The Tax Debate
President Obama has been making the case that some Americans with higher incomes are not paying their fair share of taxes. The lower tax rates that were passed in 2001 and 2003 expired at the end of 2012 for those individuals earning over $200,000 and families earning over $250,000 a year. There is also more discussion about tax reform—a major overhaul of the whole structure of federal taxes on businesses and individuals.
For all of these reasons, I expect that there will continue to be a great deal of talk about taxes this year. It is important to start with facts, and that is why I added a section last year to my website called “Tax Facts.”
An overused but still true line in politics is that “everyone is entitled to their own opinion but not to their own facts.” Different people may well reach varying conclusions about what should be done, but we all ought to have available some of the key facts about the money that the federal government takes away from us in taxes.
Below you will find a historical look at tax rates and revenues, who the government collects taxes from, and the financial burden that our complex tax code has created on individuals and businesses.
A Historical Look at Tax Rates and Revenues
Since World War II, top tax rates have fluctuated from a high of 94 percent to a low of 28 percent. But the remarkable fact is that revenue going into the government has been pretty steady. Revenue has averaged 17.7 percent of Gross Domestic Product (GDP) since 1945 and has never been more than 20.6 percent, which was at the height of the tech boom.
Federal Spending is now 24.3 percent of GDP. If tax revenue is never going to exceed 20.6 percent regardless of tax rates, it is absolutely clear that increasing taxes will never fix our deficit; only cuts in spending can do that.
A Shrinking Tax Base
According to the nonpartisan congressional Joint Committee on Taxation, 51 percent of American households paid no income tax in 2009. Even if retired Medicare and Social Security recipients are excluded, the percentage of working-age Americans who pay no income tax has risen dramatically. According to a report released by the Tax Foundation, about 41 percent of those who filed tax returns in 2010 paid nothing or received more money in refunds from the government than they paid in taxes. That number has grown from 21 percent of tax returns filed in 1990.
The decreasing number of taxpayers is due in part to the growing amount of tax credits that filers can claim. The value of tax credits in 2010 reached $224 billion. Of course, not all credits are bad, but they reduce the number of Americans who have a stake in the U.S. tax system and they add to the complexity of our tax code – which is discussed later in this newsletter.
Who is Paying Their "Fair Share"?
All of this means that a smaller percentage of Americans are now paying a larger percentage of the country’s total tax revenues. Meanwhile, phrases like “paying a fair share” have been used by President Obama to make the case that some Americans with higher incomes are not paying enough in taxes. But as the graphics below demonstrate, the numbers show that our tax system is already very progressive.
In fact, the amount of income earned by the top 20 percent fell in the last ten years, but the portion of federal taxes they paid grew.
Note: The only percentage of federal tax liabilities that is greater than its share of income is the highest quintile.
Sources of Federal Revenue
Individual income taxes have consistently made up the largest portion of federal tax revenue since World War II. The second largest portion has been social insurance and retirement taxes, but that percentage has already begun to decline and will most likely continue to do so as 78 million baby boomers retire. It is also interesting to note that there has been an overall decline in revenue from corporate income taxes since 1945, yet the United States still has the highest corporate income tax rate in the world.
The Hidden Cost of the Tax Code
There is another economic burden that is part of our complex federal tax code, the cost of compliance. In a 2011 report by the Laffer Center, economists estimated that U.S. taxpayers pay $431.1 billion to comply with and administer our complex tax system. This economic burden is referred to as the “complexity tax”. Consider these facts from the report:
There has been no major tax simplification passed by Congress since 1986, but since that time, over 14,400 amendments have been made to the tax code
Tax Facts - The 10 Golden Rules of Effective Taxation
Tax policy is all about reward and punishment. Most politicians know instinctively that taxes reduce the activity being taxed—even if they do not care to admit it. Congress and state lawmakers routinely tax things that they consider “bad” to discourage the activity. We reduce, or in some cases entirely eliminate, taxes on behavior that we want to encourage, such as home buying, going to college, giving money to charity, and so on. By lowering the tax rate in some cases to zero, we lower the after-tax cost, in the hopes that this will lead more people to engage in a desirable activity. It is wise to keep taxes on work, savings, and investment as low as possible in order not to deter people from participating in these activities.
