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  • Taxes and the Rich

    Posted by Carl from Chicago on March 30th, 2010 (All posts by )

    On the opinion page at the Wall Street Journal Alan Reynolds of the Cato Institute wrote an excellent article titled “The Rich Can’t Pay for ObamaCare“.

    The key concept is what he describes as “the elasticity of taxable income” or ETI. ETI measures how taxable income is impacted as tax rates increase; if you use a rate of 0.5 you assume that an increase in tax rates that would yield $1 if prior behavior held stead would yield 50 cents after the impact of behavioral changes is taken into account. However, instead of an ETI of 0.5, per the article:

    For incomes above $500,000, Treasury Department economist Bradley Heim recently estimated the ETI at 1.2 – which means that higher tax rates on the super-rich yield less revenue than lower tax rates.

    The article describes, in practical terms, how rich individuals can take action that illustrates this ETI:

    - dump dividend paying stocks (you will probably want to do this anyways because they are likely to fall in price because part of their value is tied to the reduced tax rate) when the 15% rate is raised
    - avoid selling stocks with capital gains when the rate rises, or sell stocks with unrealized losses at the same time to “net out” any gains owed to the government
    - reducing income near the $250k range when “phase outs” raise the MARGINAL tax rate to a very high rate through tax deferral strategies such as 401(k) contributions and the like
    - consider becoming a one-earner couple instead of a DINK if the penalty on incremental income becomes too great to make up for the cost of child care and the general decremented quality of life

    I really like this paragraph that should be an epitaph for tax policy:

    Punitive tax rates on high-income individuals do not increase revenue. Successful people are not docile sheep just waiting to be shorn.

    A sound tax policy has two main elements 1) it raises the amount of revenue that it is supposed to raise 2) it provides the minimal distortion of productive economic activity.

    Super high tax rates on the rich accomplish neither of these two attributes. They don’t raise the money as planned (in fact you could likely end up with LESS money overall) and they distort the economy by having our most valuable members of the economy step back from working at a time when their entrepreneurial drive is needed most to jump-start the economy.

    Cross posted at LITGM

     

    14 Responses to “Taxes and the Rich”

    1. Michael Kennedy Says:

      We went through all this in the 40s and 50s and the record shows that income tax receipts do not change, even with 90% tax rates. I have a friend who is Swedish. She is an orthopedic surgeon here but she is very well informed on the situation in Sweden. They have a big step up in rates at an income level that is about, let us say $150,000. The lethal step arrives about October 1st for most senior Swedish doctors. At that point, all the senior doctors head for the Mediterranean. You cannot find a senior doctor after October 1. Everyone knows it and acts accordingly.

      There was another Swedish story that made the New England Journal of Medicine about 25 years ago. The short version was that the doctors were all on salary but there was a second system to encourage primary care. The doctor was paid seven crowns per patient visit to see patients in the clinic. This resulted, unsurprisingly, with all the senior professors seeing patients in the clinic while the junior house staff were doing all the complex surgeries upstairs. It finally came to the attention of the government which changed the compensation rules to encourage the professors to return to the hospital wards and allow junior staff to man the clinic.

      There is a somewhat similar system in Germany in which the professor makes the incision in the surgery, then leaves the junior staff to complete the operation. He then returns to close the incision as patients often judge the quality of the surgery by the appearance of the scar. 60 MInutes once did one of their typically dishonest exposes on “ghost surgery” at Rochester when a famous professor of surgery allowed them to do a program on “surgical training” but when it was broadcast, it was on “ghost surgery” because the professor, whose name escapes me at the moment, allowed the chief resident to do much of his cases. I got the story from the chief resident at the time who happened to be black and was very angry about it. Anyone who chooses a teaching hospital knows that not every stitch will be placed by the professor. The Germans carried this to the extreme.

      People are not sheep. They respond to incentives. If they didn’t, we are wasting billions on advertising.

    2. methinks Says:

      We went through all this in the 40s and 50s and the record shows that income tax receipts do not change, even with 90% tax rates.

      Michael, either I’m tired or your post contradicts your first sentence.

      Even when tax rates were above 90%, nobody actually paid 90%. There were a million tax loopholes that Reagan traded in for lower marginal tax rates. In fact, according to Milton Friedman in “Capitalism and Freedom”, the people subject to the 90% tax rate only paid 23%.

      I look forward to reading the article, but I hope it covered the GDP effect. Other than reclassifying their income by investing in tax free munis (which would take another Supreme Court decision to make taxable by the Feds) or by rearranging when they receive income, high earners are more likely to be entrepreneurs and they can always choose to just work less – especially if they’re near the top of the top quintile of earners. Working only enough to earn $1MM instead of breaking your back for $2MM isn’t going to change your family’s consumption very much, but it will give you a heck of a lot more time with your loved ones. But, the government – which didn’t consider incentive effect when calculating Obmacare – is going to collect half the taxes it planned to collect. Plus, you may have to fire some employees and you certainly won’t hire new employees in a business you’re downsizing. Entrepreneurs are also welcome all over the world – they can just choose to leave the country, including immigrating out.

