A Politically Incorrect Look at Marginal Tax Rates

In my last piece, The Laffer Curve and Austrian Economics, I argued that the “Laffer Maxima” moves depending on where the economy is in the boom-bust credit cycle. I used an example of a marginal restaurant business in the bust phase, which fails when the income tax rate on the people who live nearby rises by 100 basis points.

In that piece, I did not intend to address the impact of taxes on the “middle class” vs. taxes on “the rich”.  A reader raised the question however, and thus motivated me to write this piece.

As I implied in that piece, the middle class are obliged to cut their spending dollar for dollar with any increase in any tax that they must pay.  I stated that this is because their budget is zero-sum, especially in the bust phase.  This leads to an important point: a dollar of tax increase here must necessarily decrease spending by a dollar. And this is just the primary impact. When this decrease forces the marginal business under, the secondary and tertiary impacts may be far in excess of one dollar.

In my example, the marginal restaurant had 8 employees, and a mortgage on some fixtures and tenant improvements.  Ignoring the impacts to the vendors of tomato sauce and mozzarella cheese, the default on perhaps $100,000 in debt is very significant.  And so is putting 8 people out of work.

In the bust phase, the destruction wrought by this tax that most people would consider to be “small”, is anything but small. And of course this process occurs all over the country.

It’s worth noting (though I do not intend to go into detail in this piece) that part of the problem is that the middle class has very little savings.  They live almost entirely on their cash flow, which is inelastic.

But what happens when taxes are increased on “the rich”? Is it not “fair” to redistribute wealth to even out the gaps between the “rich” and the rest of us? What happens if we increase taxes on the “rich”?

One cannot look at the economy on the basis of consumption only. It is important to understand capital accumulation and decumulation.

If a business sells $100,000 worth of product, and it cost $50,000 to make and sell, then they have a $50,000 profit. This is still true, even if they buy a $50,000 manufacturing machine. The business should treat the machine as capital which depreciates over its expected lifetime.

Likewise, if a business is neglecting its tooling, not investing in research and development, and deferring maintenance, it may seem to generate a “profit”.  But this is illusory. In an accurate assessment, it is consuming its capital. If it cannot allocate some of its “profits” towards capital, it is in reality consuming itself. It will eventually go out of business.

And this is important to understand when it comes to assessing taxes on “the rich”.  While there are some “rich” people who earn staggering salaries (e.g. actors and athletes), most “rich” are wealthy because they own productive assets and investments.

One can’t understand the impact of taxes on the rich (nor see it immediately) just by looking at macro economic data.  The “1%” do not reduce their personal consumption if taxes are increased on either incomes or capital gains. This is because they don’t spend all of their income, much less net worth, on consumption.

One needs to understand the concepts of investment, and risk-adjusted rate of return. Obviously, whatever portion of a rich man’s wealth is taken away in taxes will not be invested. The wealth will be consumed, either by the government, or those to whom the government gives it.

An increase in tax serves to replace investment with consumption. This may even boost GDP that year or even for a few years. But eventually, the destruction of capital will be felt in the economy.

This is important, because capital is the leverage on human effort. We don’t work any harder or any longer today than people did 10,000 years ago, but we are vastly more productive due to capital accumulation.  If we deliberately enact policies to decumulate capital in favor of present consumption, this would have a disastrous effect on our quality of life.

There is a more complex and pernicious effect of increasing taxes on the rich. And it is politically incorrect to say it. But it needs to be said.  We need less pandering and more honest discussion.  So bear with me.

Let’s compare and contrast to the wage earner. If the tax on a wage earner who makes $8 per hour goes up 10%, the wage earner may work an additional 10% more hours (if he can find the work), or he must spend 10% less.

The one percenter, however, has different choices. He is investing his wealth to generate a profit. For every investment, he calculates the risks and the returns if the investment is successful. He must then subtract the tax. If the net result does not justify the risk, he won’t invest.  The higher the tax, the more possible investments he will pass over, because they fail this test.  He always has an alternative: the Treasury bond.  Only if the risk-adjusted rate of return exceeds the Treasury will the rich man invest.

If he chooses not to invest, the result is that innovative start-up technology companies, energy exploration projects, new drugs and medical devices are starved for funding. But Treasury bonds go up and up, as does the consumption subsidized by the government.

This piece should not be taken as a recommendation to raise the taxes of the poor wage earner. But if one looks at the true economic impact of taxes, I think I have shown that taxing the rich hurts the economy—especially in the long term.

The correct solution is to cut spending, and cut it some more, and then cut it again, and then really begin to cut. But that is outside the scope of this piece.

4 thoughts on “A Politically Incorrect Look at Marginal Tax Rates

  1. Neil Baxter

    Thanks for this lucid economic justification of private capital, Keith. I have often stuggled to explain to others why capital (and it’s returns) should be treated differently than other income. I had focussed on the risk aspect, but the focus on the investment aspect serves to explain to the many people who give no importance to risk, why they have a stake. I will share this article with my FB friends.

    Reply
  2. Bjorn Sodergren

    I came here following some posts from the FairTax thing going around Facebook right now and I read the above.

    I do like how you easily summarized the major problem with raising taxes. Although we actually do need to raise them in the future, most understand that right now it still isn’t a good time to do so.

    But you’re right on point (obviously) about capital investment from a business perspective.
    “If a business sells $100,000 worth of product, and it cost $50,000 to make and sell, then they have a $50,000 profit. This is still true, even if they buy a $50,000 manufacturing machine. ”

    Now, part of Capital is also the cost of employment. If we raise wages on employment and offer tax credits for employers that do raise wages, the profit will stay the same or actually increase as efficiency increases with a better paid workforce.

    The loss of tax revenue from the business would be easily offset by the tax dollars gained on the employers wages. Neither is a tax increase, and both spur investment in to the part of the business that actually makes the money, the employee.

    When you start looking at investments though, you switch to an individual point of view and then you’re no longer looking at capital investments the same way. I don’t think the problem here isn’t taxing investment income v.s. risk. It’s what the market does with this investment opportunity and how much they bet on the failure of company, instead of the potential reward.

    Now today, investors aren’t spending money in to places that need capital the most, the people of the United States. Instead they are taking and shoring profits in tax free zones and don’t even spend it on investments.

    While I understand that we need cuts in our budget (military, tax loopholes and subsidies, etc), we cannot ignore that most of the wealth of the people in the United States isn’t held in US banks.

    Reply
    1. Keith Weiner Post author

      Bjorn,

      I don’t agree that we should ever raise taxes. We need to cut spending, then cut it to the bone, then cut it some more, and then really make cuts.

      It may be certain employers have a business model (e.g. Costco) to attract and retain more productive workers by offering (among other things) higher pay. It does *not* automatically follow that a government-mandated pay raise will increase the productivity of every worker.

      You raise two separate issues at the end. First, why are American corporations keeping profits offshore. The answer is the lower tax rate compared to the domestic rate. The other is whether investors’ risk appetite is affected by known costs such as taxes. I don’t think there is any way to argue this point. Of course, investors calculate the likely payout and try to calculate the odds of success. A higher tax on the payout makes all investments less attractive, and so tends to push investors towards US government bonds. That is not helpful.

      I wrote this article a long time ago. If you’re interested in investment and employment, I’ve written more stuff on this more recently, including on http://www.forbes.com/sites/keithweiner.

      Reply

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