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Posts Tagged ‘Laffer Curve’

Based on my writings, some people may think I’m 100 percent against higher taxes.

But that’s not exactly true. In some cases, I like punitive taxation. Or, to be more precise, I sometimes take pleasure when punitive tax policy backfires on bad people.

Here’s an example. An interesting article in Slate, authored by Adam Chodorow of Arizona State University Law School, looks at how a terrorist group’s attempt to form a government is being stymied by an inability to collect taxes.

Revolution is easy. Governing is hard. And there are few things more difficult than taxes. Operating a country requires money, and that typically requires taxes. … The population in this area is estimated to be between 7 million and 8 million, about the same as the population of Washington state. While ISIS currently collects about $1 billion annually, countries of similar size collect about $16 billion, suggesting that ISIS has a long way to go if it wants to operate like a real state.

But the comparatively low levels of tax are not because of a Hong Kong-type commitment to limited government.

Instead, the terror group is discovering that people don’t like giving their money to politicians and bureaucrats, even ones motivated by Islamic fundamentalism.

…taxes aren’t a great way to ingratiate oneself with the governed. …More than one government has fallen because of its tax policy. ISIS must face these challenges just as any emerging polity does… ISIS may have displayed prowess on the battlefield, but it has revealed that it is as stymied and constrained by the complexities of taxation as the rest of us. …ISIS’s taxes appear to be…no more popular in the territory it controls than they would be here in the U.S. As the Times reported, ISIS’s taxes are now so onerous that large numbers of people, who were apparently willing to tolerate ISIS’s religious authoritarianism, are fleeing Syria and Iraq to escape them. At some point people will either rise up or leave, threatening ISIS’s internal revenue source.

So taxes are becoming so onerous that taxpayers (and taxable income) are escaping.

Hmmm…, excessive taxation leading to less taxable economic activity. That seems like a familiar concept.

Something I’ve written about one or two times. Or maybe 50 or 100 times.

Ah, yes, our old friend, the Laffer Curve!

ISIS is…constrained by a lack of administrative resources and the simple reality once sketched on the back of a cocktail napkin by the economist Arthur Laffer: that tax rates can only get so high before they actually drive down government revenues. Given current conditions, ISIS may be near or at the limits of its ability to tax, even if it can recruit jihadi tax accountants to its cause. Thus, …it’s not clear how much room the group has to grow internal revenues. More important, its efforts to do so may do more to damage its prospects than outside forces can accomplish.

This sounds like the tax equivalent of War of the Worlds, the H.G. Wells’ classic in which alien invaders wreak havoc on earth until they are felled by bacteria.

Tom Cruise was the star of a 2005 movie adaptation of this story, but I’m thinking I could rekindle my acting career and star in a movie of how the Laffer Curve thwarts ISIS!

But to have a happy ending, ISIS has to be defeated. And Professor Chodorow closes his article with a very helpful suggestion.

Rather than send in ground troops, …view our tax code as a weapon of mass destruction… We could make full use of it in the war on ISIS, perhaps by translating it into Arabic in the hopes that the group adopts it.

Sounds like the advice I gave about threatening Assad with Obamacare.

P.S. If they do decide to make a movie about the Laffer Curve and ISIS, maybe Obama could star as tax adviser for ISIS. At least if he’s not too busy in some of the other movie roles people have envisioned.

P.P.S. I like excessive taxes when they lead to the downfall of terrorist thugs. But I also take perverse pleasure when class-warfare tax hikes backfire in places such as France and the United Kingdom. I feel sorry for the taxpayers of those nations, to be sure, but it sometimes helps to have examples of what not to do.

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If you owned a restaurant and wanted to generate more income and boost your bottom line, would you double your prices thinking that this would double your revenue?

Of course not. You would understand that a lot of your patrons would simply dine elsewhere. And if they didn’t have other restaurants available, many of them would simply eat at home.

But now imagine you’re a politicians and you want more tax revenue so you can try to buy more votes and redistribute more money to the special interests that fund your campaign.

Would you assume that doubling a tax rate would lead to twice as much revenue?

Based on the shoddy methodology of the Joint Committee on Taxation (JCT), which is in charge of the revenue-estimating process on Capitol Hill, the answer is yes.

To be fair, the bureaucrats at the JCT probably wouldn’t say that tax revenue would double, but their model basically assumes that tax policy doesn’t affect the economy’s overall performance. So even if there’s a huge increase in the tax burden, they assume overall economic output won’t be affected.