      The net effect is a declining GDP, significantly lower tax revenues and more people dependent on Obamacare at the same time. People talk about implosion, but a country usually turns into a hellhole long before it implodes.

    3. David Foster Says:

      - dump dividend paying stocks (you will probably want to do this anyways because they are likely to fall in price because part of their value is tied to the reduced tax rate) when the 15% rate is raised
      - avoid selling stocks with capital gains when the rate rises, or sell stocks with unrealized losses at the same time to “net out” any gains owed to the government

      The combination of those two things makes it impossible to ever get any return out of the stock, either via dividends or via price appreciation. (Unless your portfolio performs poorly, you will not be able to net out capital gains with capital losses indefinitely)

    4. Carl from Chicago Says:

      I think the post is actually saying that these tax rates will reduce collections, net.

      Just like the Beatles said

      “one for you, 19 for me”

      taxman

    5. Eddie Says:

      I could agree with all this if they (a) closed loopholes and simplified taxes for everyone and (b) if rich people would stop hiding their assets and wealth in overseas accounts in Switzerland and the Caribbean. The numbers for tax fraud are staggering, so I feel little sympathy for a group who has so many dedicated tax cheats among them, especially in a time of war.

    6. methinks Says:

      Eddie,

      The “rich” wouldn’t have incentive to hide anything if America didn’t have the most progressive tax rates in the world.

      Of course, they don’t have to cheat. They can very legally invest in tax exempt municipal bonds, defer taxes using retirement accounts and delay selling assets, or simply work a whole hell of a lot less.

      The vast majority of America’s “rich” are working rich. Why trade the time with your family to work for the marginal dollar of which the vast majority will go the the government?

      I don’t know what war has to do with it, but what’s more disgusting is that about half of all Americans don’t pay ANY income taxes at all – and that number is growing. So, I feel little sympathy for a group of people who expects someone else to pay for all the big government they want in a time of war or otherwise.

    7. Eddie Says:

      Methinks,

      I do agree that is a most unfortunate outcome of politically popular but fiscally and democratically ruinous tax policies to the extent that so many do not pay taxes. The enormous unpopularity of taxes will only lead to higher and higher service fees, which in themselves are more balanced in their impact on citizens from all classes paying equally.

      While anecdotal evidence offered here that people will not work as much in order to avoid higher taxes does not show conclusively that will be the case, the popularity of various tax avoidance schemes (whether legal or not) among the rich does make me wonder.

      When I mention in a time of war that’s because I consider an act of treason to knowingly and willfully avoid paying your fair share of taxes, denying the gov’t the resources it needs to fight the war effort. The wealthy who were caught doing this should lose everything they have or face a stiff prison sentence. It is my belief the wealthy benefit far more from the activities of the US military than anyone else. The free and secure movement of capital, goods, and services depends upon the security in large part created and maintained by our armed forces and their allies. They should be willing to pay their fair share. Or they can move to another country if they’d like, but I doubt in the near to mid future there will be many countries worth moving to that won’t boast high taxes and fees because of their rapidly aging populations and various other social ills and challenges that must be paid for somehow to retain stability in their societies.

      I don’t agree with so many not paying taxes or certain states taxing the wealthy beyond reasonable levels, but that is something that can be addressed at the ballot box (as we’ve seen in Virginia and NJ of late). We can reform our tax codes to make it less onerous on the rich while still raising more money by eliminating so much of the cheating and loopholes that goes on that denies the Treasury its fair share (including the politically legalized cheating amongst the poor and elderly).

    8. methinks Says:

      Eddie,

      While anecdotal evidence offered here that people will not work as much in order to avoid higher taxes does not show conclusively that will be the case, the popularity of various tax avoidance schemes (whether legal or not) among the rich does make me wonder.

      I don’t know what you’re wondering about. Certainly people work less if they are taxed more. There is plenty empirical evidence that goes well beyond anecdotal that this is exactly what happens. Surely you don’t think high earners are too stupid to do the cost/benefit analysis for the marginal dollar. You’re saying that people don’t respond to incentives. Do you respond to incentives? Think about it.

      When I mention in a time of war that’s because I consider an act of treason to knowingly and willfully avoid paying your fair share of taxes, denying the gov’t the resources it needs to fight the war effort.

