The Democrats want to raise taxes as a way to grow government and allow for increased spending. I think this could be bad policy for a multitude of reasons. First off, increased tax rates do not necessarily translate into more government revenue. Higher tax rates on income decreases the incentive to work while higher tax rates of goods leads some consumers to forgo those particular goods. Higher rates also leads people to cheat on taxes or find loopholes. Let me explain:
In 1991, as a way to shift tax burden towards the rich, a 10% luxury tax was passed to be tacked on to purchases of things such as boats costing more than $100,000, cars over $30,000 and other “luxury” items. Key Democratic figures, the likes of Ted Kennedy and George Mitchell, patted themselves on the back for delivering the law that would force the wealthy to pay a heftier portion of government revenues. It was Republican President George Bush who signed the law, so I can safely say both parties worked together, against common sense, to hurt the economy with this tax. What was the effect of this law?
Welp, when the tax went into effect, luxury yachts sold in the United States fell by 77% in the first year. The wealthy that wanted yachts either forwent the purchase or bought the yacht overseas where the tax could not be tacked on. The 10% tax effectively ruined the American yacht building industry. Within the first 3 months of the tax becoming law, zero yachts were sold in the US. Zero! Not a single yacht. Because yachts were not saling, 25,000 workers in the industry lost their jobs. A law put into place to increase the tax burden on the “wealthy” yielded a grand total of nothing in the first few months. The advocates behind the tax promised equality because the rich would pay more, but in reality, the middle class felt the full brunt of the tax. Fortunately, the tax was repealed in short order.
Nearly a decade later, in 2000, Patrick Kennedy (notice the last name) proposed a tax credit for those who buy boats longer than 50ft. What had history taught this young democrat? A tax break for the wealthy might not be that bad of an idea. Why though? His district in Rhode Island builds a lot of yachts and if the wealthy have an incentive to buy more luxury yachts, his district would benefit tremendously in more jobs for the middle class. Weird. He realized a common sense idea. While I’m not exactly for this kind of political bending of the tax code because it skews the free market system (maybe I’ll hit that up later, got plenty of thoughts on the housing credit), a tax break/credit, can oddly enough, be good for everybody.
Introducing the Laffer Curve.
(I made this graph with no particular reference, for example only)
The Laffer Curve illustrates the economic impact of tax rates and how they relate to total tax revenue. The case of the yachts helps explain. We can all agree that if the tax rate is 0%, the government would receive no tax revenue (the government would not function, anarchy would take over, the country would fall to third world status, everybody would die. Not good). But, if the tax rate was 100%, the government would also receive no tax revenue because there would be zero incentive to work (the government would not function, anarchy would take over, the country would fall to third world status, everybody would die. Not good). So, as the diagram will show, the tax rate should be somewhere between 1% and 99% to generate tax revenue, but where? If the rate is 95%, while workers will keep 5%, there is very little incentive to work and the government would receive very little in tax revenue because only a small percentage of the population would be willing to work. On the opposite side, if the tax rate is 5%, nearly everyone would be willing to work but the government would probably not have enough tax revenue to provide its basic functions and would be ineffective. Too far to either extreme is problematic. Looking at the chart you can see that there is one point were government revenue is maximized, if the tax rate increases from that point, total government revenue will actually fall (not only is there a problem with a high tax rate decreasing someone’s incentive to work, but it also leads to more tax cheats, either way, revenue falls.) If the tax rate is on the downward slopping side of the curve, a decrease in tax rate would actually increase tax revenue. I could spend a good deal of time explaining why the government does not need to be at the point of maximum revenue but I have already probably lost most. Sorry that I am completely incapable of being short and sweet.
TAX RATE * TAXABLE INCOME = TAX REVENUE
Even John Maynard Keynes once said, “….taxation may be so high as to defeat its object, and that, given sufficient time to gather fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”
I’ll let you decide how this little tidbit of economics can be attributed to policy decisions in Washington today.
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