Fundmastery Blog

Kurt Brouwer May 21st, 2008

Raising taxes on the rich or trying to ’soak’ the rich seems to be a popular idea now. There have been proposals to add surtaxes to high income earners, to raise taxes back to the rates prevalent in the 1990s and so on.

With the Alternative Minimum Tax (AMT), we have seen that trying to target the very rich just ended up dousing millions of Americans with higher taxes (Congress Patches Alternative Minimum Tax). And, many of the same politicians who touted the AMT are now complaining that it is hurting their constituents, but they haven’t apologized for inflicting it on us in the first place.

In a previous post (see Does Soaking The Rich Actually Work?), we pointed out that it is difficult to ’soak’ the rich by raising income taxes because they have ways to defer or delay the receipt of income. It should be no surprise to readers of this blog, that when you raise tax rates, investors change their behavior accordingly. For example, when capital gains tax rates go up, investors slow down realization of gains. When capital gains tax rates go down, investors speed up realization of gains. Hmmm. Is there a correlation? Yes there is.

It’s important to remember that, as opposed to ordinary income from salaries and bonuses, investors have far more control of when and if they will realize a gain on a sale of stocks, mutual funds, real estate or a business. And, this is not just an issue for the ‘rich.’ In recent years, most of the households reporting capital gains have been under $100,000 in annual income. For more on this see What Happens When You Raise Capital Gains Tax Rates?.

From the Wall Street Journal, we now have proof that all these efforts to raise taxes don’t seem to work in actual practice. There is a constant for tax revenues of 19.5% of GDP that has applied through all sorts of tax hikes and tax cuts over the past 50 years.

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You Can’t Soak The Rich (Wall Street Journal, May 20, 2008, David Ranson)

Source: Wall Street Journal

…Will increasing tax rates on the rich increase revenues..?

Mr. Hauser uncovered the means to answer these questions definitively. On this page in 1993, he stated that “No matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5% of GDP.” …

The chart nearby, updating the evidence to 2007, confirms Hauser’s Law. The federal tax “yield” (revenues divided by GDP) has remained close to 19.5%, even as the top tax bracket was brought down from 91% to the present 35%. This is what scientists call an “independence theorem,” and it cuts the Gordian Knot of tax policy debate.

The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP. So if we want to increase tax revenue, we need to increase GDP.

What happens if we instead raise tax rates? Economists of all persuasions accept that a tax rate hike will reduce GDP, in which case Hauser’s Law says it will also lower tax revenue. That’s a highly inconvenient truth for redistributive tax policy, and it flies in the face of deeply felt beliefs about social justice. It would surely be unpopular today with those presidential candidates who plan to raise tax rates on the rich – if they knew about it…

Just as a point of reference, I don’t think you can really say that economists of all persuasions would agree that the sky is blue, much less what the tax rate should be. Further, I think the author misstated when he wrote that a tax rate hike will reduce GDP. I suspect he meant that a tax rate hike would reduce the rate of GDP growth. That’s pretty defensible from all the economic research I have seen.

In any case, the clear message here is that tax receipts of 19.5% of GDP have been consistent for 50 years. We can see this in the chart because the actual tax revenue yield really has not changed through all the ups and downs of income tax rates. However, for this period, income tax rates have generally declined, albeit with lots of chopping and changing. Even though the percentage has not changed during this span of years, the actual revenues in dollars have tripled as this chart from the Heritage Foundation demonstrates:

Source: Heritage Foundation

The time period for this chart begins in 1965 versus 1950 for the previous one. Nonetheless, I think it is fair to say that reductions in tax rates helped achieve economic growth which resulted in higher tax revenues. Even over this period, 1965 — 2008, tax revenues tripled.

We really don’t know what the optimum tax rate would be that maintains revenues at 19.5% of GDP while allowing for maximum GDP growth, but we do know that economic growth is good for everyone and as the economy grows, tax revenues will grow too. Ideally, our leaders in Washington would try to figure the optimum tax structure to stimulate growth. Unfortunately, the trend is going the other way as raising taxes on the ‘rich’ is a populist theme many politicians have adopted (see Largest Tax Increase Since World War II). And, as we have seen with the AMT, our political leaders often misunderstand the long-term consequences of tax law changes.

Via: BrothersJuddBlog

 

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