Assuming the goal is faster growth and higher living standards, there are three core principles of good tax policy.
- Low marginal tax rates on productive activity such as work and entrepreneurship.
- No tax bias (i.e., extra layers of tax) against saving and investment.
- No preferences and loopholes that encourage inefficient economic choices.
You could call this list the Holy Trinity of supply-side economics. Simply stated, incentives matter, so it makes no sense for government to discourage the things that make a nation more prosperous.
Regarding low marginal tax rates, my left-leaning friends sometimes dismiss the importance of this principle by pointing out that they don’t pay much attention to their marginal tax rates.
I can sympathize with their skepticism. When I was first learning about public finance and studying supply-and-demand curves showing deadweight loss, I also wondered about the supply-side claim that marginal tax rates mattered. Even after I started working, I had doubts. Would I somehow work harder if my tax rate fell? Or goof off if my tax rate went up? It didn’t make much sense.
What I didn’t recognize, however, is that I was looking at the issue from the perspective of someone working a standard, 9-to-5 job with a modest income. And it is true that such workers are not very responsive (especially in the short run) to changes in tax rates.
In the real world, though, there are lots of people who don’t fit that profile. They have jobs that give them substantial control over the timing, level, and composition of their income.
And these people – such as business owners, professionals, second earners, investors, and entrepreneurs – often are very responsive to changes in marginal tax rates.
We have a new example of this phenomenon. Check out these excerpts from a story in the U.K.-based Times.
About three quarters of GPs and hospital consultants have cut or are planning to cut their hours… About 42 per cent of family doctors and 30 per cent of consultants
have reduced their working times already, claiming that they are being financially penalised the more they work. A further 34 per cent and 40 per cent respectively have confirmed that they plan to reduce their hours in the coming months… The government has launched an urgent consultation over the issue, which is the result of changes to pension rules limiting the amount that those earning £110,000 or more can pay into their pensions before they are hit with a large tax bill.
In other words, high tax rates have made leisure more attractive than work. Why work long hours, after all, if the tax authority is the biggest beneficiary?
There are also indirect victims of these high tax rates.
Last month figures from NHS Providers, which represents hospitals, showed that waiting lists had climbed by up to 50 per cent since April as doctors stopped taking on extra shifts to avoid the financial penalties. Richard Vautrey, chairman of the BMA GPs’ committee, said: “These results show the extent to which GPs are being forced to reduce their hours or indeed leave the profession altogether because of pension taxes. …swift and decisive action is needed from the government to end this shambolic situation and to limit the damage that a punitive pensions taxation system is inflicting on doctors, their patients and across the NHS as a whole.”
The U.K.’s government-run health system already has plenty of problems, including long wait times and denial of care. The last thing it needs is for doctors and other professionals to cut back their hours because politicians are too greedy.
The moral of the story is that tax rates matter. Depending on the type of person, they can matter a lot.
This doesn’t mean tax rates need to be zero (though I like that idea).
It simply means that taxes impose costs, and those costs become increasingly apparent as tax rates climb.
P.S. If you want a horror story about marginal tax rates, check out what happened to Cam Newton, the quarterback of the Carolina Panthers.
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