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The Real Damage Done by High Tax Rates

Posted on: Jul13 2012 | Leave A Comment

President Obama has once again put the question of income tax
rates on center stage. As a Wall Street Journal headline
put it, “Obama Intensifies Tax Fight.” He is apparently hell-bent
on making our income tax structure more progressive.

Raising tax rates on upper-income earners is an appealing idea
to many people. The President certainly hopes that it is. The most
common argument against the idea is that it would diminish the
incentive for business owners to invest, hire, and grow their
businesses. Although that is all too true, it’s only one kind of
damage done by high marginal tax rates. Even if we were not in a
recession, more tax progressivity would still be a bad idea.

It’s well known that taxes reduce economic effort. If you want
less of something, tax it. That, by itself, reduces wealth creation
and economic growth. Less well recognized, however, is that high
tax rates misdirect and misallocate economic activity.

A flatter, less progressive income tax rate schedule is an idea
that never seems to go away. Perhaps the earliest argument for a
flat tax was in Milton Friedman’s 1962 classic, Capitalism and
Freedom
. Its latest sighting is in what’s called the “Ryan
Budget” authored by Congressman Paul Ryan. The official name for
his budget plan is “The Path to Prosperity: Restoring America’s
Promise.” His proposal advocates only two federal personal income
tax rates — 10 and 25 percent. A notable and similar
recommendation was part of President Obama’s own deficit reduction
team of Erskine Bowles and former senator Alan Simpson. Their
“National Commission on Fiscal Responsibility and Reform”
recommended federal rates of 8, 14, and 23 percent. Obama totally
ignored the Bowles-Simpson recommendations.

High marginal tax rates reduce wealth creation in more ways than
is immediately obvious. High tax rates not only reduce incentives
overall, they also alter and rearrange incentives. Most of the
damage done by excessively high tax rates is hidden from view and
almost impossible to measure precisely. Although hidden, the damage
is real and significant.

Our wealth is as much dependent on how efficiently we use
resources as it is on the quantity of resources we have. The worst
damage done by high tax rates is the way they distort decisions in
the economy and result in a misallocation of resources.

Higher taxes increase the effort expended in avoiding taxes.
When you increase the reward for avoidance, you will get more
avoidance. It will follow as the night the day. More decisions will
be determined by tax considerations. The result is a less
productive economy.

Investing is a process of choosing among alternatives. A
generalization that is true in most cases is that money and effort
go to where they are most rewarded (or more precisely, where there
is the best risk-reward ratio). Different rates of returns attract
or repel investment capital.

An economy functions most efficiently and experiences the
highest possible growth when resources move to their highest-valued
uses. That is the natural tendency in a free market economy. High
tax rates, however, significantly distort this tendency. Too often
resources move not to where they create the highest economic value,
but to where they result in the most tax avoidance. High tax rates
reduce the reward for productive spending and increase the reward
for wasteful spending. If the tax minimizing choice is the most
economically productive it’s a happy accident, and a rare one.

High rates make avoiding the tax an option with a very high rate
of return. The higher the tax rate the greater the effort expended
to avoid them, the greater the misdirection of economic decisions,
and the greater the loss to economy and all its participants. High
tax rates result in “overinvestment” in tax avoidance.
Overinvestment in one activity means reduced investment
elsewhere.

High tax rates also reduce the price or “opportunity cost” of
leisure. You could define leisure as wealth non-creation. There’s
nothing inherently wrong with choosing more leisure, but it does
cost something in terms of output. The higher the tax rate, the
lower the price of leisure. More leisure means less wealth
creation. High tax rates are equivalent to a subsidy for leisure.
Is that really something we want to do? Have we made a policy
choice that people work too hard?

ONE CLEAR EXAMPLE of taxes distorting economic choices is the
tax on capital gains. The capital gains tax is due only when the
gains are “realized.” In other words, only when the appreciated
asset someone owns is sold. In most cases the choice to sell
something is controlled by the owner. The capital gains tax is the
closest thing we have to a voluntary tax, at least in regard to
timing.

The voluntary characteristic of the tax on capital gains is why
such taxes are especially sensitive to changes in rates. Even more
than is the case with other taxes, revenue from changes often move
contrary to the changes in rates. Capital gains taxes are the
easiest tax to avoid or at least to postpone. In the past whenever
capital gains taxes have been reduced there is invariably an
increase in the turnover rate of investments and, therefore, many
more “realized” gains and increased tax revenue.

There are millions of assets people would like to sell but don’t
because they do not want to trigger the tax. Among other things,
this prevents people from diversifying their investments as much as
they would prefer. Many people have most of their wealth
concentrated in one or two assets. Diversification is far and away
the most effective way to reduce risk. Consequently, the tax on
capital gains results in people bearing an undesired amount of
risk.

When tax rates are raised there is almost never a proportional
increase in government revenue. Why not? To understand why, it
helps to remember that ours is mostly a voluntary exchange economy.
Although taxes are not voluntary, the economic transactions you
enter into are.

Taxpayers in the top brackets have the most flexibility in how
they arrange their incomes, where they reside, and how they invest.
This week we learned that the billionaire Denise Rich has renounced
her U.S. citizenship in order to avoid U.S. income and estate
taxes. Last month Facebook co-founder Eduardo Saverin announced
that he had renounced his citizenship for the same reasons. Now,
rather than getting, for example, 35 percent of these peoples’
incomes and estates, our federal and state treasuries will get
zero. California and New York, two states with top income tax rates
over ten percent, have experienced out-migration of upper income
residents in recent years.

A friend of mine is a chemical engineer for a large biotech
firm. For several years he spent much of his time in Singapore
overseeing the construction of a major new research and production
facility there. When I asked him why the decision was made to build
it there rather than the U.S., he answered even before I finished
my question: “Taxes.”

Over-investment in tax avoidance is magnified in an environment
of tax complexity. Every serious proposal for a flatter income tax
schedule has also included tax simplification and the elimination
of tax loopholes. Lower rates and a broader base — you can’t have
one without the other. It was such a combination that was central
to the tax reform President Reagan successfully passed in 1986.
Reagan reduced the top income tax bracket from 70 percent to 28
percent. What followed was an extended period of robust economic
growth.

A flatter tax rate schedule would increase productivity and
economic efficiency. We would all be better off, not just
“millionaires and billionaires.” President Obama, however, is far
more focused on punishing the rich than he is in growing the
economy.

Obama wants the top federal tax bracket to increase from 35
percent to 39.6 percent, the capital gains rate to increase from 15
percent to 20 percent, and the estate tax rate to increase from 35
percent to 45 percent. Buried in Obamacare’s 2,500 plus pages is a
totally new 3.8 percent tax on all “unearned income,” which
includes interest and dividends from investments, income from
rental property, and the sale of single family homes. In other
words, if Obama gets his way the top marginal rate will increase
from 35 percent to 43.4 percent. That would have a poisonous impact
on the economy.

Mitt Romney, on the other hand, wants a top income tax rate of
28 percent, the capital gains rate to be zero for incomes below
$200,000, complete repeal of the estate tax, and a complete repeal
of Obamacare .

The battle lines have been drawn. May lower rates and the
economy be the victors!


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