A Further Perspective

The Real Damage Done by High Tax Rates

The real problem is how they misdirect and misallocate economic activity.

By 7.13.12

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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. In May, Facebook co-founder Eduardo Saverin renounced his citizenship for what many consider 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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