Art of Taxation) Progressive taxation, a system where tax rates increase with income, sits at the center of this debate. Finding the right balance between these competing priorities is crucial. A well-designed progressive tax system can ensure that the wealthy contribute their fair share while avoiding excessive burdens that stifle economic dynamism and threaten personal liberties. Open and transparent discussions are essential to navigate this complex landscape and determine an appropriate tax structure that meets the needs of society.

Conclusion

Vilfredo Pareto’s 19th-century observations continue to resonate today, particularly in the realm of taxation and business. By understanding the 80/20 rule, we can appreciate why progressive tax systems are designed to ensure that a small percentage of high earners shoulder a significant portion of the tax burden, promoting a more equitable society. So next time you hear about the Pareto Principle, remember its roots in a botanist’s garden and its profound impact on how we structure our taxes.

Citations

  1. https://www.investopedia.com/terms/1/#19excludeGlossary.asp
  2. https://www.britannica.com/money/#22excludeGlossary
  3. https://www.talentstream.co.za/#25excludeGlossary
  4. https://academic.oup.com/jrssig/article/11/1/39/7028957
  5. IRS – IRS Statistics of Income 2021 Publication 1304 

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