      Well, first of all, the war is not that expensive compared to the vast entitlements that are choking the American economy. Second, the middle quintile pays a tax rate of 14.2% while the top 0.1% of earners pay an effective tax rate of almost 32% (with the lowest earners in the top quintile – which is incomes below $100K – paying a rate no lower than 20.7%). So, some of them hiding money abroad, are paying more than twice what the middle quintile pays. Note that “effective” tax rate includes payroll taxes. They are also the entrepreneurs and the providers of jobs and innovation in this country. So, how do you figure they aren’t “paying their fair share”?

      It is my belief the wealthy benefit far more from the activities of the US military than anyone else.

      You’re wrong. The rich can hire their own militias. It’s the poor and the middle class who can’t afford it. So, you gain much more than the rich from protection which is subsidized by them. But, even if what you say is true, the rich already pay a tax rate more than twice that of the middle class (the bottom quintile pays only around 4% – of course, these numbers don’t include transfer payments, so the income of the poor and middle class is understated and the tax rate they pay is actually even lower).

      You’re also wrong about nowhere to go. Singapore, for instance, doesn’t suffer from any of the ailments you mentioned and the country has consistently worked to drive its top marginal tax rate to below 20%. Plus, Singapore welcomes all businesses (legal) with open arms. Asia is the new frontier, my friend. The U.S. is drowning under the weight of its enormous government.

      I don’t agree with so many not paying taxes or certain states taxing the wealthy beyond reasonable levels, but that is something that can be addressed at the ballot box (as we’ve seen in Virginia and NJ of late).

      So, according to your confused logic, if at that ballot box the vast majority of the population figures out that it can tax away the wealth of the top 2% of earners, then the top 2% of earners has to give up all rights to the product of their labour and allow itself to be robbed or go to prison? Until recently, we had a constitution preventing that. How about you lazy middle class guys get off your duff and put in the work necessary to earn all that money the government needs from you to keep those pork projects going and return the favours to political donors? What’s that? No INCENTIVE to work for the government? Well, that’s the point.

    9. Eddie Says:

      So, according to your confused logic, if at that ballot box the vast majority of the population figures out that it can tax away the wealth of the top 2% of earners, then the top 2% of earners has to give up all rights to the product of their labour and allow itself to be robbed or go to prison? Until recently, we had a constitution preventing that. How about you lazy middle class guys get off your duff and put in the work necessary to earn all that money the government needs from you to keep those pork projects going and return the favours to political donors? What’s that? No INCENTIVE to work for the government? Well, that’s the point.

      That’s not what I’m saying. I am saying that in VA & NJ, you had state leadership that had the idea of raising taxes, staying inefficient, and driving businesses out of the state. They were voted out, not just because change was in the air out of spite at the economy, but because the effective argument was made by politically motivated wealthy citizens and their supporters that these state tax policies (especially on businesses) were killing the economy. If the economy continues to be in the doldrums, especially regarding employment figures, I can see this argument spreading its effectiveness across a good number of states where hostile climates to businesses exist. How that translates to taxes on the wealthy can be seen in the backlash brewing in Oregon over raising taxes on the wealthy but could also be registered in the polls showing Americans want to raise taxes on the rich. I don’t know if it will work, but I am certain that in some places (and God help us all even the federal gov’t at some point) we will have tax reform that doesn’t mean raising taxes on the wealthy and businesses.

      You’re wrong. The rich can hire their own militias. It’s the poor and the middle class who can’t afford it. So, you gain much more than the rich from protection which is subsidized by them. But, even if what you say is true, the rich already pay a tax rate more than twice that of the middle class (the bottom quintile pays only around 4% – of course, these numbers don’t include transfer payments, so the income of the poor and middle class is understated and the tax rate they pay is actually even lower).

      You’re also wrong about nowhere to go. Singapore, for instance, doesn’t suffer from any of the ailments you mentioned and the country has consistently worked to drive its top marginal tax rate to below 20%. Plus, Singapore welcomes all businesses (legal) with open arms. Asia is the new frontier, my friend. The U.S. is drowning under the weight of its enormous government.

      I would argue you are wrong. The accumulation of wealth and the security it provides stems largely from a functioning free market economy, if not a functioning mostly free market global economy. If we lost the US Navy today and the passage of goods from China to this country slowed down considerably because of insecurity, the wealthy who are investing in or owners of importing producers would lose considerably. Sure the middle class and poor would suffer as well, but their losses might not be as great.

      As well, if you really think Asia is the future, I’d wonder if you’ve looked at their demographic concerns (particularly all those missing young workers to pay taxes to support social systems more generous than us in many ways in countries like Singapore, South Korea, Japan, etc). If you skimmed beyond the surface of Singapore, you’d notice a leadership panicking about failed program after failed program to boost internal birth rates and agonizing over how to attract young people like myself (I’m 50/50 on moving to Singapore in 3-4 years after graduate school) to move there and stay there, paying taxes and maintaining a stable society. Their tax rates may not go up as much as Europe’s or our own (if we can’t figure out what to do about our own skyrocketing elderly cost problem, not to mention all of Bush & Obama’s unfunded entitlements), but they will be going up.