This obviously is an absurd assumption. You don’t have to be a rocket scientist to realize that taxes impact economic performance. Low-tax economies like Hong Kong and Singapore, for instance, routinely outperform medium-tax economies like the United States. Similarly, differences in tax policy are one of the reasons why the United States generally grows faster than (or doesn’t grow as slowly as) Europe’s high-tax welfare states.

The lesson that should be learned is that the JCT should not estimate the revenue impact of a change in tax policy simply by looking at the change in the tax rate and the current trendline for taxable income. To get a more accurate answer, the bureaucrats also should try to estimate the degree to which taxable income will change.

This is the essential insight of the Laffer Curve. You can’t calculate changes in tax revenue simply by looking at changes in tax rates. You also have to consider the resulting changes in taxable income.

So it’s an empirical question whether a shift in a tax rate will cause revenues to change a little or a lot, just as it’s an empirical issue whether revenues will go up or down.

It depends on how sensitive taxpayers are to changes in tax rates. Some types of taxpayers are very responsive, while other aren’t.

Now let’s consider two implications.

First, you presumably shouldn’t want to be at the revenue-maximizing point of the Laffer Curve. Unless, of course, you think giving politicians an extra $1 to spend is worth destroying $5 or $10 of income for households.

Second, you definitely don’t want to be on the revenue-losing side of the Laffer Curve. That means households are losing so much income that politicians actually have less money to spend, a lose-lose scenario.

Politicians, though, often can’t resist the temptation to raise tax burdens all the way to the short-run revenue-maximizing point.

Many of them simply don’t care if the private economy suffers several dollars of lost output per dollar of additional tax revenue. All that matters is that they have the ability to buy more votes with other people’s money.

But what’s really amazing is that some of them are so short-sighted and greedy that they raise the tax burden by so much that revenues actually fall.

And that’s what is happening in New York, where the tax burden on cigarettes has become so high that tax revenues are falling. Here are some excerpts from a story in the Syracuse newspaper.

The number of state-taxed cigarette packs sold in New York has plummeted by 54 percent in the past decade. …more smokers are buying cigarettes in ways that avoid New York’s $4.35 per pack tax, the highest in the nation. They cross state lines, shop from black market vendors and travel to Native American outlets to save $6 per pack or more, experts say. New York is losing big. In the past five years, the state’s cigarette tax collections have dropped by about $400 million…off-the-tax-grid shopping options add up to as much as $1.3 billion in uncollected state cigarette taxes each year, according to a study by the National Academies of Sciences, Engineering, and Medicine.

It’s not just happening in New York.

I’ve already written about massive Laffer Curve effects from excessive tobacco taxation in Michigan, Ireland, Bulgaria, and Quebec, and Washington.

And the article notes that Oklahoma’s non-compliance rate is even higher.

About 35 percent of smokers in Oklahoma buy cigarettes in ways that avoid state taxes, compared with about one-third of smokers in New York who do the same, experts said.

Needless to say, politicians hate it when the sheep don’t willingly line up to be fleeced. So they’re trying to change policy in ways that divert more money into their greedy hands.

That’s the bad news. The good news is that they’re not very successful.

a federal court in 2011 ruled in the state’s favor and paved the way for Gov. Andrew Cuomo to try to collect the state tax from Native American nations by making their wholesalers pick up the cost. Instead, many nations abandoned the wholesale route and stopped selling name-brand cigarettes. They began stocking their stores with significantly cheaper ones made by Indian-owned manufacturers, experts said, like Seneca-brand cigarettes.

And even when policy changes are “successful,” that doesn’t necessarily translate into more loot that politicians can use to buy votes.

When taxes become extortion, people will evade when they can’t avoid.

…the illegal trade of cigarettes has grown, especially in New York City where smokers are supposed to pay an extra $1.50 per pack on top of the state tax. A recent study by New York University estimated as many as 15 percent of New York City cigarettes sales avoided the state tax.

The Germans call it Schadenfreude when you take pleasure from another person’s misfortune. Normally, I would think people who feel this way have a character flaw.

But not in this case. I confess that get a certain joy from this story because politicians are being punished for their greed. I like the fact that they have less money to waste.

We can call it the revenge of the Laffer Curve!

P.S. Years ago, the JCT actually estimated that a 100 percent tax rate would generate more tax revenue. I realize it’s only a small sign of progress, but I don’t think the bureaucrats would make that assertion today.

P.P.S. Here’s my as-yet-unheeded Laffer Curve lesson for President Obama, based on the fact that rich taxpayers paid five times as much tax after Reagan reduced the top tax rate from 70 percent to 28 percent.

P.P.P.S. And here’s something that’s downright depressing. Some leftists are so resentful of successful people that they want higher tax rates even if the result is less revenue. And you’ll notice at the 4:20 mark of this video that President Obama is one of those people.

