With an astronomical national debt that is added to daily, the media and liberal politicians always stress the need to “tax the rich”. Rarely ever is it suggested the government should cease spending a trillion more every year than they take in. Instead, they push “Medicare for all”, “free” education, and other prohibitively expensive new spending programs. Always, getting the rich to pay their “fair share” is said to cover the new spending. If you’ve ever studied Economics 101, you know that increasing tax rates doesn’t necessarily bring in more revenue. The Laffer Curve explains the general concept. It’s intuitive to think raising tax rates increases overall revenue; after all, the general equation is TOTAL TAX REVENUE = AVERAGE TAX RATE * TAXABLE INCOME. The problem is there are two factors–rate and taxable income. When you raise the rate, the second part of the equation does NOT remain steady. Let’s examine 10 reasons why raising rates often decreases total revenues:
- People work less since their take-home pay decreases. Say you make $30 per hour. Would you work the same amount of hours if your pay decreased to $25? How about $20 per hour? Eventually, the rate goes low enough where you decide it’s not worth it. All workers have a different scale in their mind. When people work less, they have less taxable income, which means total overall revenue diminishes.
- Businesses are less willing to invest since the projected return decreases. Businesses evaluate each potential investment by looking at cost versus expected return on investment (ROI). If the projected return drops, the chances of the investment being made decrease. That not only hurts the overall productivity of the economy, but you lose the cascading of spending. For example, a business decides not to build a new factory. Construction companies lose potential service revenue. Lumbar/building supply companies lose potential revenue from the construction company. Jobs that could be created along the way are lost.
- Richer Americans and businesses often move overseas, taking all their tax revenue to another country. Nowadays it’s much easier for people or businesses to move to another country. The Caribbean is filled with low-tax havens. If you keep raising taxes enough that you drive the rich away, your effective tax collected equals 0 percent.
- Investments are shifted from taxable bonds & stocks to tax-free investments like municipal bonds. Savvy investors regularly evaluate their potential rate of return of each investment and will adjust accordingly. For example, say they make $100 taxable income on a $1000 investment. With a tax rate of 50%, the after-tax return = 100/1000 * .5 = 5%. If the tax rate goes to 60%, the new after-tax return is 100/1000*(1-.6) = 4%. If a municipal bond pays a tax-free rate of 4.5%, the investor now has incentive to buy the bond, which means all the tax revenue is lost.
- There’s less consumer spending since individuals have less disposable income. Whenever you raise taxes, you take disposable income from consumers. They have less to spend on computers, phones, cars, travel, etc., which means businesses lose all that revenue. The effect cascades since the businesses have less money to hire and invest.
- There’s a “brain drain” on the productivity of the economy as highly-trained workers log fewer hours. There’s already a major shortage of highly skilled workers in the U.S.–doctors, engineers, programmers, etc.; as discussed, people are less willing to work additional hours if they make less money. This effects the overall productivity of the economy.
- Businesses have less money to hire employees, award bonuses, and raise wages. Most companies know their success depends on their employees, so they award them when they have the money to do so. Successful businesses also want to expand, which means hiring more people. Less after-tax income decreases the ability to do both of these things.
- Individuals are less willing to invest their savings since after-tax returns are smaller. Say you can earn 7% return from a relatively-safe stock investment, but only 4% from a no-risk bank CD. You may decide the greater return is worth the added risk. However, if tax rates are raised, your stock may only earn you 5%, so now the higher rate just isn’t worth the risk. This leads to less investment as a nation as well as less taxable income for individuals.
- Individuals and businesses hire more lawyers and accountants to find more legal tax shelters (tax avoidance). As taxes go up, it’s natural for people to hire experts and spend more time trying to find legal tax shelters such as real estate, long-term no-dividend stocks, offshore tax havens, etc. This reduces overall taxable income, leading to less revenue than expected.
- Individuals and businesses have more incentive to cheat on taxes (tax evasion). As the government takes more and more of your tax-home pay, there’s an increased incentive to use illegal means of avoiding taxes–not reporting tips & cash transactions, hiring people off the books, engaging in black market transactions of goods, and so on.
As you can see, simply raising tax rates doesn’t simply bring in more revenue. And the reverse is also true–Ronald Reagan nearly doubled tax revenues by dramatically cutting tax rates. JFK and George W. Bush also managed to increase tax revenue significantly by cutting rates. The U.S. tax system is too complex to simply say “tax the rich”. Humans will always adjust their behavior based on the punishment & reward incentives of the tax system.
Other Links That May Interest You
75 Types of Taxes You Pay the Government
11 Ways the Media Manipulates the Truth
Laffer Curve Tutorial
President Ronald Reagan Trivia
Written by: Joe Messerli
Last Modified: 8/04/2018