Why Overtaxing The Rich Is Often Counterproductive

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A couple of disclaimers up front. The author is not close to being rich. His family pays income taxes to the Federal government at the 15% tax bracket level. The author’s family lives in a typical suburban, middle class home of about 2,000 square feet. The author drives a seven year old vehicle and his wife drives a five year old vehicle. Thus, what follows is not because the author has a big financial stake in how the rich are taxed.

Second, the title of the article contains a disclaimer: “overtaxing.”  This is obviously a subjective measure. Two people might have a different view on the same level of taxation, one thinking it is fair and one thinking it is too generous to the rich. The point of this discussion is not to arrive at what “fair” is but to understand the ramifications of what happens when the economy’s producers are taxed at higher and higher levels, regardless of what each person thinks is fair.

The first example is based on a short article in the May 8, 2011 St. Petersburg Times business section. The article quoted a survey done by  the magazine, “Chief Executive,” which surveyed what were the best and worst states for business. The best states for business turned out to be the following:

1) Texas
2) North Carolina
3) Florida
4) Tennessee
5) Georgia

The worst five states turned out to be:

1) California
2) New York
3) Illinois
4) New Jersey
5) Michigan

Without doing any further analysis, you see some immediate patterns in the survey results:

– The best states tend to be in the southern part of the country whereas the worst states tend to be in the northern part of the country with the exception of California.

– The best states tend to be in states that historically have been dominated by Republicans in office and the worst states tend to be dominated by Democrats in office.

– The best states are likely to have more lenient right to work laws while the worst states tend to have stronger, more restrictive union regulations.

Interesting but anecdotal. What happens when we look at these ten states along some hard core statistical measures?

– Let’s first look at state government debt levels. Theoretically, no person or business would want to live in a state that was in severe debt trouble since the solution for solving that debt problem is probably going to be higher taxes and lower service levels from the state government. According to a January, 2010 Forbes magazine study, Illinois is in the worst debt situation of all fifty states, New York is in the second worst shape, California is in the fourth worst shape and New Jersey is in the fifth worst shape. Since the article did not write about more than the ten worst, the reminder of the states’ positions was not available. However, none of the states that were the five best for business listed above were in the ten worst positions relative to debt.

– What about taxes? it seems logical that families and businesses would want to live where the tax burden is the least, all other things being equal. According to a state based information website, Statemaster, as far as total tax burden (income taxes, property taxes, sales taxes, etc.) the worst five states for business listed above all ranked in the worst half of the fifty states while the best five state for business all ranked in the better half of the fifty states.

The average ranking of the worst five states was about 12th worst while the best five states average rank was about 40th. Thus, the best states for business have a distinct advantage since they impose a far lower tax burden on their residents. Note: this analysis does not include the latest substantial tax increases passed by the Illinois state government which would make this bad tax state even worse going forward.

– What about population trends? If you use population trends as a surrogate for long term growth, you might see where the future of the country lies from an economic growth perspective. One approach would be to look at the states that lost and gained seats in Congress as a result of the 2010 Census.

Turns out that the states listed as the worst for business lost a total of five Congressional seats as a result of population changes over the past ten years. the five states listed as the best states gained seven Congressional seats as a result of long term population changes.

– The only important measure where there is not a substantial difference between the two lists is the current unemployment picture. Both lists have relatively good performers for unemployment level and relatively bad performers. However, which states do you think will recover more quickly, those with lower taxes, growing populations, and lower state debt or those with higher taxes, shrinking populations, and higher state debt?

The point to be made is that higher and higher taxes and debt usually result in worst and worst effects. Individuals, families, and businesses will react and change their behavior according to many factors including the level of taxation. These individual changes in behavior may not be the right economic decisions for the greater good, even if the tax levels are raised. Thus, those states that adhere to the principle that the rich can always pay more in taxes, usually end up losing in the long run.

The textbook example is probably the state of Maryland. A number of years ago the state decided to raise the state income tax rate on millionaires living in the state, expecting to annually get an additional $106 million worth of tax revenue from the increase,

However, when the tax returns were tabulated, it turned out that rather than gaining $106 million more in tax revenue from these people, the state actually ended up getting $257 million less in tax revenue (Wall Street Journal – March 12, 2010). The number of millionaires filing taxes actually dropped by 30% as a possible result of 1) some died and did not need to file, 2) some had bad economic years and did not make a million dollars and 3) some moved out of Maryland into states that were more tax friendly. If one was betting, most people would likely bet the third factor was the biggest component since it is doubtful 30% of the millionaires all died in one year and doubtful 30% all of a sudden did  not make a million dollars, especially since the article did not report similar drops of income for millionaires in the 30% range in surrounding states.

Was it fair to make the rich in Maryland pay more in taxes? That is a subjective judgement. However, understand that by making them pay more, many of them took themselves and their families and possibly there business elsewhere along with their tax receipts. They also took their disposable income that they may have spent on Maryland restaurants, movies, clothes, cars, etc. The state government may have lost $257 million in tax revenue directly but the state as a whole probably lost a lot more in disposable income and jobs.

The lesson to the political class that run the different levels of government and the people that vote them in: running a low debt, low tax government operation is the best way to have a growing population, a growing economy,  steady job creation, and stability. Anything else is stupid, no matter how fair or unfair you think it is.

The second example is based on an article from the October 17, 2010 edition of the St. Petersburg Times. It looks at a specific individual’s decision regarding additional taxation on “the rich” vs. the aggregate example and statistics discussed above. The article was written by N. Gregory Mankiw who is a professor of economics at Harvard and who has worked in government positions in the past. Given his profession, we are assuming that the numbers and analyses he discusses in his article are quite accurate and valid.