P.P.P.P.S. Speaking of leftists, here’s my response when one of them argued against the Laffer Curve.

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Since I’m a big fan of the Laffer Curve, I’m always interested in real-world examples showing good results when governments reduce marginal tax rates on productive activity.

Heck, I’m equally interested in real-world results when governments do the wrong thing and increase tax burdens on work, saving, investment, and entrepreneurship (and, sadly, these examples are more common).

My goal, to be sure, isn’t to maximize revenue for politicians. Instead, I prefer the growth-maximizing point on the Laffer Curve.

In any event, my modest hope is that politicians will learn that higher tax rates lead to less taxable income. Whether taxable income falls by a lot or a little obviously depends on the specific circumstance. But in either case, I want policy makers to understand that there are negative economic effects.

Writing for Forbes, Jeremy Scott of Tax Notes analyzes the supply-side policies of Israel’s Benjamin Netanyahu.

Netanyahu…argued that the Laffer curve worked, and that his 2003 tax cuts had transformed Israel into a market economy and an engine of growth. …He pushed through controversial reforms… The top individual tax rate was cut from 64 percent to 44 percent, while corporate taxes were slashed from 36 percent to 18 percent. …Netanyahu credits these reforms for making Israel’s high-tech boom of the last few years possible. …tax receipts did rise after Netanyahu’s tax cuts. In fact, they were sharply higher in 2007 than in 2003, before falling for several years because of the global recession. …His tax cuts did pay for themselves. And he has transformed Israel into more of a market economy…In fact, the prime minister recently announced plans for more cuts to taxes, this time to the VAT and corporate levies.

Pretty impressive.

Though I have to say that rising revenues doesn’t necessarily mean that the tax cuts were completely self-financing. To answer that question, you have to know what would have happened in the absence of the tax cut. And since that information never will be available, all we can do is speculate.

That being said, I have no doubt there was a strong Laffer Curve response in Israel. Simply stated, dropping the top tax rate on personal income by 20 percentage points creates a much more conducive environment for investment and entrepreneurship.

And cutting the corporate tax rate in half is also a sure-fire recipe for improved investment and job creation.

I’m also impressed that there’s been some progress on the spending side of the fiscal ledger.

Netanyahu explained that the public sector had become a fat man resting on a thin man’s back. If Israel were to be successful, it would have to reverse the roles. The private sector would need to become the fat man, something that would be possible only with tax cuts and a trimming of public spending. …Government spending was capped for three years.

The article doesn’t specify the years during which spending was capped, but the IMF data shows a de facto spending freeze between 2002 and 2005. And the same data, along with OECD data, shows that the burden of government spending has dropped by about 10 percentage points of GDP since that period of spending restraint early last decade.

Here’s the big picture from the Fraser Institute’s Economic Freedom of the World. As you can see from the data on Israel, the nation moved dramatically in the right direction after 1980. And there’s also been an upward bump in recent years.

Since I’m not an expert on Israeli economic policy, I don’t know the degree to which Netanyahu deserves a lot of credit or a little credit, but it’s good to see a country actually moving in the right direction.

Let’s close by touching on two other points. First, there was one passage in the Forbes column that rubbed me the wrong way. Mr. Scott claimed that Netanyahu’s tax cuts worked and Reagan’s didn’t.

Netanyahu might have succeeded where President Reagan failed.

I think this is completely wrong. While it’s possible that the tax cuts in Israel has a bigger Laffer-Curve effect than the tax cuts in the United States, the IRS data clearly shows that Reagan’s lower tax rates led to more revenue from the rich.

Second, the U.S. phased out economic aid to Israel last decade. I suspect that step helped encourage better economic policy since Israeli policy makers knew that American taxpayers no longer would subsidize statism. Maybe, just maybe, there’s a lesson there for other nations?

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During last night’s Democratic debate, Senator Bernie Sanders said he would not raise tax rates as high as they were in the 1950s. And if Twitter data is accurate, his comment about being “not that much of a socialist compared to [President] Eisenhower” was one of the evening’s most memorable moments.

But a clever line is not the same as smart policy. Promising not to raise top tax rates to 90 percent or above is hardly a sign of moderation from the Vermont politician.

Fortunately, not all Democrats are infatuated with punitive tax rates.

Or at least they didn’t used to be. When President John F. Kennedy took office, he understood that the Eisenhower tax rates (in fairness to Ike, he’s merely guilty of not trying to reduce confiscatory tax rates imposed by FDR) were harming the economy and JFK argued for across-the-board tax rate reductions.