      You also seem to be making an argument about the unfairness and stupidity of the tax laws harming the wealthy. They don’t seem to be suffering too much but if they really are to the extent that some of them just have to break the law and subvert it, why don’t they just get the law changed and/or reformed? Its not as difficult as it seems. It happened in 2001 to an extent. It can happen again. Otherwise you seem to be claiming its fine for them to break the law because they are harmed somehow by it. Of course, perhaps its because I used the phrase fair share. What I meant by that was their legally mandated (by their elected representatives) tax rates. If they don’t like it, instead of hiding money overseas and breaking the law, get the law changed. Again, its not that hard. The wealthy 30,40,50 years, etc. beyond paid considerably more (and wrongfully so I might argue), or am I wrong on that?

    10. Carl from Chicago Says:

      I don’t know where this thread went into “breaking the law”.

      As a financial professional, there are many legal and reputable ways to minimize your tax bill. It is not viewed as illegal or unethical to do so.

      The purpose of this article, and this thread, is to talk about SOUND TAX POLICY. Sound tax policy, as I noted above:

      1) raises the amount of money it intends to raise
      2) does so in a manner that has the fewest negative distortions of economic activity

      As I noted above, taxing the rich in this manner is ALREADY viewed to not raise that much money even by the optimists in the government (in terms of revenue raising) – some score it at 0.5 but the government economist is the one who ranks it at 1.2, meaning that this tax hike ABSOLUTELY FAILS because it will raise LESS money than current policy, as MANY bad tax policies actually do.

      As far as negative distortions, encouraging your most productive members of society to work less is a huge distortion.

      The point is, by all reasonable measures, THIS IS BAD TAX POLICY. PERIOD.

    11. renminbi Says:

      When I was working blue collar I not only refused overtime,but after using up my sick leave I took leave without pay- I was well aware that the overtime was not worth my while.
      While I was building up my business I left NY-why get ripped off? Once I got to where I wanted to be, I came back- I was willing to be a sport. My advice to anyone with real ambition to build a business?NY or CA or IL are nto the places to be. Jimmy Rogers may have been prescient in going to Singapore.

    12. david foster Says:

      The ultimate distortion is this: if taxes keep going up and up and up, then it makes economic sense for an individual to turn taxes from a *cost center* into a *profit center*.

      How does one do this? See my post paying higher taxes can be very profitable.

    13. methinks Says:

      Carl,

      I don’t know where this thread went into “breaking the law”.

      That would be right around the time “the rich don’t pay their fair share” by paying twice as much as a percentage of their income meme showed up. They go hand in hand. If the “rich” won’t hand over everything we’ll tell them too at gunpoint, we ratchet up the coercion in the name of the common good and all that. Blah blah blah.

      They don’t teach anything of any value in American schools, apparently because the vast majority of graduates know what a social justice is but have no idea what has happened in history (except America is a racist, genocidal country) and have learned zero basic economics but tons of economic fallacies (wealth is a fixed lump which must be “spread around”).

    14. shannon Love Says:

      I think most people have the intuition that rich people work just like those who work for wages only for a greater reward. They think rich people have to keep getting up and going to work investing and creating jobs just like the rest of us have to go to work every morning to earn our wages.

      Well, they don’t. The rich generate economic goods in a fundamentally different way than the rest of us.

      The biggest difference is that the wealthy live in a world of financial risk. For those who invest and manage, there is never any guarantee they will come out ahead when they spend time and money making jobs for people.

      The rest of us do not run that risk. We go to work, we get paid, end of story. We always come out ahead for the time and effort we put into it. If you work a year at a job with $40,000 a year take home, you come out the other side $40,000 richer than when you started. No matter what happens, you always end up with $40,000 more than what you started with.

      Wealthy investors have no such guarantee. If a wealthy investor puts a $1,000,000 dollars into an investment, a year later he may have $1,100,000, $900,000 (negative $100,000) or zero. Raising taxes makes it even more likely they will lose money. Investors pay taxes on their successes and they don’t get to write off all their failures. If you invest a $100,000 in 10 different ventures and make $10,000 on 9 of them but lose the $100,000 on the 10th, you’ve lost $10,000 but you have still have to pay taxes on the $90,000 in “profit” you made. If the government takes a third of that, you end up $40,000 in the hole.

      Unless you raise taxes really high, a working person is always better off getting up and going to work. People assume this is true for the wealthy as well. They assume that rich people are always better of for having invested so they will keep investing no matter what. Therefore, they see no problem with loading up taxes on the wealthy because they assume the wealthy will still have to invest even at a much lower return.

      You have to point out these intuition based assumptions to people to get them to think about the problem differently.