Workers save, but they do so for the purpose of conserving resources so they or their children can consume in the future. A corollary to this is that people do not work to pay taxes—though some politicians seem to think they do.
To state this in economic terms, the difference between the price paid by people who demand goods and services for consumption and the price received by people who provide these goods and services—the suppliers—is called the wedge. Income and other payroll taxes, as well as regulations, restrictions, and government requirements, separate the wages employers pay from the wages employees receive. If a worker pays 15 percent of his income in payroll taxes, 25 percent in federal income taxes, and 5 percent in state income taxes, his $50,000 wage is reduced to roughly $27,500 after taxes. The lost $22,500 of income is the tax wedge, or approximately 45 percent. As large as the wedge seems in this example, it is just part of the total wedge. The wedge also includes excise, sales, and property taxes, plus an assortment of costs, such as the market value of the accountants and lawyers hired to maintain compliance with government regulations. As the wedge grows, the total cost to a firm of employing a person goes up, but the net payment received by the person goes down. Thus, both the quantity of labor demanded and quantity supplied fall to a new, lower equilibrium level, and a lower level of economic activity ensues. This is why all taxes ultimately affect people’s incentive to work and invest, though some taxes clearly have a more detrimental effect than others.
Lower marginal tax rates reduce the tax wedge and lead to an expansion in the production base and improved resource allocation. Thus, while less tax revenue may be collected per unit of tax base, the tax base itself increases. This expansion of the tax base will, therefore, offset some (and in some cases, all) of the loss in revenues because of the now lower rates.
Tax rate changes also affect the amount of tax avoidance. The higher the marginal tax rate, the greater the incentive to reduce taxable income. Tax avoidance takes many forms, from workers electing to take an improvement in nontaxable fringe benefits in lieu of higher gross wages to investment in tax shelter programs. Business decisions, too, are based increasingly on tax considerations as opposed to market efficiency. For example, the incentive to avoid a 40 percent tax, which takes $40 of every $100 earned, is twice as high as the incentive to avoid a 20 percent tax, for which a worker forfeits $20 of every $100 earned.
An obvious way to avoid paying a tax is to eliminate market transactions upon which the tax is applied. This can be accomplished through vertical integration: Manufacturers can establish wholesale outlets; retailers can purchase goods directly from manufacturers; companies can acquire suppliers or distributors. The number of steps remains the same, but fewer and fewer steps involve market transactions and thereby avoid the tax. If states refrain from applying their sales taxes on business-to-business transactions, they will avoid the numerous economic distortions caused by tax cascading. Michigan, for example, should not tax the sale of rubber to a tire company, then tax the tire when it is sold to the auto company, then tax the sale of the car from the auto company to the dealer, then tax the dealer’s sale of the car to the final purchaser of the car, or the rubber and wheels are taxed multiple times. Additionally, the tax cost becomes embedded in the price of the product and remains hidden from the consumer.
The Laffer Curve summarizes this phenomenon. We start this curve with the undeniable fact that there are two tax rates that generate no tax revenue:
A zero tax rate and a 100 percent tax rate. (Remember Golden Rule #2: People don’t work for the privilege of paying taxes, so if all their earnings are taken in taxes, they do not work, or at least they do not earn income the government knows about. And, thus, the government receives no revenues.)
Now, within what is referred to as the “normal range,” an increase in tax rates will lead to an increase in tax revenues. At some point, however, higher tax rates become counterproductive. Above this point, called the “prohibitive range,” an increase in tax rates leads to a reduction in tax revenues and vice versa. Over the entire range, with a tax rate reduction, the revenues collected per dollar of tax base falls. This is the arithmetic effect. But the number of units in the tax base expands. Lower tax rates lead to higher levels of personal income, employment, retail sales, investment, and general economic activity. This is the economic, or incentive, effect. Tax avoidance also declines. In the normal range, the arithmetic effect of a tax rate reduction dominates. In the prohibitive range, the economic effect is dominant.