…an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits. Surely the lesson of the last decade is that budget deficits are not caused by wild-eyed spenders but by slow economic growth and periodic recessions and any new recession would break all deficit records. In short, 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 rates now.

Here’s a video featuring some of President Kennedy’s wisdom on lower tax rates.

If that wasn’t enough, here’s another video featuring JFK’s wisdom on taxation.

By the way, if Senator Sanders really wants the rich to pay more, one of the lessons reasonable people learned from the Kennedy tax cuts is that upper-income taxpayers respond to lower tax rates by earning and reporting more income. Here’s a chart from a study I wrote almost 20 years ago.

Last but not least, let’s preemptively address a likely argument from Senator Sanders. He might be tempted to say that he doesn’t want the 90-percent tax rate of the Eisenhower years, but that he’s perfectly content with the 70-percent top tax rate that existed after the Kennedy tax cuts.

But if that’s the case, instead of teaching Sanders a lesson from JFK, then he needs to learn a lesson from Ronald Reagan.

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More than two years ago, I cited some solid research from the Tax Foundation to debunk some misguided analysis from the New York Times about the taxation of multinational companies.

Well, it’s déjà vu all over again, as the late Yogi Berra might say. That’s because we once again find something in the New York Times that cries out for correction.

Here’s some of what Patricia Cohen recently wrote about ostensibly generating lots of tax revenue by pillaging America’s top-1 percent taxpayers.

…what could a tax-the-rich plan actually achieve? As it turns out, quite a lot…the government could raise large amounts of revenue exclusively from this small group, while still allowing them to take home a majority of their income.

Oh, how generous of her for deciding that the awful, evil rich people can keep perhaps keep 50.1 percent of what they earn. Sounds like she should join the other cranks advising Jeremy Corbyn in the United Kingdom.

But I’m getting distracted. Let’s focus on the more important topic, which is her claim that it’s easy to generate a lot of tax revenue by soaking the rich.

The top 1 percent on average already pay roughly a third of their incomes to the federal government, according to a Treasury Department analysishow much more revenue could be generated by asking the rich to pay a larger share of their income in taxes?

Interestingly, Ms. Cohen shares some data showing that the rich already are paying far higher tax rates than the rest of us. Here’s the table that accompanied her article.

Normal people would look at those numbers, or at similar data produced by the IRS, and conclude that we’re already selectively over-penalizing upper-income taxpayers.

But statists see income in the private sector as belonging to the state, so there’s no such thing as too much money for government.

And Ms. Cohen seems to have this attitude. She engages in some simplistic calculations to estimate how much loot could be seized.

Raising their total tax burden to, say, 40 percent would generate about $157 billion in revenue the first year. Increasing it to 45 percent brings in a whopping $276 billion. Move a rung down the ladder and expand the contribution of those in the 95th to 99th percentile — who earn on average $405,000. Raising their total tax rate to 30 percent from a quarter of their total yearly income would generate an additional $86 billion. …A 35 percent share produces $176 billion.

Gee, how easy, at least on paper. If the politicians can figure out how to raise average tax rates to 45 percent for the rich (and 35 percent for the upper-middle class), then they get about $450 billion of additional tax revenue every year.

And you can buy a lot of votes with that much of other people’s money.

But sometimes things that are simple on paper are not so simple in reality.

It turns out that raising someone’s average tax rate (total tax payments/total income) requires some very big (and very bad) decisions on marginal tax rates (tax paid on the last dollar of income/last dollar of income).

Scott Greenberg of the Tax Foundation does that heavy lifting and his analysis makes mincemeat out of Ms. Cohen’s argument.

…how exactly would Congress go about raising the effective tax rate of the 1% from 33.4 percent to 45 percent? The article is not specific about this point. In fact, the article acknowledges that it is “sidestepping… the messy question of just which taxes would be increased.” This is irresponsible policy analysis… When one examines exactly which taxes would have to be increased to raise the effective tax rate of the 1% from 33.4 percent to 45 percent, the endeavor begins to appear much more difficult than the New York Times portrays.

For instance.

…the top tax bracket on ordinary income is 39.6%. How high would Congress have to raise this rate, in order to raise the effective tax rate of the 1% to 45 percent? According to our estimates, Congress would have to raise the top rate on ordinary income to 74 percent, in order to raise the effective rate of the 1% from 33.4 percent to 45 percent.What if Congress decided to increase, not only the top rate on ordinary income, but also the top rate on capital gains and dividends? …According to our estimates, Congress would have to raise the top rate on ordinary income, capital gains, and dividends to 56 percent, in order to increase the effective rate of the 1% to 45 percent.

