Friday, August 22, 2008

Better Tax Policy?

I don't agree with everything Megan McArdle says here, but it's a very well-written explanation of why narrowing the tax base and raising rates at the higher end isn't a good idea...
High taxes on a narrow base are about the opposite of optimal tax theory. This is not because economists are mean, cruel people who are primarily interested in serving their corporate overlords, but rather because the narrower the base, and the higher the rates, the more sharply the marginal returns to rate increases diminish.

Take an extreme example. The top 1% of households, about 1 million in all, have about 20% of national income. They've also experienced most of the income gains in the last twenty years. So let's say we want to fund federal operations entirely out of their pockets. Well, to do so, we'd need an income tax rate of 100%. Even ardent liberals will surely concede that at these levels, the supply-siders are right, and we'll soon end up with no tax base.

Even a less extreme example--make them pay half the tax burden--ends up with a 50% effective rate on high earners. And to get a 50% effective rate, you need an even higher marginal rate. The problem for people who want to load tax increases on these people while cutting taxes for everyone else is that if you actually succeed in shifting the tax burden this way, you'll rapidly end up on the wrong side of the Laffer Curve.

But Megan, I hear you cry, don't you spend all this time saying that the supply siders are wrong about the Laffer Curve? Well yes. But they're not wrong that the Laffer Curve exists; it's practically a tautology. You collect no revenue if tax rates are 0%, and no revenue if they're 100%, because people won't work. The curve must maximize somwhere in between. Where supply-siders go wrong is in claiming that we're to the right of that maxima, where cutting tax rates actually raises revenue. Empirical evidence indicates that we're still on the left. But that doesn't mean we can't end up on the right, if we screw up our tax policy.

Barack Obama's tax plans probably won't put us there, even with the partial lifting of the payroll tax cap. But Barack Obama's plans do nothing to close the really fairly gargantuan deficit we're staring down--he wants to use the money to fund new spending. (And also, to fund his tax cuts for other people, which is sort of a problem; like most politicians running for office, he seems to be planning to spend the same tax increase several times over.) We've got an enormous budget gap coming down the pike in the really not-very-distant future. And the next round of tax hikes, if confined to the rich, will almost certainly put us on the wrong side of the Laffer Curve--you're talking tax rates on them of 60% or more. Rich people have the most discretion over their incomes, the most room to cut back and consume more leisure instead of work. Not everyone will--I doubt the president of GM will decide to take up golf instead. But on the margin, some will, or they'll shift their income to more tax advantaged forms, or places. If we try to concentrate all our taxation on the rich, we will quickly reach the limits of our ability to tax.
I don't know for certain where we stand on the Laffer Curve today. I doubt anyone does, although Megan seems to indicate there's empirical evidence that we're on the left-hand side right now. But I think this is a well-written explanation of why supply-siders think higher taxes can and do lead to lower revenues, and why the Democrats' game of "soak the rich" is a bad idea. I also have to note this comment in the thread:
Regardless of whether we are to the right or the left of the Laffer curve, taxing people at effective rates that will approach 50% of annual income (as in Obama's proposals) is simply wrong and profoundly unfair. No one should be forced at the point of a gun to pay half of their income to the "common good" - especially since the "common good" is defined by a gaggle of self-interested and often corrupt politicians who are primarily interested getting into and staying in office. This is my biggest problem with Obama - he seems intent on robbing Peter to buy Paul's vote.

What we really need is a flat tax, no deductions. Taking taxation out of the policy toolkit would go a long way toward improving our system of government.
I generally find arguments made on fairness grounds useless. However, the commenter's right that there is a line at which the question needs to be asked -- how much money out of one's earnings should go to government? Unfortunately, the answer is a value judgment for each person and will differ, and will also be incredibly dependent on whatever public policy goals we intend government to accomplish. I'd argue that the empirical number produced by the Laffer Curve may or may not produce the best result, but it's probably as good as we can get in the absence of the ability to have a mature debate about what our tax system is intended to do.

Whew. This is too much for a Friday afternoon. Let's get back to Rick Astley for VP.


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