Cronyism

Myth of the Day: Raising Tax Rates on the Rich will Not Harm the Economy

By: Kati Siconolfi, Nick Oswald, and Will Freeland

As states consider fundamental tax reform this session, misconceptions about sound tax policy abound. Perhaps one of the most popular misconceptions is the notion that raising tax rates on the rich will not harm the economy.  In Tax Myths Debunked, co-authors Dr. Eric Fruits and Dr. Randall Pozdena use extensive evidence to demonstrate that taxing higher-income earners will certainly not generate economic growth and will not close the gaping budgetary gaps that plague many states governments as well as the federal government.

Dr. Pozdena, former vice president of research at the Federal Reserve Bank of San Francisco, and Dr. Eric Fruits find that taxing higher-income earners does not generate as much revenue as one might anticipate.  These economists looked at how much revenue a generic 10 percentage point tax increase would generate on various levels of income earners in the country as a whole, assuming no behavioral response to such a tax increase:

  • Taxing the incomes of the top 1 percent of taxpayers would only yield $93.8 billion (these are taxpayers with incomes about $380,000.)
  • Taxing the incomes of the top 5 percent of taxpayers would only yield $180 billion (these are taxpayers with incomes over $150,000.)
  • Taxing the top 10 percent of taxpayers would yield $340 billion (these are taxpayers with incomes about $110,000.)

Dr. Fruits and Dr. Pozdena show that these policies would fail to generate enough revenue to address the national debt, nor close many of the budget gaps that exist across state governments, particularly with respect to public pensions. The authors conclude that “even the most aggressive of these policies would barely cover one fiscal year’s interest on the outstanding debt” for the federal government.

These tax increase proposals already ignore that the United States already has the most progressive income tax in the world, according to the OECD. This means that the wealthy already pay their “fair share” or more, since they are relied on more for tax revenue in the U.S. than in any other country in the world. And moreover, tax increases of this sort would most certainly yield a behavioral response which would result in lower economic growth and poorer economic performance. Taxing wages and investment income, which are the product of hard work and prudent investment, ensures that you get less of these socially desirable activities.

Additionally, when progressives attempt to target the rich and attempt to roll back inequality through redistribution, the blunt instrument of progressive income taxation often treats middle class taxpayers as “The Rich,” thereby levying an unjustified and counterproductive tax burden on many. The disparity between those who make a large lump sum of money once or twice in their career versus those who are truly of the 1 percent is quite vast. The Tax Foundation in Who Are America’s Millionaires? points out that between the years 1999 and 2007, only 50% of tax filers who’s income reached millionaire status over the period did it more than once.

Most of these so-called millionaires are actually middle-class Americans who are making financial changes to their life savings, receiving a one-time large lump sum of money due to the sale of a small business or some other asset, or having one or two exceptional years of performance in their job. The reality behind these numbers is that it is the people of the middle-class that are unexpectedly being burdened by the high tax rates, not necessarily the so-called “rich”.

These distortions created by income taxes are not limited to those currently making money, but the decisions faced by young people considering what path to take in their career. Take two hypothetical paths forward for a talented recent graduate. One position that is extremely difficult and demanding, requires graduate school (meaning higher debt and delayed earnings), will require 70-80 hours a week of work, pay $500,000 a year, and the graduate will work for only 10 years before essentially retiring. Then consider another job which is substantially more pleasant, requires no graduate school (meaning no grad school debt or delayed earnings) requires only 40 hours a week of work, pays around $100,000, and which an individual will work at for 50 years. These jobs have the same lifetime earnings so ignoring the time value of money, the recent graduate should be indifferent between the two positions.

But once you add a sharp progressive income tax affecting just the higher paying job, suddenly the high paying but unpleasant job doesn’t look so appealing since the high wage that would compensate for the positions unpleasantness will now be taxed by government at a higher rate, pushing the financial returns for the two positions closer together. This likely means less people entering these careers requiring large investments in education and long, sometimes unpleasant hours (doctors, lawyers, engineers, corporate leadership, etc.). These fields have tremendous social value and finding those who can do them competently is difficult (hence, the reason they are highly compensated). This same analysis holds for entrepreneurial behavior, which involves high risk, long hours, and the possibility of very unpleasant work responsibilities. Higher marginal income tax rates lower the return to these actions, thereby reducing the number of people willing to engage in them. Thus, high marginal income tax rates that push people out of these fields have an unseen social cost.

As we’ve discussed previously on American Legislator, good tax policy is all about proper incentives. Higher tax rates lower the return for productive activity, such as innovation, work, and production.  As a result, people are more likely to take their investments and jobs to states with more favorable business climates, as we have detailed extensively in Rich States, Poor States. Ideas such as a flat tax rate or better, sales taxes relying on the taxation of consumption and not income, are two proposals that would help advance economic growth

 To read more about the relationship between tax policy, stimulus spending, and their effects on an economy during a recession, check out Tax Myths Debunked. Co-authors Dr. Pozdena and Dr. Fruits use overwhelming evidence to confirm that the path to prosperity is in free-market, pro-growth policies. The report is available for free download at www.alec.org/tax-myths-debunked.


In Depth: Cronyism

Cronyism in tax policy stifles innovation, hinders competition and introduces a deep temptation for corruption. The 2014 ALEC Center for State Fiscal Reform study, The Unseen Costs of Tax Cronyism: Favoritism and Foregone Growth, found that in the most recent year in which states published their respective tax expenditure …

+ Cronyism In Depth