In other words, if you target the rich with higher income tax rates, you’d have to have a rate higher than the confiscatory structure that existed before any of the Reagan tax cuts.

Or you could boost the top rate “only” to 56 percent, but only by also dramatically increasing the double taxation of dividends and capital gains.

And that might not be very smart, at least if you care about economic performance. Scott explains.

The high rates that would need to be in place to tax the 1% at a 45 percent effective rate would almost certainly have negative economic consequences. According to our Taxes and Growth model, raising the top rate on ordinary income to 74 percent would shrink the size of the U.S. economy by 3.5 percent in the long run, by discouraging labor and pass-through business. While this tax increase would raise $3.49 trillion over 10 years under conventional scoring, after taking its economic effects into account, it would only raise $2.37 trillion. This is a significantly smaller figure than that cited by the New York Times. Furthermore, raising the top rate on ordinary income, capital gains, and dividends to 56 percent would lead to an even larger decline in GDP, of 4.9 percent. This is because taxes on investment income are especially harmful to long-term economic growth. After taking economic effects into account, this proposal would only raise $1.96 trillion over 10 years.

So the politicians would still have some extra revenue, but they would destroy several dollars of private economic activity for every one dollar of revenue they would collect.

In what world would that be a good trade?

Oh, and by the way, those revenue estimates overstate how much money the politicians would collect. In the real world, higher tax rates also would increase tax avoidance and tax evasion.

…none of these figures take into account the effects of increased tax evasion and profit shifting by wealthy Americans that would surely occur in response to such high rates. After all, when taxes rise, taxpayers have more incentives to avoid them. And it is well-documented that, when rates on capital gains rise, shareholders simply defer their realizations, making it difficult to raise much revenue from tax increases on capital gains income.

So here’s the bottom line.

…the New York Times claims that the federal government could raise large amounts of revenue by taxing the rich just a little bit more. In fact, taxes on the rich would have to go up enormously in order to bring in the sorts of revenue figures cited by the article. The negative economic effects of these tax increases would then reduce these revenues considerably.

I’d like to think Scott’s analysis will change minds and cause statists to reassess their desire to impose high tax rates.

But I’m not overly hopeful. Let’s not forget that some of these people aren’t particularly interested in generating more revenue for politicians. Their real motive is hate and envy.

P.S. Let’s hope American statists never learn about Francois Hollande’s flat tax.

P.P.S. Speaking of which, here are some amusing cartoons about class-warfare tax policy.

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I have a very mixed view of the Committee for a Responsible Federal Budget, which is an organization representing self-styled deficit hawks in Washington.

They do careful work and I always feel confident about citing their numbers.

Yet I frequently get frustrated because they seem to think that tax increases have to be part of any budget deal, regardless of the evidence that such an approach will backfire.

So when CRFB published a “Fiscal FactChecker” to debunk 16 supposed budget myths that they expect during this campaign season, I knew I’d find lots of stuff I would like…and lots of stuff I wouldn’t like.

Let’s look at what they said were myths, along with my two cents on CRFB’s analysis.

Myth #1: We Can Continue Borrowing without Consequences

Reality check: CRFB’s view is largely correct. If we leave policy on autopilot, demographic changes and poorly structured entitlement programs  will lead to an ever-rising burden of government spending, which almost surely will mean ever-rising levels of government debt (as well as ever-rising tax burdens). At some point, this will lead to serious consequences, presumably bad monetary policy (i.e., printing money to finance the budget) and/or Greek-style crisis (investors no longer buying bonds because they don’t trust the government will pay them back).

The only reason I don’t fully agree with CRFB is that we could permanently borrow without consequence if the debt grew 1 percent per year while the economy grew 3 percent per year. Unfortunately, given the “new normal” of weak growth, that’s not a realistic scenario.

Myth #2: With Deficits Falling, Our Debt Problems are Behind Us

Reality check: The folks at CRFB are right. Annual deficits have dropped to about $500 billion after peaking above $1 trillion during Obama’s first term, but that’s just the calm before the storm. As already noted, demographics and entitlements are a baked-into-the-cake recipe for a bigger burden of government and more red ink.

That being said, I think that CRFB’s focus is misplaced. They fixate on debt, which is the symptom, when they should be more concerned with reducing excessive government, which is the underlying disease.

Myth #3: There is No Harm in Waiting to Solve Our Debt Problems

Reality check: We have a spending problem. Deficits and debt are merely symptoms of that problem. But other than this chronic mistake, CRFB is right that it is far better to address our fiscal challenges sooner rather than later.

