Paul L. Caron

Wednesday, August 22, 2012

The Impact of Tax Rates on Economic Productivity and Fairness

Manhattan Institute:  The U.S. Tax System: Who Really Pays?, by Stephen Moore (Wall Street Journal):

“It is a paradoxical truth that tax rates are too high today, and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the tax rates…. [A]n economy constrained by high tax rates will never produce enough revenue to balance the budget, just as it will never create enough jobs or enough profits.” —John F. Kennedy, 1963

Even if most policymakers and members of the public instinctively understand the wisdom of President Kennedy’s words, tax rates are set to go way up, not down, next year because of the scheduled expiration of the Bush tax cuts at the beginning of 2013. The Obamacare law also raises tax rates on wealthy individuals by an additional 3.8 percentage points next year. President Obama and others in Congress argue that these higher tax rates are justified because of the growing consensus that the rich don’t pay their fair share of taxes. Unless we do something to spread the burden more equitably, the argument goes, American society will become more unfair and the economy more unsustainable with each passing year.

At first glance, the tax rate issue seems inseparable from the tax fairness issue, since higher taxes are expected to shift society’s wealth from the private sector to the public sector, where, broadly speaking, it is redistributed to lower-wage earners and the needy. In reality, the people at the bottom of the scale have benefited directly and indirectly from every tax rate reduction dating back to Kennedy’s rate reductions in the early 1960s and through the tax cuts adopted early in the administration of George W. Bush. If those lower rates, along with the Alternative Minimum Tax fix, are allowed to expire, the poor will be burdened even more than the wealthy because the whole economic pie will shrink. ...

Below are a series of statements reflecting popular conceptions and misconceptions about the impact of tax rates on economic productivity and fairness. We’ll address these statements (and debunk attendant myths) one at a time.

1. To become fairer, the tax code needs to tax the rich more heavily.

Figure 1

Figure 2

2. The rich are paying less in income taxes than they have in the past 50 years.

Figure 3

3. When all the other taxes are counted, the rich get off easy.

Figure 4

4. Tax cuts are just Robin Hood in reverse, taking from the poor to give to the rich.

Figure 5

5. Lower tax rates can make the tax burden fairer.

Figure 6

6. All those tax cuts created deficits that have mortgaged our children’s future.

Figure 7

7. Ordinary Americans pay more than their fair share of taxes.

Figure 11

8. The 15 percent tax on investment income, which is well below the income-tax rate that most salaried workers pay, is a gift to the wealthy.

9. A higher capital-gains rate would just level the playing field.

10. The "wealthy" are likely to be the people next door.

11. It is increasingly harder to climb the economic ladder, and changing the tax code will help.

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If Kennedy's remarks were always true, then the best way to get infinite revenue is to reduce the tax rate to zero. If one thinks that is absurd, then one must recognize that a statement made when the highest rate of personal income tax was 91% may or may not be true when the highest rate is 39.6%.

Unless, of course, one's true goal is to shrink the government until it is small enough to drown in the bathtub, in which event one's devotion to this purpose makes it sensible to flog the Kennedy statement forever, regardless of how low taxes have become since then. Where are we in this continuum? OECD stats routinely suggest that the U.S. is and has for many years been among the lowest tax jurisdictions in the developed world.

Posted by: Jeffrey Killeen | Aug 24, 2012 9:09:54 AM

I disagree with your insinuation that the bottom half hardly pay taxes.
My salary says I earn $3,700 a month. But what I actually take home is only $2,900a month! About $800 in taxes are withheld from me every month. I could do a lot with that 800. If I put that money into paying off my house, I could pay off my modest house in 10 years instead of 30. Paying off my mortgage will reduce my monthly payment fromm 900 a month to only 300 - the property tax and insurance. At that low amount I could lose my job and flip burgers and still live ok! Instead of talking about justifying tax cuts for the rich, the real stimulus will be to let me keep that 800 a month I worked for.

Posted by: Lizzy | Aug 24, 2012 7:12:04 AM

This article fell for the leftist Robin Hood revision. Robin Hood took the people's tax money back from the Sheriff of Nottingham who taxed them too much. he didn't just from any rich to give to the poor.

Posted by: Mark in Florida | Aug 23, 2012 6:56:28 PM

I have posted this before. HIgh tax rates cause income inequality. How? High tax rates reduce the number of jobs in the economy, and with fewer jobs in the economy workers get paid less. Paying workers less mean business owners make a higher profit which is income inequality. Lower tax rates lead to more jobs in the economy which means the workers get paid better, and business profits are lower, so income inequality is lower. Ideally there are enough jobs available in the economy such that each is paid at at level of near their economic contribution and the business employing them makes less profit from their labor. At this point workers will be able to accumulate wealth for their own investments, retirement or to start a business. It means only one member of the household would need to have a job to raise a family.
This can be demonstrated visually using the Laffer curve as a basis. If the Tax revenue curve is plotted with the vertical axis being tax revenues and the horizontal axis being tax rate, the tax revenue is zero$ at zero% and zero$ at 100%. Some where between them is a tax maximizing non zero$ revenue. Dividing the revenue curve$ by the tax rate% you get a size of the taxed economy curve. It is very high on the low tax rate% and is at zero at 100% tax rate. This is a good proxy for the number of jobs in the economy curve. Plot a horizontal line across this curve, for arguments sake someplace around the revenue$ maximum point, this represents the size of the workforce. Below this size of the workforce curve there are more workers than jobs, so the jobs are poorly paid, and income inequality is high. Above this size of workforce curve there are more potential jobs than workers available to fill them, so jobs are well paid, employers must compete to hire workers and so will pay them nearly as much as the economic value they produce. This leads to a leveling on income inequality. Overall tax revenues from businesses will decline, tax revenues from workers will rise. And for businesses lower tax rates on a lower profit may net, after taxes, about the same. And best of all with workers well paid, government does not need to support and subsidize half the population.
The purpose of an economic system should be to maximize the standard of living of the citizens, not to maximize the size and scope of government.

Posted by: Dirk | Aug 23, 2012 5:31:24 PM

AMTbuff, so the EITC doesn't count? Are you kidding? It's income tax, it's just that it is negative. Saying what you said is just like claiming the disparity between rich and poor has grown ginormously because you don't count the EITC as income when comparing classes.

Posted by: Syl | Aug 23, 2012 5:29:29 PM

So, for the people demanding higher taxes: what entitles you to more of my labor? I don't remember adopting anyone.

Posted by: Rob Crawford | Aug 23, 2012 3:45:17 PM

The creation of the EITC in 1975 bumped the number of returns filed. Prior to that people with no liability had no reason to file a return. You can see the bump in the chart above. It's an artifact of the deceptive presentation of the data. Had the chart shown either percent of households or percent of individuals with zero or negative income tax liability, there would have been no bump.

This isn't the worst statistical manipulation you'll see in tax advocacy, but gaming the use of households vs. individuals vs. tax returns is very common.

When your point is valid you should make it in the least slanted way possible. That's the beef I had with the recent TPC analysis of its variant on Romney's tax reform outline.

Posted by: AMTbuff | Aug 23, 2012 10:23:09 AM

that's a bit misleading because there were more loopholes back in the day. close to no one payed. you have to look at the federal budget, it was tiny.

Posted by: zman | Aug 23, 2012 9:05:53 AM

The quote from JFK is interesting, but--in 1963, JFK was concerned with budget surpluses, which under Keynesian theory, would act as a drag on the economy if not dissipated by some means. Equally importantly, or perhaps more so, the top marginal tax rate at the time was 91%.

Posted by: Publius Novus | Aug 23, 2012 7:52:25 AM