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Archive for the ‘Income tax’ Category

On the issue of so-called progressive taxation, our left-wing friends have conflicting goals. Some of them want to maximize tax revenue in order to finance ever-bigger government.

But others are much more motivated by a desire to punish success. They want high tax rates on the “rich” even if the government collects less revenue.

Some of them simply pretend there isn’t a conflict, as you might imagine. They childishly assert that the Laffer Curve doesn’t exist and that upper-income taxpayers are fiscal pinatas, capable of generating never-ending amounts of tax revenue.

But more rational leftists admit that the Laffer Curve is real. They may argue that the revenue-maximizing rate is up around 70 percent, which is grossly inconsistent with the evidence from the 1980s, but at least they understand that successful taxpayers can and do respond when tax rates increase.

So the question for grown-up leftists is simple: What’s the answer if they have to choose between collecting more revenue and punishing the rich with class-warfare taxation?

And here’s some new research looking at this tradeoff. Authored by economists from the University of Oslo in Norway, École polytechnique de Lausanne in France, and the University of Pennsylvania, they look at “Tax progressivity and the government’s ability to collect additional tax revenue.”

The recent massive expansion of public debt around the world during the Great Recession raises the question how much debt a government can maximally service by raising the level of taxes. Or, to phrase this classic public finance question differently, how much additional tax revenue can the government generate by increasing income taxes?

And since they’re part of the real world (unlike, say, the Joint Committee on Taxation or the Obama Administration), they recognize that higher tax rates impose costs on the economy that lead to feedback effects on tax revenue.

Our research (Holter et al. 2014) investigates how tax progressivity and household heterogeneity impacts the Laffer curve. We argue that a more progressive labour income tax schedule significantly reduces the maximal amount of tax revenues a government can raise…under progressive taxes heterogeneous workers will face different average and marginal tax rates. …the answer to our question is closely connected to the individual (and then properly aggregated) response of labour supply to taxes. The microeconometric literature, as surveyed e.g. by Keane (2011), has found that both the intensive and extensive margins of labour supply (the latter especially for women), life-cycle considerations, and human capital accumulation are important determinants of these individual responses. …households make a consumption–savings choice and decide on whether or not to participate in the labour market (the extensive margin), how many hours to work conditional on participation (the intensive margin), and thus how much labour market experience to accumulate (which in turn partially determines future earnings capacities).

The above passage has a bit of economic jargon, but it’s simply saying that taxpayers respond to incentives.

They also provide estimates of tax progressivity for various developed nations. They’re only looking at the personal income tax, so these numbers don’t include, for instance, the heavy burden of the value-added tax on low-income people in Europe.

The good news (at least relatively speaking) is that the American income tax is not as punitive as it is in many other nations.

But the key thing to consider, at least in the context of this new research, is the degree to which so-called progressivity comes with a high price.

Here is some additional analysis from their research.

Why does the degree of tax progressivity matter for the government’s ability to generate labour income tax revenues…? changes in tax progressivity typically affects hours worked…increasing tax progressivity induces differential income and substitution effects on the workers in different parts of the earnings distribution. …a more progressive tax system may disproportionately reduce labour supply for high earners and lead to a reduction in tax revenue. …more progressive taxes will reduce the incentives for young agents to accumulate labour market experience and become high (and thus more highly taxed) earners.

Now let’s look at some of the results.

Remarkably, they find that the best way of maximizing revenue is to minimize the economic damage of the tax system. And that means…drum roll, please…a flat tax.

For its current choice of progressivity (the green line), the US can sustain a debt burden of about 330% of its benchmark GDP, by increasing the average tax rate to about 42%. Thus, according to our findings the US is currently still nowhere close to its maximally sustainable debt levels…we also observe that larger public debt can be sustained with a less progressive tax system. Converting to a flat tax system (the black line) increases the maximum sustainable debt to more than 350% of benchmark GDP, whereas adopting Danish tax progressivity lowers it to less than 250% of benchmark GDP.