CRFB offers some good analysis of why it’s easier to solve the problem by acting quickly, but this isn’t just about math. Welfare State Wagon CartoonsIt’s also important to impose some sort of spending restraint before a majority of the voting-age population has been lured into some form of government dependency. Once you get to the point when more people are riding in the wagon than pulling the wagon (think Greece), reform becomes almost impossible.

Myth #4: Deficit Reduction is Code for Austerity, Which Will Harm the Economy

Reality check: The folks at CRFB list this as a myth, but they actually agree with the assertion, stating that deficit reduction policies “have damaged economic performance and increased unemployment.” They even seem sympathetic to “modest increases to near-term deficits by replacing short-term ‘sequester’ cuts”, which would gut this century’s biggest victory for good fiscal policy!

There are two reasons for CRFB’s confusion. First, they seem to accept the Keynesian argument about bigger government and red ink boosting growth, notwithstanding all the evidence to the contrary. Second, they fail to distinguish between good austerity and bad austerity. If austerity means higher taxes, as has been the case so often in Europe, then it is unambiguously bad for growth. But if it means spending restraint (or even actual spending cuts), then it is clearly good for growth. There may be some short-term disruption since resources don’t instantaneously get reallocated, but the long-term benefits are enormous because labor and capital are used more productively in the private economy.

Myth #5: Tax Cuts Pay For Themselves

Reality check: I agree with the folks at CRFB. As a general rule, tax cuts will reduce government revenue, even after measuring possible pro-growth effects that lead to higher levels of taxable income.

But it’s also important to recognize that not all tax cuts are created equal. Some tax cuts have very large “supply-side” effects, particularly once the economy has a chance to adjust in response to better policy. So a lower capital gains tax or a repeal of the death tax, to cite a couple of examples, might increase revenue in the long run. And we definitely saw a huge response when Reagan lowered top tax rates in the 1980s. But other tax cuts, such as expanded child credits, presumably generate almost no pro-growth effects because there’s no change in the relative price of productive behavior.

Myth #6: We Can Fix the Debt Solely by Taxing the Top 1%

Reality check: The CRFB report correctly points out that confiscatory tax rates on upper-income taxpayers would backfire for the simple reason that rich people would simply choose to earn and report less income. And they didn’t even include the indirect economic damage (and reductions in taxable income) caused by less saving, investment, and entrepreneurship.

Ironically, the CRFB folks seem to recognize that tax rates beyond a certain level would result in less revenue for government. Which implies, of course, that it is possible (notwithstanding what they said in Myth #5) for some tax cuts to pay for themselves.

Myth #7: We Can Lower Tax Rates by Closing a Few Egregious Loopholes

Reality check: It depends on the definition of “egregious.” In the CRFB report, they equate “egregious” with “unpopular” in order to justify their argument.

But if we define “egregious” to mean “economically foolish and misguided,” then there are lots of preferences in the tax code that could – and should – be abolished in order to finance much lower tax rates. Including the healthcare exclusion, the mortgage interest deduction, the charitable giving deduction, and (especially) the deduction for state and local taxes.

Myth #8: Any Tax Increases Will Cripple Economic Growth

Reality check: The CRFB folks are right. A small tax increase obviously won’t “cripple” economic growth. Indeed, it’s even possible that a tax increase might lead to more growth if it was combined with pro-growth policies in other areas. Heck, that’s exactly what happened during the Clinton years. But now let’s inject some reality into the conversation. Any non-trivial tax increase on productive behavior will have some negative impact on economic performance and competitiveness. The evidence is overwhelming that higher tax rates hurt growth and the evidence is also overwhelming that more double taxation will harm the economy.

The CRFB report suggests that the harm of tax hikes could be offset by the supposed pro-growth impact of a lower budget deficit, but the evidence for that proposition if very shaky. Moreover, there’s a substantial amount of real-world data showing that tax increases worsen fiscal balance. Simply stated, tax hikes don’t augment spending restraint, they undermine spending restraint. Which may be why the only “bipartisan” budget deal that actually led to a balanced budget was the one that lowered taxes instead of raising them.

Myth #9: Medicare and Social Security Are Earned Benefits and Should Not Be Touched

Reality check: CRFB is completely correct on this one. The theory of age-related “social insurance” programs such as Medicare and Social Security is that people pay into the programs while young and then get benefits when they are old. This is why they are called “earned benefits.”

The problem is that politicians don’t like asking people to pay and they do like giving people benefits, so the programs are poorly designed. The average Medicare recipient, for instance, costs taxpayers $3 for every $1 that recipient paid into the program. Social Security isn’t that lopsided, but the program desperately needs reform because of demographic change. But the reforms shouldn’t be driven solely by budget considerations, which could lead to trapping people in poorly designed entitlement schemes. We need genuine structural reform.

