A Tax Increase Primer
The marginal tax is the dollar amount or percentage paid on an additional dollar in income. When you speak of increasing the tax rates you are referring to the increase in marginal rates.
The effective tax is the actual dollar in revenue generated on the total income. This takes into account deductions, credits, and tax-preferred income streams like municipal bonds and capital gains. These deductions and preferred income treatments are the results of policy to encourage taxpayers to pursue these investments not just for their own benefit, but for the larger social benefits derived from such investments. While we treat capital gains and dividend income with a rate lower than the maximum rate on earned income, many countries do not tax capital gains at all. They view capital investment and the economic growth and jobs they create as a worthy outcome of their policy.
The Laffer Curve argues that higher taxes, particularly at the margin, create a disincentive to earn and thus decrease the actual tax dollars generated. This largely depends on the amount of the tax increase and where on the theoretical curve you are. It also depends on which tax you are raising. If you are raising the income tax on a salaried or hourly paid worker, he has few alternatives to paying the tax. If you are raising the rates on capital gains income or dividends the wealthy have enormous flexibility to avoid the taxes. They can favor investments that depend on capital appreciations over a long term, they can place assets in trust, or they can otherwise structure their income to minimize the impact of the law. In a competitive global investment environment they can move their capital to a friendlier location.
The Laffer Curve likewise explains how a decrease in tax rates can actually increase tax revenues. This happened under Calvin Coolidge, John Kennedy, Ronald Reagan, and Bill Clinton. (Clinton raised income taxes but lowered the rates on capital gains and dividends.)
Marginal tax incentives also apply to other forms of income. For many poor people on government assistance they stand to lose transfer income if they earn a taxable income. The loss in benefits has the same power and influence over behavior as an increase in the marginal tax rates.
If one is receiving $10,000 in various benefits and takes a job making $20,000 and thus stands to lose those benefits, then they are effectively paying a marginal tax of 50%, not including their FICA and other withholding. This is one of the reasons participants get trapped in dependency, and poverty seems to remain in spite of the enormous sums spent to alleviate it.
A more effective way to increase the revenue from the rich without creating disincentives for middle-income earners to increase their effort is to limit deductions. Should a millionaire retain a mortgage deduction on a million dollar house? Should the amount of tax-free income from municipal bonds be unlimited?
The estate tax is particularly attractive to social progressives but it has some very undesirable effects. We all benefit from a long-term investment view, a view that often extends well beyond a single generation. This is true whether you own a working farm or a factory. This creates and preserves capital for economic growth and job creation. The estate tax encourages a very short-term perspective.
If you knew that at the end of every year you would have to pay a tax of 50% on assets you have saved during the year, what would you do? Likely, you would minimize your savings, spending more, and saving and investing less. You would not have to pay a tax on the enjoyment of a better lifestyle.
The wealthy are no different. A high estate tax creates an incentive for conspicuous consumption over investment. While they will use whatever expensive legal tax avoidance schemes are available, we all suffer from the smaller investment pool.
In our pursuit of social justice, taking the silver spoon of the wealthy from the mouths of their children, we deplete the investment pool that creates jobs for the much less fortunate. One can sarcastically dismiss this as "trickle down" economics, but such disdain for this perception does not change the reality of the incentive nor its outcome.
This also applies to other taxes that affect investment income. Perhaps we can increase investment capital while still keeping a progressive system in place. For example, we could exempt the first $50,000 or even $100,000 of investment income for everybody and then tax the rest at the same rate as earned income. This would encourage a wider dispersion of investment capital and reduce dependency on social security at retirement.
The more progressive we make the income taxes, however, the more dependent the government becomes on the wealthy, and the more sensitive government finance becomes to economic downturns and bad fiscal policy. If we want a more progressive tax policy with the wealthy paying a greater share, then we should encourage the proliferation of the wealthy. One way to get more taxes from millionaires is to have more millionaires, the opposite of what is happening now.
A growing population produces more income earners and tax payers. A declining population reduces income growth and taxes paid. Some of this loss may be offset by increased productivity, but there is a limit quickly reached in the amount of revenue collected from a decline in the number of income producers that can be recouped from increasing the tax rates on the surviving earners.
Such policies as increasing immigration and encouraging the growth of child bearing families will increase economic growth and tax revenues over time, assuming of course that the growth is in the population of income and wealth producers and not net consumers of government transfer payments.
There is a very real limit on how much the wealthy will pay. Without controlling government spending and entitlements we will quickly outstrip the ability to support the welfare state no matter how high we raise the rates. And even if higher rates did not reduce the willingness and ability of the taxpayers to generate the revenues needed (an assumption which I do not believe is valid) it would produce less revenue than creating the conditions to stimulate economic growth. These conditions include low and consistent marginal tax rates, a simplified and consistent tax code with fewer deductions which interfere with the efficient allocation of capital, reasonable and consistent regulations, and a sound currency and monetary policy.
Consistency in tax and regulatory policy may be even more important that having the lowest possible rate or the friendliest possible regulations. Fear and uncertainty, fed by record deficits and endless class warfare speeches, can do as much to squelch investment as the laws themselves.
We also dilute the effect of a single tax increase when we look at it in isolation. Behavior is impacted by the sum of all of the taxes levied: state, local, FICA, and Medicare as well as the friction costs of mandates and regulations. A small increase in a number of different taxes can slow economic growth as quickly as fewer larger tax increases.
An effective tax system should be simple and not subject to change every time an elected official steps up to a microphone. The most effective tax system we could devise, however, cannot overcome the economic and social problems of a government that has grown too large and consumes too much of our productive effort.