 The basis of his reasoning in the article is the fact that he earns over $250,000 a year based on his various income earning activities and would have seen his top Federal tax bracket rise from 35% to 39.6% if President Obama had gotten his way and raised the tax rates for people like him. By his own admission, Mr. Mankiw is living comfortably within his earning potential. However, his one primary desire, like many parents, is to leave some wealth and money behind for his kids.

 His hypothesis is what would he do if someone offered him $1,000 increment income to write an article, based on his knowledge, background, and expertise. In a utopian world, where there is no taxes, he would be able to take that $1,000 put it in an investment earning 8% a year and within 30 years, he would have a $10,000 legacy he could pass onto his children. Nice thought, noble family thing to do.

– Although the market values his expertise at $1,000, he does not end up with that much. In fact, according to his calculations, after you figure in Obama’s higher tax rates for him, increased Medicare taxes because of Obama Care, state income taxes, existing Federal income tax rates, etc., that $1,000 quickly becomes $523.

– In addition, he no longer can get that 8% investment return he desires. Why? Because the company he invests in, that would have been able to provide that kind of return, has to pay taxes on their earnings, taxes that cannot be passed onto the shareholders. In addition, as an investor he has to pay taxes on any dividends or capital gains his $523 returns, so that this round of taxes reduces his potential 8% return to only 4%.

 – Over 30 years at only 4%, his initial $1,000 action does not get him the desired $10,000 for his kids but only $1,700.

 – However, the political class is not done yet. When Mr. Mankiw dies, his estate will also get hit with an estate tax before the money can pass to his kids. Thus, according to his calculation, after the estate tax is done, his kids are left with only about $1,000 to inherit.

Thus, under the existing tax plans in the country and Obama’s plans to increase taxes, both income and Medicare taxes, his $1,000 effort, once invested, really grows to …$1,000 after 30 years. He estimates that if Obama’s did not get his increased taxes, income tax and Medicare tax, he would be able to leave $2,000 to his kids, still a paltry return after 30 years of investment. In fact, he calculates that his marginal tax rate is actually 90%, not 39.6% that Obama wants it to be. His conclusion: why should he knock himself out for incremental wealth when the government will strip it away from him in taxes?

 He is quick to point out that most people couldn’t care less whether or not he took on the $1,000 job and he would be right. However, he also points out what would happen if others in the economy did the same thing he did:

 – What if your favorite movie star stopped making pictures because the incremental work was no longer worth the extra effort, given the increased tax situation?

 – What if your favorite recording star stopped doing concerts because the incremental work was not worth the extra effort, given the increase tax situation?

 – What if a top cardiac surgeon stopped doing incremental work because it was not worth the extra effort, given the increase tax situation, and you had a heart problem?

 – What if a top cancer specialist stopped doing incremental work because it was not worth the extra effort, given the increased tax situation, and you had a cancer condition?

– What if a top philanthropist stopped earning money that would go to his charities because it was not worth the extra effort, given the increased tax situation, and you needed that output from his charities?

You get the point. A society starts to mummify and stagnate when members of that economy decide it is better to do nothing, because of the tax burden, than to exert one’s self, leveraging one’s skills, expertise, or compassion to make the world and the lives of others better and richer. The world and yourself is worse off if a favorite actor, favorite recording star, best doctors, best charity providers, and yes, best economists, do not share their abilities and insights with the rest of us because the tax burden is not worth the effort.

Trade off these societal losses with what the American class has done with our taxes lately:

 – The Federal government admits that it loses upwards of $100 billion of taxpayer wealth every year through fraud and mismanagement of its Medicare, Medicaid, Social Security, and income tax processes.

– The Federal government spends more on defense than every other nation in the world combined, possibly because of the hundreds of billions of dollars it wastes every year through fraud and mismanagement, development of unnecessary weapons systems, costly and unnecessary foreign deployment of U.S. troops overseas, etc.

– The Federal government supports dozens, if not hundreds, of unnecessary corporate welfare programs, from the inane multi-billion dollar annual subsidies of corn ethanol production to the promotion of U.S. cranberry juice overseas. These programs should be the responsibility of the corporations that receive the subsidies, not the American taxpayer.

– The Federal government supports thousands of unnecessary local entertainment programs such as the annual Nevada Cowboy Poetry contest, programs that should be supported by themselves or local interests, not by Washington D.C. and taxpayers that do not care about Nevada, cowboys, or poetry.

– The Federal government operates dozens of redundant programs across a multitude of government entities, a redundancy in effort, staffing, and expense, a redundancy that wastes billions of dollars a year but produces very little tangible results and benefits.

 We do not have enough years to list out all of the wasteful spending and inefficiencies of the Federal government and the political class that runs it. In return for all of this waste, we face the potential of losing the wonders, joys, and services that talented people could provide us if their efforts were not suppressed by higher and higher tax burdens. When that happens, no Cowboy poem is worth it, no matter how good it is. Rather than debating what the tax rates should be for the high earners in the economy, maybe we should be debating on how to get the outrageous, existing government spending under control before the politicians throw more wealth down the drain.

 Are our tax laws fair? That is for each person to subjectively decide. And to also decide whether poetry contests outweigh the suppression of individual initiative. But Mr. Mankiw provides a real life example of the reality of raising taxes and that reality is not a positive one if it negatively affects your entertainment, your health, or your understanding of economics.
 

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