Myth #10: Repealing “Obamacare” Will Fix the Debt

Reality check: Obamacare is a very costly piece of legislation that increased the burden of government spending and made the tax system more onerous. Repealing the law would dramatically improve fiscal policy.

But CRFB, because of the aforementioned misplaced fixation on red ink, doesn’t have a big problem with Obamacare because the increase in taxes and the increase in spending are roughly equivalent. So the organization is technically correct that repealing the law won’t “fix the debt.” But it would help address America’s real fiscal problem, which is a bloated and costly public sector.

Myth #11: The Health Care Cost Problem is Solved

Reality check: CRFB’s analysis is correct, though it would have been nice to see some discussion of how third-party payer is the problem.

Myth #12: Social Security’s Shortfall Can be Closed Simply by Raising Taxes on or Means-Testing Benefits for the Wealthy

Reality check: To their credit, CRFB is basically arguing against President Obama’s scheme to impose Social Security payroll taxes on all labor income, which would turn the program from a social-insurance system into a pure income-redistribution scheme.

On paper, such a system actually could eliminate the vast majority of Social Security’s giant unfunded liability. In reality, this would mean a huge increase in marginal tax rates on investors, entrepreneurs, and small business owners, which would have a serious adverse economic impact.

Myth #13: We Can Solve Our Debt Situation by Cutting Waste, Fraud, Abuse, Earmarks, and/or Foreign Aid

Reality check: Earmarks (which have been substantially curtailed already) and foreign aid are a relatively small share of the budget, so CRFB is right that getting rid of that spending won’t have a big impact. But what about the larger question. Could our fiscal mess (which is a spending problem, not a “debt situation”) be fixed by eliminating waste, fraud, and abuse?

It depends on how one defines “waste, fraud, and abuse.” If one uses a very narrow definition, such as technical malfeasance, then waste, fraud, and abuse might “only” amount to a couple of hundred billions dollars per year. But from an economic perspective (i.e., grossly inefficient misallocation of resources), then entire federal departments such as HUD, Education, Transportation, Agriculture, etc, should be classified as waste, fraud, and abuse.

Myth #14: We Can Grow Our Way Out of Debt

Reality check: CRFB is correct that faster growth won’t solve all of our fiscal problems. Unless one makes an untenable assumption that economic growth will be faster than the projected growth of entitlement spending. And even that kind of heroic assumption would be untenable since faster growth generally obligates the government to pay higher benefits in the future.

Myth #15: A Balanced Budget Amendment is All We Need to Fix the Debt

Reality check: CRFB accurately explains that a BBA is simply an obstacle to additional debt. Politicians still would be obliged to change laws to fulfill that requirement. But that analysis misses the point. A BBA focuses on red ink, whereas the real problem is that government is too big and growing too fast. State balanced-budget requirement haven’t stopped states like California and Illinois from serious fiscal imbalances and eroding competitiveness. The so-called Maastricht anti-deficit and anti-debt rules in the European Union haven’t stopped nations such as France and Greece from fiscal chaos.

This is why the real solution is to have some sort of enforceable cap on government spending. That approach has worked well in jurisdictions such as Switzerland, Hong Kong, and Colorado. And even research from the IMF (a bureaucracy that shares CRFB’s misplaced fixation on debt) has concluded that expenditure limits are the only effective fiscal rules.

Myth #16: We Can Fix the Debt Solely by Cutting Welfare Spending

Reality check: The federal government is spending about $1 trillion this year on means-tested (i.e., anti-poverty) programs, which is about one-fourth of total outlays, so getting Washington out of the business of income redistribution would substantially lower the burden of federal spending (somewhat offset, to be sure, by increases in state and local spending). And for those who fixate on red ink, that would turn today’s $500 billion deficit into a $500 billion surplus.

That being said, there would still be a big long-run problem caused by other federal programs, most notably Social Security and Medicare. So CRFB is correct in that dealing with welfare-related spending doesn’t fully solve the long-run problem, regardless of whether you focus on the problem of spending or the symptom of borrowing.

This has been a lengthy post, so let’s have a very simple summary.

We know that modest spending restraint can quickly balance the budget.

We also know lots of nations that have made rapid progress with modest amounts of spending restraint.

And we know that the tax-hike option simply leads to more spending.

So the only question to answer is why the CRFB crowd can’t put two and two together and get four?

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Every so often, I’ll assert that some statists are so consumed by envy and spite that they favor high tax rates on the “rich” even if the net effect (because of diminished economic output) is less revenue for government.

