As the media begins full-tilt coverage of the ballyhooed fiscal cliff, beltway Democrats are pitted against Republicans over proposed income, estate, capital gains and payroll tax increases. At stake is who is tagged as “wealthy” and at what percent the government is entitled to expropriate their capital.
Lost within much of the bitter debate are the behavioral repercussions of taxation that rarely factor into the static assumptions made by our government overseers. Taxes affect individual behavior, and this concept seems to be understood by nearly everybody despite being selectively applied to convenient situations.
An old adage perhaps says it best: Tax what you want less of.
Way back in June of this year voters defeated Proposition 29 in the California primary election, which would have raised cigarette taxes by $1 per pack. Progressive groups boasted that the increased tax would be passed on to cigarette consumers via the higher prices of cigarettes, which would allegedly prevent 220,000 children from smoking and stop 100,000 adult smokers from lighting up because of higher costs associated with this activity.
Proponents used a simple economic principle when crafting their argument: Higher taxes equal fewer cigarettes. Strangely, many of these same socially crusading progressives who extol the effects of higher sin taxes are incredulous when identical principles are extended to other economic activities.
If higher taxes disincentive cigarette consumption, could they also discourage production, investment and labor, which is realized through profit and income? Could higher taxes also encourage other behaviors in order to escape the taxman, such as tax evasion, smuggling, and the growth of black market activities?
Across the pond, our British cousins had a similar experience with the disincentivizing effects of higher income taxes, which paradoxically led to lower government revenues. Perhaps we should be comforted to know that American politicians are not alone when presuming static human reactions to manipulated incentives.
In a burst of belt-tightening austerity, British legislators decided that in order to raise government revenues, a soak-the-rich strategy would deliver the best results. In April 2010 they jacked-up the income tax to 50 percent for those earning above a threshold of £150,000 ($240,000) a year.
Despite taxing at a higher percentage, the government paradoxically took in less money from Britain’s top earners in absolute terms. This new higher tax rate gave greater encouragement for wealthy Britons to use accounting tricks to obfuscate their earnings, stash their capital in overseas accounts, or relocate abroad to escape the burden.
Higher taxes also discouraged labor altogether, since greater governmental expropriation necessitates less personal realization from the fruits of labor and thus fewer incentives to work. None of these reactive activities helped the British economy.
Again, human behavior reacts to environmental changes and rarely follows bureaucrats’ static models.
Back in the U.S., we also see the effects of looming tax increases. If politicians seek to decrease the size and frequency of dividends (the profit paid to shareholders of public companies), the best strategy is to raise taxes to disincentive such activity. When dividends were taxed at the same rate as income in the ‘80s and ‘90s, they (and tax revenue) grew slowly until the rate was cut to 15 percent in 2003.
Thereafter reported dividends jumped from $103 billion in 2002 to $337 billion in 2006, dumping record revenue into government coffers. Conversely, many companies are now paying earlier and larger than expected dividends before the end of the year when such earnings will be taxed as regular income versus the current 15 percent rate.
Expect both dividends and associated government tax revenues to shrink after the New Year, as companies pull back issuance in reaction to higher taxes.
These actions can be best rationalized within the framework of the Laffer Curve, and a simple thought experiment helps illustrate the concept: If a government were to confiscate 1 percent of an economy, tax revenues would be low and the private economy relatively unscathed. Conversely, if a government were to confiscate 99 percent of the capital in an economy, the next year’s tax receipts would be miniscule since there would be little capital from which to produce, and people would be highly incentivized to participate in the black market or cease production altogether.
Somewhere between these two extremes lies an apex where tax collection maximizes and a move toward either higher or lower tax rates lower government revenue. However, this revenue collection high point will still continue to crimp economic growth, but not enough to offset the amount of revenue left uncollected from a lower tax and a higher economic growth environment.
This brief thought experiment is a grotesque simplification of an incomprehensibly complex and ever-changing phenomenon, thus any attempt to identify a theoretical tax-maximization scheme is conjecture at best. Nevertheless the underlying principle is sound and useful when conceptualizing the effects of taxation on an economy.
Which side of Laffer’s slope is current American taxation policy? Unknown, but enough tax hikes will eventually lead us over the peak and sliding down.