The Fox Butterfield Effect and the Laffer Curve

A former reporter for the New York Times, Fox Butterfield, became a bit of a laughingstock in the 1990s for publishing a series of articles addressing the supposed quandary of how crime rates could be falling during periods when prison populations were expanding. A number of critics sarcastically explained that crimes rates were falling because bad guys were behind bars and invented the term “Butterfield Effect” to describe the failure of someone to put 2 + 2 together. We now have a version of the Butterfield Effect in tax policy.

Recent IRS data show that rich people earned a record amount of income in 2007 and also faced their lowest effective tax rate in almost two decades. Proponents of soak-the-rich tax policy complain about these developments, as seen in the Bloomberg excerpt below, but they seem oblivious to the Laffer Curve insight that rich people earned more income in part because tax rates were lower. So if they penalize the rich with higher tax rates, as President Obama is proposing, they will be disappointed to discover that they collect considerably less revenue than predicted for the simple reason that wealthy taxpayers will respond by earning less taxable income.

The 400 highest-earning U.S. households reported an average of $345 million in income in 2007, up 31 percent from a year earlier, IRS statistics show. The average tax rate for the households fell to the lowest in almost 20 years. …The statistics underscore “two long-term trends: that income at the very top has exploded and their taxes have been cut dramatically,” said Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities, a Washington-based research group that supports increasing taxes on high-income individuals.

As an aside, it’s also worth noting that the IRS tax-rate numbers are very misleading. The tax burden on the rich has dropped largely because of lower tax rates on dividends and capital gains. But when the IRS says upper-income taxpayers had an average tax rate of 16.6 percent, this does not include the other layers of tax that are imposed. The corporate income tax is 35 percent (just counting the federal level), for instance, so the actual average tax rate on these forms of income is far higher. Double taxation is counterproductive to growth and competitiveness, though, which is why the correct tax rate on dividends and capital gains is zero. For more on the Laffer Curve, this three-part video series addresses theory, evidence, and the biased revenue-estimating process.