In other words, they deliberately and openly want to be on the right side (which is definitely the wrong side) of the Laffer Curve.

Critics sometimes accuse me of misrepresenting the left’s ideology, to which I respond by pointing to a poll of left-wing voters who strongly favored soak-the-rich tax hikes even if there was no extra tax collected.

But now I have an even better example.

Writing for Vox, Matthew Yglesias openly argues that we should be on the downward-sloping portion of the Laffer Curve. Just in case you think I’m exaggerating, “the case for confiscatory taxation” is part of the title for his article.

Here’s some of what he wrote.

Maybe at least some taxes should be really high. Maybe even really really high. So high as to useless for revenue-raising purposes — but powerful for achieving other ends. We already accept this principle for tobacco taxes. If all we wanted to do was raise revenue, we might want to slightly cut cigarette taxes. …But we don’t do that because we care about public health. We tax tobacco not to make money but to discourage smoking.

The tobacco tax analogy is very appropriate.

Indeed, one of my favorite arguments is to point out that we have high taxes on cigarettes precisely because politicians want to discourage smoking.

As a good libertarian, I then point out that government shouldn’t be trying to control our private lives, but my bigger point is that the economic arguments about taxes and smoking are the same as those involving taxes on work, saving, investment.

Needless to say, I want people to understand that high tax rates are a penalty, and it’s particularly foolish to impose penalties on productive behavior.

But not according to Matt. He specifically argues for ultra-high tax rates as a “deterrence” to high levels of income.

If we take seriously the idea that endlessly growing inequality can have a cancerous effect on our democracy, we should consider it for top incomes as well. …apply the same principle of taxation-as-deterrence to very high levels of income. …Imagine a world in which we…imposed a 90 percent marginal tax rate on salaries above $10 million. This seems unlikely to raise substantial amounts of revenue.

I suppose we should give him credit for admitting that high tax rates won’t generate revenue. Which means he’s more honest than some of his fellow statists who want us to believe confiscatory tax rates will produce more money.

But honesty isn’t the same as wisdom.

Let’s look at the economic consequences. Yglesias does admit that there might be some behavioral effects because upper-income taxpayers will be discouraged from earning and reporting income.

Maybe…we really would see a reduction of effort, or at least a relaxation of the intensity with which the performers pursue money. But would that be so bad? Imagine the very best hedge fund managers and law firm partners became inclined to quit the field a bit sooner and devote their time to hobbies. What would we lose, as a society? …some would presumably just move to Switzerland or the Cayman Islands to avoid taxes. That would be a real hit to local economies, but hardly a disaster. …Very high taxation of labor income would mean fewer huge compensation packages, not more revenue. Precisely as Laffer pointed out decades ago, imposing a 90 percent tax rate on something is not really a way to tax it at all — it’s a way to make sure it doesn’t happen.

While I suppose it’s good that Yglesias admits that high tax rates have behavioral effects, he clearly underestimates the damaging impact of such a policy.

He presumably doesn’t understand that rich people earn very large shares of their income from business and investment sources. As such, they have considerable ability to alter the timing, level, and composition of their earnings.

But my biggest problem with Yglesias’ proposals is that he seems to believe in the fixed-pie fallacy that public policy doesn’t have any meaningful impact of economic performance. This leads him to conclude that it’s okay to rape and pillage the “rich” since that will simply mean more income and wealth is available for the rest of us.

That’s utter nonsense. The economy is not a fixed pie and there is overwhelming evidence that nations with better policy grow faster and create more prosperity.

In other words, confiscatory taxation will have a negative effect on everyone, not just upper-income taxpayers.

There will be less saving and investment, which translates into lower wages and salaries for ordinary workers.

And as we saw in France, high tax rates drive out highly productive people, and we have good evidence that “super-entrepreneurs” and inventors are quite sensitive to tax policy.

To be fair, I imagine that Yglesias would try to argue that these negative effects are somehow offset by benefits that somehow materialize when there’s more equality of income.

But the only study I’ve seen that tries to make a connection between growth and equality was from the OECD and that report was justly ridiculed for horrible methodology (not to mention that it’s hard to take serious a study that lists France, Spain, and Ireland as success stories).

P.S. This is my favorite bit of real-world evidence showing why there should be low tax rates on the rich (in addition, of course, to low tax rates on the rest of us).

P.P.S. And don’t forget that leftists generally view higher taxes on the rich as a precursor to higher taxes on the rest of the population.

P.P.P.S. In the interests of full disclosure, Yglesias says I’m insane and irrational.

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