Here are a couple of charts from their study, both of which underscore that punitive tax rates are very counterproductive, assuming the goal is to either maximize revenue or to sustain a larger public sector.

Notice that if you want to punish “the rich” and impose Danish-type levels of progressivity (the dashed line), you’ll get less revenue and won’t be able to sustain as much debt.

Now let’s shift from discussing intellectual quandaries for the left and talk about challenges for believers in limited government.

We like a flat tax because it treats people equally and it raises revenue in a relatively non-destructive manner.

But because it is an “efficient” form of taxation, it’s also an “efficient” way to generate revenues to finance bigger government.

Indeed, this was one of the findings in a 1998 study by Professors Gary Becker and Casey Mulligan.

So does this mean that instead of supporting a flat tax, we should a loophole-riddled system based on high tax rates solely because that system will be so inefficient that it won’t generate revenue?

Of course not. At the risk of stating the obvious, this is why my work on fundamental tax reform is intertwined with my work on constitutional and legal mechanisms to limit the size and scope of government.

And it’s also why Obama’s class-warfare approach is so perversely destructive. If you think I’m exaggerating, watch this video – especially beginning about the 4:30 mark.

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I’ve shared some interested rankings on tax policy, including a map from the Tax Foundation showing which states have the earliest and latest Tax Freedom Days.

There’s also a depressing table showing that the United States “earns” a lowly 94th place in a ranking of business-friendly tax system.

Heck, there’s even a map showing the states with the highest wine taxes, as well as a map showing which states have the lightest and heaviest tax burdens compared to income.

So I was very interested to see this table from the Tax Foundation revealing which countries have the most punitive regimes for penalizing success.

Portugal has the dubious honor of having the most progressive (i.e., discriminatory) tax system in the developed world.

I don’t think anyone is surprised to see France in second place, though I confess that I was not expecting to see pro-reform success stories such as Chile and Canada in the top five.

And I’m totally embarrassed that the United States is #8, worse than such garden spots as Greece, Mexico, and Belgium.

Though it’s important to understand that the Tax Foundation is relying on a narrow definition of progressivity.

One way to measure and compare the progressivity of income tax codes across countries is to express the level of income at which each country’s top tax bracket applies as a multiple of that country’s average income.

That’s a useful bit of information and it shows one aspect of progressivity, but it’s also a bit misleading since it implies that the Swedish tax system (with a top tax rate of 56.7 percent) is less progressive than the Slovakian tax system (with a top tax rate of 21.7 percent).

You won’t be surprised that I think a ranking that purports to show the burden of “progressive” taxation should include the top tax rate.

Speaking of which, this is why I like the Tax Foundation’s measure of progressivity on the state level.

The…table also shows the gap between the top marginal tax rate and the marginal tax rate on $25,000 of taxable income. …Twenty-one states and the District of Columbia have progressive rate structures that rise after $25,000. California, New Jersey, and Vermont have the most progressive rate structures by a wide margin.

Who could have guessed that California would be the worst state, though I’m not surprised to see New Jersey (the worst place to die) and Vermont (worst place for self reliance) have such poor ratings as well.

And is anyone even remotely shocked to see that states with no income taxes manage to avoid any problems with ‘so-called” progressivity? Not surprisingly, they also grow faster and create more jobs.

The moral of the story, at the very least, is that America needs a simple and fair flat tax.

And not the Obama or Hollande version.

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The Tax Foundation in Washington does some great work on fiscal issues, but I also admire their use of maps when they want to show how various states perform on key indicators.

They’re best known for “Tax Freedom Day,” which measures how long people have to work each year before they’ve earned enough to satisfy the tax demands of federal, state, and local government. And they have a map so you can easily see how your state ranks.

But my favorite map from the Tax Foundation is the one showing that the geese with the golden eggs are moving from high-tax states to low-tax states. That’s tax competition in action!

I also like their map showing which states have done the best and worst jobs of controlling the burden of government spending, as well as their map showing which states steal the biggest share of economic output from taxpayers.

