Taxes

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

Back when Dan and I were invited over to Chicago Boyz they mentioned my posts on taxation and the energy industry as particularly interesting. Over the last few years I have not written that much on tax policy, because the news has been so uniformly bad that it is quite depressing to contemplate.

This article from the Wall Street Journal is titled “Escape from Taxation” and reviews the negative impact on the state of New Jersey caused by ever-increasing state income tax rates. As you can see in the table, the highest marginal tax rate on income in New Jersey has increased from 2.5% in 1976 to 10.75% in 2009. New Jersey’s growth used to be in part attributed to its lower tax burden when compared to New York state; today that gap has been (mostly) erased and with it has gone inbound migration of wealthy individuals and corresponding growth.

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As a “solution” to our economic problems, the government has been spending money on stimulus programs. Since the government can’t directly incent business development, this type of money ends up going to 1) minor infrastructure projects and 2) funds for local governments and states to spend on salaries, programs.

As we know, the government has to raise revenues to pay for these programs in the form of taxes. Then the taxes, which distort business activities in myriad ways, are paid out in the form of salaries and grants in a relatively inefficient manner through a variety of poorly managed government programs.

While it isn’t popularly known, the US has among the highest corporate tax rates in the developed world and it isn’t just a co-incidence that other venues such as Hong Kong and Brazil are seeing an upsurge in IPOs and stock listings. The US today is not a competitive place to start a business, all else being equal.

The current government is not only taxing the US at an unsustainable rate as far as competitiveness, it is spending money that it doesn’t have (deficit spending), which will burden the US and future generations with high interest payments. The current deficit for 2009 is estimated to be about $1.6 trillion dollars, which will add about $100 billion / year in interest payments (fluctuates depending on rates).

All of these taxes don’t help put people in meaningful (non-government) jobs. In fact, they hurt our competitiveness and hurt the businesses most likely to grow and create jobs. Since unemployment is important even to our elected officials (unlike debt, competitiveness and future interest burdens, apparently) because an unemployed electorate is an angry electorate, institutions like the NY Times have to start thinking about tax cuts as a way to spur job creation.

From the article, titled “Tax Cuts Might Accomplish What Spending Hasn’t“,

When devising its fiscal package, the administration relied on conventional ideas based in part on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy. (Per the administration) it says that an extra dollar of government spending raises GDP by $1.57, while a dollar of tax cuts raises GDP by only 99 cents.
 
According to the Romers (on the President’s Council of Economic Advisors), each dollar of tax cuts has historically raised GDP by about $3 – three times the figure used in the administrations’ report. That is also far greater than most estimates of the effects of government spending.

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Tax rates vary significantly by state. The states with the lowest income tax rates, and most importantly the lowest “marginal” rates (the tax rate on your last dollar of income) tend to attract the wealthy and entrepreneurs and have higher rates of growth. Florida, Texas and Nevada in particular benefit from this type of tax regime. As an Illinois resident, virtually the only positive element of the tax situation in Illinois is that we have a “flat”, non-graduated state income tax rate at 3%. In all other areas (property taxes & sales taxes in particular) our rates are onerous and damaging to the business community. To see the income tax rate on a state-by-state basis, check out this site here and put in your state to see the tax brackets and the marginal tax at the highest income rates.

As states get into financial trouble, the situation is getting even worse. California has very high marginal rates, and continuous attempts to raise taxes (although the fact that tax increases must be approved by 2/3 of the legislature gives Republicans some say in that state), at a top rate of 10.3%! Admittedly this is a bit of a simplification, because states with progressive tax brackets like California typically allow for more deductions, while Illinois at 3% pretty much just takes your Federal taxable income and applies the rate with few distinctions. Changing Illinois to a graduated rate requires changing the state constitution, which is a big barrier to never ending schemes to move to this type of arrangement. Another factor on state taxes is that they are deductible against Federal taxes, although in fact the amount of the deduction is lower than it may appear because you have to cross the standard deduction before you can deduct the taxes, and there may be other income limits on deductions.

For wealthy individuals, the problem is acute. If you live in California, you may be taxed at up to 10.3% on your last dollar of income, while across the state border in Nevada you face ZERO state income taxes. This can be a big difference.

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