Of course, where a state’s tax rate lies along the Laffer Curve depends on many factors, including tax rates in neighboring jurisdictions. If a state with a high employment or payroll tax borders a state with large population centers along that border, businesses will have an incentive to shift their operations from inside the jurisdiction of the high tax state to the jurisdiction of the low tax state.
Economists have observed a clear Laffer Curve effect with respect to cigarette taxes. States with high tobacco taxes that are located next to states with low tobacco taxes have very low retail sales of cigarettes relative to the low tax states. Illinois smokers buy many cartons of cigarettes when in Indiana, and the retail sales of cigarettes in the two states show this.
Taxes on capital are almost impossible to enforce in the 21st century because capital is instantly transportable. For example, imagine the behavior of an entrepreneur or corporation that builds a factory at a time when profit taxes are low. Once the factory is built, the low rate is raised substantially without warning. The owners of the factory may feel cheated by the tax bait and switch, but they probably do not shut the factory down because it still earns a positive after tax profit. The factory will remain in operation for a time even though the rate of return, after tax, has fallen sharply. If the factory were to be shut down, the after-tax return would be zero. After some time has passed, when equipment needs servicing, the lower rate of return will discourage further investment, and the plant will eventually move where tax rates are lower.
A study by the American Enterprise Institute has found that high corporate income taxes at the national level are associated with lower growth in wages. Again, it appears a chain reaction occurs when corporate taxes get too high. Capital moves out of the high tax area, but wages are a function of the ratio of capital to labor, so the reduction in capital decreases the wage rate.
The distinction between initial impact and burden was perhaps best explained by one of our favorite 20th century economists, Nobel winner Friedrich A. Hayek, who makes the point as follows in his classic, The Constitution of Liberty:
“The illusion that by some means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less well off.”
For example, an increase in the tax rate on corporate profits would be expected to lead to a diminution in the amount of corporate activity, and hence profits, within the taxing district. That alone implies less than a proportionate increase in corporate tax revenues. Such a reduction in corporate activity also implies a reduction in employment and personal income. As a result, personal income tax revenues would fall. This decline, too, could offset the increase in corporate tax revenues. Conversely, a reduction in corporate tax rates may lead to a less than expected loss in revenues and an increase in tax receipts from other sources.
Ideally, the tax system of a state, city, or country will distort economic activity only minimally. High tax rates alter economic behavior. Ronald Reagan used to tell the story that he would stop making movies during his acting career once he was in the 90 percent tax bracket because the income he received was so low after taxes were taken away. If the tax base is broad, tax rates can be kept as low and nonconfiscatory as possible. This is one reason we favor a flat tax with minimal deductions and loopholes. It is also why more than 20 nations have now adopted a flat tax.
Unemployment benefits, welfare payments, and subsidies all represent a redistribution of income. For every transfer recipient, there is an equivalent tax payment or future tax liability. Thus, income effects cancel. In many instances, these payments are given to people only in the absence of work or output. Examples include food stamps (income tests), Social Security benefits (retirement tests), agricultural subsidies, and, of course, unemployment compensation itself. Thus, the wedge on work effort is growing at the same time that subsidies for not working are increasing. Transfer payments represent a tax on production and a subsidy to leisure. Their automatic increase in the event of a fall in market income leads to an even sharper drop in output.
In some high benefit states, such as Hawaii, Massachusetts, and New York, the entire package of welfare payments can pay people the equivalent of a $10 per hour job (and let us not forget: Welfare benefits are not taxed, but wages and salaries are). Because these benefits shrink as income levels from work climb, welfare can impose very high marginal tax rates (60 percent or more) on low income Americans. And those disincentives to work have a deleterious effect. We found a high, statistically significant, negative relationship between the level of benefits in a state and the percentage reduction in caseloads.
In sum, high welfare benefits magnify the tax wedge between effort and reward. As such, output is expected to fall as a consequence of making benefits from not working more generous. Thus, an increase in unemployment benefits is expected to lead to a rise in unemployment.