So it should go without saying that I’m going to share their new State Business Tax Climate Index. And the accompanying map.

Tax Foundation State Tax Ranking

What are some important takeaways from this ranking? Five things caught my eye.

1. It’s a very good idea for a state to not impose an income tax. The top six states all avoid this punitive levy and every no-income tax state is in the top 15. And you won’t be surprised to learn that these states grow faster and create more jobs.

2. It’s just a matter of time before states such as New York and California are beset by fiscal crisis. When a jurisdiction has something special – like California’s climate or the appeal (to some) of New York City – it can get away with imposing higher tax burdens. But there’s a limit, and migration patterns show that productive people are voting with their feet.

3. Scott Walker and Chris Christie often are mentioned as serious 2016 presidential candidates, and both have become well known for trying to deal with the problem of over-compensated state bureaucrats. But they both preside over states in the bottom 10 of this ranking, and presumably should address this problem if they want to demonstrate that they’re on the side of taxpayers.

4. It’s possible for a state to make a dramatic jump. North Carolina currently is one of the bottom 10, but that will soon change because of reforms – including a flat tax – that were enacted this year. As the Tax Foundation noted: “While the state remains ranked 44th for this edition, it will move to as high as 17th as these reforms take effect in coming years.”

5. States also can move dramatically in the wrong direction. Connecticut is now one of America’s least-competitive states, in large part because politicians managed to push through a state income tax in the early 1990s.

P.S. If you like maps, here are some interesting ones, starting with some international comparisons.

Here are some good state maps with useful information.

There’s even a local map.

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There have been some unfortunate and dark days in American history, but what was the worst day?

Some obvious choices include December 7, when the Japanese bombed Pearl Harbor, and September 11, when the terrorists launched their despicable attack.

Another option (somewhat tongue in cheek) might be January 20 since Republican partisans would say that’s the day that both Jimmy Carter and Barack Obama became President while Democratic partisans would say that’s the day Ronald Reagan became President.

But allow me to suggest that today, October 3, should be a candidate for America’s worst day.

Why? Because on this day in 1913, one of America’s worst Presidents, Woodrow Wilson, signed into law the Revenue Act of 1913, which imposed the income tax.

The law signed that day by President Wilson, to be fair, wasn’t that awful. The top tax rate was only 7 percent, the tax form was only 2 pages, and the entire tax code was only 400 pages. And a big chunk of the revenue actually was used to lower the tax burden on international trade (the basic tariff rate dropped form 40 percent to 25 percent).

But just as tiny acorns become large oak trees, small taxes become big taxes and simple tax codes become complex monstrosities. And that’s exactly what happened in the United States.

We now have a top tax rate of 39.6 percent, and it’s actually much higher than that when you include the impact of other taxes, as well as the pervasive double taxation of saving and investment.

And the relatively simply tax law of 1913 has metastasized into 74,000 pages of Byzantine complexity.

Not to mention that the tax code has become one of the main sources of political corruption in Washington, impoverishing us while enriching the politicians, lobbyists, bureaucrats, and interest groups. Or the oppressive and dishonest IRS.

However, even though I take second place to nobody in my disdain for the income tax, the worst thing about that law is not the tax rates, the double taxation, or the complexity. The worst thing is that the income tax enabled the modern welfare state.

Before the income tax, politicians had no way to finance big government. Their only significant pre-1913 sources of revenue were tariffs and excise taxes, and they couldn’t raise those tax rates too high because of Laffer Curve effects (something that modern-day politicians sometimes still discover).

Once the income tax was adopted, though, it became a lot easier to finance subsidies, handouts, and redistribution. As you can see from the chart, the federal government used to be very small during peacetime.

But as the decades have passed, the Leviathan state in Washington has grown. And in the absence of genuine entitlement reform, it’s just a matter of time before the United States morphs into a bankrupt European-style welfare state.

And as government becomes bigger and bigger, diverting more and more resources from the productive sector of the economy, we can expect more stagnation and misery.

