Fundmastery Blog

Kurt Brouwer January 26th, 2008

This is a challenging piece from Arthur Laffer writing in the Wall Street Journal. It’s challenging in two ways. First, you have to stay awake long enough to actually read the piece and think through what the author is saying. This isn’t easy for those of us who find tax discussions less than stimulating. Second, it is challenging because this piece punctures arguments on taxes from both the left and the right. Read on [emphasis added]:

The Tax Threat To Prosperity (Wall Street Journal, January 25, 2008, Arthur B. Laffer)

‘Over the past 30 years, the U.S. has seen large changes in income tax rates as well as other tax rates. And, as would be expected, the budgetary implications of these tax changes have once again become a hotly debated partisan issue.

But missing from the discussion are the huge differences in how the top 1% of income earners respond to changes in tax rates versus, say, the bottom 75% or 80% of taxpayers — the so-called middle class and lowest income groups. The “rich” quite simply are not like the rest of us.

From the standpoint of logic, the supply of their taxable income should be far more sensitive to changes in tax rates than the supply of taxable income of the middle class and poor. In the highest tax bracket, 100% of all taxpayers have the highest tax rate as their marginal tax rate. And it’s the marginal tax rate that elicits supply-side responses…’

Before we go on with the article, I just want to help you focus on something Laffer wrote and also to get ready for an important point he is about to make. His quip that the rich are not like us is a quote from F. Scott Fitzgerald’s novel, The Great Gatsby. Cute, but also true. Laffer means that high income taxpayers have far more opportunities to avoid taxes than do lower income taxpayers. Therefore, higher or lower tax rates will affect the behavior of the rich far more than everyone else (see 1% of Taxpayers Pay Nearly 40% of All Income Taxes).

Also, I had not previously considered this next point, but it is clearly very important. He points out that lowering rates at the low end of the tax code will simply reduce overall tax revenues — from both the high income folks and the low income folks. Here’s why:

‘…Of course, if you look at a tax schedule, it’s obvious that people with the highest taxable income also pay taxes in every other tax bracket. These lower tax rates are “inframarginal” and don’t affect behavior. From the standpoint of the rich alone, a cut in these lower tax rates reduces tax revenues.

Some 99% of all taxpayers paid taxes at the 10% rate in 2005, for example. Yet only 25% of all taxpayers had 10% as their marginal tax rate. Thus a cut in the 10% tax rate would have a supply-side impact on a relatively small portion of all those who pay the 10% rate — while for the rest who pay the 10% rate, a tax cut would result in a deadweight revenue loss.

On these grounds alone one should expect a greater supply-side response with a change in the highest tax rate than any other tax rate…’

We all know that the tax rate goes up as income goes up, but Laffer points out that even high income taxpayers are in the lower brackets on the first income they earn. Therefore, he draws three conclusions: 1) If you reduce the tax rate on the lower brackets, high income taxpayers pay a little bit less too so that is a revenue loss; 2) Lower income taxpayers will also pay less and that is a revenue loss; and 3) The only change that would affect the behavior of high income taxpayers would be a change in the top rate because this would either raise or lower their marginal tax rate. The marginal tax rate is the rate on which your last dollar of income is taxed. This is also your highest tax rate. Laffer continues:

‘…Academicians and politicians have finally come to understand that it’s the after-tax rate of return that determines people’s behavior. Even though statutory tax rates are far lower today than they were when, say, Kennedy or Reagan took office, it is still very true that for every dollar of static revenue change there is a much larger incentive affect in the highest tax bracket than in the lowest tax bracket…

…We have accurate data on both the total taxes paid by the top 1% of income earners, and on their comprehensive household income as measured by the Congressional Budget Office. From these two data series we can calculate the effective average tax rate for the top 1% of all income earners.

Surprise, surprise: The effective average tax rate for the top 1% of income earners barely wiggles as Congress changes tax codes after tax codes, and as the economy goes from boom to bust and back again (see chart).

Source: Wall Street Journal / Congressional Budget Office

The question is, how can that effective average tax rate be so stable? The answer is simply that the very highest income earners are and have always been able to vary their reported income and thus control the amount of taxes they pay. Whether through tax shelters, deferrals, gifts, write-offs, cross income mobility or any of a number of other measures, the effective average tax rate barely budges. But this group’s total tax payments are incredibly volatile.

For the low- and middle-income earners, the effective average tax rate has tumbled over the past 25 years, and so have tax revenues no matter how they’re measured.

Using recent data, in other words, it would appear on its face that the Democratic proposal to raise taxes on the upper-income earners, and lower taxes on the middle- and lower- income earners, will result in huge revenue losses on both accounts…’

Based on this chart, it would seem that attempts to increase the effective tax rate often backfire because high income taxpayers can defer income or seek other means of avoiding taxes.

So, in answer to my question in the title of this post: soaking the rich works, but only up to a point. But, once that point has been passed, it ceases working because high income taxpayers can be quite creative in finding ways to reduce their tax burden. It is also true, however, that tax cuts designed to stimulate economic growth have to be structured very carefully so they impact the behavior of taxpayers in positive ways. Just cutting taxes on the lower tax brackets will almost certainly result in lower tax revenues, but it will also be unlikely to stimulate meaningful growth.

And, when the government tries more aggressive tax laws as a means of soaking the rich, we find that there are unintended consequences. A perfect example of this is the Alternative Minimum Tax (see Congress Patches Alternative Minimum Tax), which was enacted in 1969 to tax the very rich.

Unfortunately, it was never indexed for inflation so now it soaks millions of taxpayers who are definitely not rich.

• Economy , Geopolitics , Money , Personal Finance
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