That’s why October 3 is an awful day in American history. All the bad results described above were made possible by the income tax.

P.S. It’s totally off topic, but I don’t think we should commemorate September 11. I’d much rather we celebrate May 1, which is the day that Osama bin Laden became fish food.

P.P.S. If the income tax facilitated today’s bloated government, it should go without saying that giving politicians another big source of revenue would lead to an even bigger burden of government. That’s why the value-added tax is such an awful idea.

P.P.P.S. Government also used to be very small in Western Europe before the income tax. Indeed, it was during that period when European nations became rich.

P.P.P.P.S. One could also argue that February 3 is the worst day in history because that’s when Delaware ratified the 16th Amendment, thus making an income tax constitutional.

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I’m normally reluctant to write about “depreciation” because I imagine eyes glazing around the world. After all, not many people care about the tax treatment of business investment expenses.

But I was surprised by the positive response I received after writing a post about Obama’s demagoguery against “tax loopholes” for corporate jets. So with considerable trepidation let’s take another look at the issue.

First, a bit of background. Every economic theory agrees that investment is a key for long-run growth and higher living standards. Even Marxist and socialist theory agrees with this insight (though they foolishly think government somehow is competent to be in charge of investments).

Let’s look at two remarkable charts, starting with one that shows the very powerful link between total investment and wages for workers.

As you can see (click the chart to see a larger version), if we want people to earn more money, it definitely helps for there to be more investment. More “capital” means that workers have higher productivity, and that’s the primary determinant of wages and salary.

Our second chart shows how the internal revenue code treats income that is consumed compared to how it penalizes income that is saved and invested. Simply stated, the current system is very biased against capital formation because of the combined impact of capital gains taxes, corporate income taxes, double taxes on dividends, and death taxes.

Indeed, one of the reasons why the right kind of tax reform will generate more prosperity is that double taxation of saving and investment is eliminated. With either a flat tax or national sales tax, economic activity is taxed only one time. No death tax, no capital gains tax, no double tax on dividends in either plan.

All of this background information helps underscore why it is especially foolish for the tax code to specifically penalize business investment. And this happens because companies have to “depreciate” rather than “expense” their investments.

Here’s how I described depreciation in my post on corporate jets.

If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income… A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets. But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).

And I also addressed the issue when writing about the economic illiteracy in one of the Obama-Romney debates.

Now let’s see what some experts on the topic have to say.

Here’s some very sage analysis from Alan Viard of the American Enterprise Institute.

…a deal that cuts the corporate rate could end up doing more harm than good. The problem is that Congress and the Obama administration are thinking of pairing the rate cut with a slow-down of companies’ depreciation deductions. That’s a bad combination. A key goal of corporate tax reform should be to reduce the tax penalty on business investment. Investments in equipment, factories, and other forms of capital help power the long-run economic growth that boosts wages and living standards for American workers. …If depreciation is slowed down enough to offset the full revenue loss from the rate cut, then there’s no reduction in the investment penalty, on balance. The depreciation changes take back with the left hand everything that the rate cut gives with the right hand. …In fact, the policy makes the tax penalty on new investments bigger. …Why is this bad combination being considered? Maybe because the rate cut is easy to understand and the harm of slower depreciation is easy to overlook. …Yes, let’s cut the corporate tax rate. But, let’s not slow down depreciation to pay for it.

Amen. Proposals to lower America’s destructively high corporate tax rate are needed, but I don’t want politicians “paying for” the change with other policies that are similarly harmful to growth and competitiveness.

Margo Thorning of the American Council for Capital Formation adds some wisdom with her column in today’s Wall Street Journal.

…proposals that would increase the tax burden on capital-intensive industries—which are contributing to U.S. economic growth and employment—should be viewed with caution. …stretching out depreciation allowances reduces a company’s annual cash flow and raises the “hurdle rate” that new investments would have to meet before they are approved. For capital-intensive firms in sectors such as energy, manufacturing, utilities and transportation, the trade-off between delayed cash flow and lower corporate income-tax rates may result in cutbacks in capital spending. …Each additional $1 billion in investment is associated with 23,000 new jobs, according to data from the Department of Commerce and the Bureau of Labor Statistics. …Rather than drawing out depreciation schedules, a better, pro-growth approach to corporate tax reform would be to allow all investment to be expensed—in other words, deducted from income in the first year.

I share Margo’s concerns, which is why I’m very suspicious when the President says he wants to lower the corporate tax rate and “reform” the system.

Last but not least, Matt Mitchell (no relation) of the Mercatus Center recently added his two cents to the discussion.

The idea that “accelerated” depreciation is a loophole can be traced back to Stanley Surrey, the Harvard law professor whose work in the 1950s, 60s, and 70s influenced many…, including Senator Bill Bradley. …immediate expensing would mean abandoning “the attempt to tax business income.” That’s because it would essentially turn the corporate income tax into a corporate consumption tax. And that may be a good thing. Capital taxation is notoriously inefficient. This is one reason why Robert Hall and Alvin Rabushka permitted immediate 100 percent expensing in their famous flat consumption tax.

You should realize, by the way, that the distorted view of what’s a loophole doesn’t just apply to depreciation. The Joint Committee on Taxation (the same folks who basically assume that the revenue-maximizing tax rate is 100 percent) also tells lawmakers that it’s a loophole if you don’t double-tax capital gains, or if you allow people to avoid double taxation by utilizing IRAs.

With advice like that, no wonder the tax code is a mess.

Anyhow, congratulations are in order. If you’ve made it this far, you almost surely know more about depreciation than every single politician in Washington. Though, to be sure, that’s not exactly a big achievement.

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Two months ago exactly, I appeared on TV to talk about the concept of eliminating the personal and corporate income tax in Louisiana.

Now Governor Jindal has unveiled a specific proposal.

The plan will eliminate two major tax types: personal income tax and corporate income and franchise tax. Eliminating income taxes in a revenue-neutral manner and improving sales tax administration will dramatically simplify Louisiana’s tax system and reduce administrative problems for families and small businesses. The effective start date of the program is January 1, 2014. …The plan will ensure revenue neutrality by…[b]roadening the state sales tax base and raising the state rate to 5.88%.

This is a superb plan.

Of all the possible ways for a state to generate revenue, the income tax is the most destructive.

My new man crush

That’s why researchers consistently have found that states without this punitive levy grow faster and create more jobs.

It’s also worth noting that jurisdictions such as Monaco, Bermuda, and the Cayman Islands manage to be very prosperous in the absence of an income tax, though the incredible wealth of these places is partly a function of bad policy elsewhere, so the comparison isn’t perfect.

Anyhow, Gov. Jindal expands on this research with some very powerful data.

Over the last ten years, more than 60 percent of the three million new jobs in American were created by the nine states without an income tax. Every year for the past 40 years, states without an income tax had faster growth than states with the highest income taxes.  Economic growth in the nine states without income taxes was 50 percent faster than in the nine states with the highest top income tax rates.  Over the past decade, states without income taxes have seen nearly 60 percent higher population growth than the national average. …While we have reversed the more than two-decade problem of out-migration, we can do more to keep people here. Here are a couple of staggering statistics. Between 1995 and 2010, according to IRS data, Louisiana lost $3 billion in adjusted gross income to Texas.

Amen.

I particularly like that he recognizes the power of tax competition as an argument for better tax policy. Taxpayers win when Texas and Louisiana compete to have less oppressive tax systems.

Indeed, this should help explain why I am so fixated on the importance of making governments compete with each other. Simply stated, governments are very prone to over-tax and over-spend if they think taxpayers have no escape options.

So let’s keep our fingers crossed that Gov. Jindal’s proposal gets a friendly reception from the state legislature.

If he succeeds, I imagine he will vault himself to the top tier of Republicans looking to replace Obama.

And, who knows, maybe he can reinvigorate the argument that we can replace the corrupt internal revenue code with a national sales tax?

P.S. Jindal is good on more than just tax policy. He’s already implemented some good school choice reform, notwithstanding wretched and predictable opposition from the state’s teachers’ union.

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What’s the worst thing about Delaware?

No, not Joe Biden. He’s just a harmless clown and the butt of some good jokes.

Instead, the so-called First State is actually the Worst State because 100 years ago, on this very day, Delaware made the personal income tax possible by ratifying the 16th Amendment.

Though, to be fair, I suppose the 35 states that already had ratified the Amendment were more despicable since they were even more anxious to enable this noxious levy (and Alabama was first in line, which is a further sign that Georgia deserved to win the Southeastern Conference Championship Game, but I digress).

Let’s not get bogged down in details. The purpose of this post is not to re-hash history, but to instead ask what lessons we can learn from the adoption of the income tax.

The most obvious lesson is that politicians can’t be trusted with additional powers. The first income tax had a top tax rate of just 7 percent and the entire tax code was 400 pages long. Now we have a top tax rate of 39.6 percent (even higher if you include additional levies for Medicare and Obamacare) and the tax code has become a 72,000-page monstrosity.

But the main lesson I want to discuss today is that giving politicians a new source of money inevitably leads to much higher spending.

Here’s a chart, based on data from the Office of Management and Budget, showing the burden of federal spending since 1789.

Since OMB only provides aggregate spending data for the 1789-1849 and 1850-190 periods, which would mean completely flat lines on my chart, I took some wild guesses about how much was spent during the War of 1812 and the Civil War in order to make the chart look a bit more realistic.

But that’s not very important. What I want people to notice is that we enjoyed a very tiny federal government for much of our nation’s history. Federal spending would jump during wars, but then it would quickly shrink back to a very modest level – averaging at most 3 percent of economic output.

Federal Spending 1789-2012

So what’s the lesson to learn from this data? Well, you’ll notice that the normal pattern of government shrinking back to its proper size after a war came to an end once the income tax was adopted.

In the pre-income tax days, the federal government had to rely on tariffs and excise taxes, and those revenues were incapable of generating much revenue for the government, both because of political resistance (tariffs were quite unpopular in agricultural states) and Laffer Curve reasons (high tariffs and excise taxes led to smuggling and noncompliance).

But once the politicians had a new source of revenue, they couldn’t resist the temptation to grab more money. And then we got a ratchet effect, with government growing during wartime, but then never shrinking back to its pre-war level once hostilities ended (Robert Higgs wrote a book about this unfortunate phenomenon).

The same thing happened in Europe. The burden of government spending used to be quite modest on the other side of the Atlantic, with outlays consuming only about 10 percent of economic output.

Once European politicians got the income tax, however, that also enabled a big increase is the size of the state.

But Europe also gives us a very good warning about the dangers of giving politicians a second major source of revenue.

Here’s a chart I prepared for a study published when I was at the Heritage Foundation. You’ll notice from 1960-1970 that the overall burden of government spending in Europe was not that different than it was in the United States.

That’s about the time, however, that the European governments began to impose value-added taxes.

The rest, as they say, is history.

VAT and Govt Spending in EU

I’m not claiming, by the way, that the VAT is the only reason why the burden of government spending expanded in Europe. The Europeans also impose harsher payroll taxes and higher energy taxes. And their income taxes tend to be much more onerous for middle-income households.

But I am arguing that the VAT helped enable bigger government in Europe, just like the income tax decades earlier also enabled bigger government in both Europe and the United States.

So ask yourself a simple question: If we allow politicians in Washington to impose a VAT on top of the income tax, do you think they’ll use the money to expand the size and scope of government?

If it takes more than three seconds to answer that question, I suggest you emigrate to France as quickly as possible.

P.S. You probably won’t be surprised to learn that the crazy bureaucrats at the Paris-based OECD think the VAT is good for growth and jobs. Sort of makes you wonder why we’re subsidizing those statists with American tax dollars.

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