Tag: marginal tax rates

The Joint Committee on Taxation’s Voodoo Economics

The Wall Street Journal has an excellent editorial this morning on the obscure – but critically important – issue of measuring what happens to tax revenue in response to changes in tax policy. This is sometimes known as the dynamic scoring versus static scoring debate and sometimes referred to as the Laffer Curve controversy.

The key thing to understand is that the Joint Committee on Taxation (which produces revenue estimates) assumes that even big changes in tax policy have zero macroeconomic impact. Adopt a flat tax? The JCT assumes no effect on the economic performance. Double tax rates? The JCT assumes no impact on growth.

The JCT does include a few microeconomic effects into its revenue-estimating models (an increase in gas taxes, for instance, would reduce gasoline consumption), but it is quite likely that they underestimate the impact of high tax rates on incentives to work, save, and invest. We don’t know for sure, though, because the JCT refuses to make its methodology public. This raises a rather obvious question: Why is the JCT so afraid of transparency? Here’s some of what the WSJ had to say about the issue, including some comparisons of what the JCT predicted and what happened in the real world.

…it’s worth reviewing whether Joint Tax estimates are accurate. This is especially important now, because President Obama and Democrats in Congress want to allow the 2003 tax cuts to expire on January 1 for individuals earning more than $200,000. The JCT calculates that increasing the tax rates on capital gains, dividends and personal income will raise nearly $100 billion a year. …we are not saying that every tax cut “pays for itself.” Some tax cuts—such as temporary rebates—have little impact on growth and thus they may lose revenue more or less as Joint Tax predicts. Cuts in marginal rates, on the other hand, have substantial revenue effects, as economic studies have shown. …So how well did Joint Tax do when it predicted a giant revenue decline from the 2003 investment tax cuts? Not too well. We compared the combined Congressional Budget Office and Joint Tax estimate of revenues after the 2003 tax cuts were enacted with the actual revenues collected from 2003-2007. In each year total federal revenues came in substantially higher than Joint Tax predicted—$434 billion higher than forecast over the five years. …As for capital gains tax receipts, they nearly tripled from 2003 to 2007, even though the capital gains tax rate fell to 15% from 20%. Yet the behavioral models that Mr. Barthold celebrates predicted that the capital gains cuts would cost the government just under $10 billion from 2003-07 when the actual capital gains revenues over five years were $221 billion higher than JCT and CBO predicted. …Estimating future federal tax revenues is an inexact science to be sure. Our complaint is that Joint Tax typically overestimates the revenue gains from raising tax rates, while overestimating the revenue losses from tax rate cuts. This leads to a policy bias in favor of higher tax rates, which is precisely what liberal Democrats wanted when they created the Joint Tax Committee.

All of the revenue-estimating issues are explained in greater detail in my three-part video series on the Laffer Curve. Part I looks at the theory. Part II looks at the evidence. Part III, which can be watched below, analyzes the role of the Joint Committee on Taxation and speculates on why the JCT refuses to be transparent.

 

Is Hillary Clinton Ignorant about Geography, Fiscal Policy, or Both?

Hillary Clinton recently opined that Brazil was a great role model for the idea of soaking the rich with higher tax rates. She didn’t really offer evidence for that specific assertion, but Politico reports that she did say that “Brazil has the highest tax-to-GDP rate in the Western Hemisphere and guess what — they’re growing like crazy.”

I’m not sure if “growing like crazy” is an accurate description, particularly since poor nations normally have decent growth rates because they start from such a low baseline.

But let’s excuse that bit of rhetorical excess and focus on the really flawed portion of her remarks.

Contrary to her direct quote, Brazil does not have the “highest tax-to-GDP rate in the Western Hemisphere.” It may have the highest tax burden in South America. And it may even have the highest tax burden in all of Latin America, but its overall tax burden of about 24 percent of GDP is slightly below the aggregate tax burden in the United States.

I suppose I should issue a caveat and say there’s a very slight chance that the recession has temporarily pushed U.S. tax receipts as a share of GDP below the Brazilian level, but that isn’t apparent from the IMF data. Moreover, there’s no doubt that the tax burden in Canada is significantly higher than the Brazilian burden.

So Secretary Clinton either was unaware that the United States and Canada are in the Western Hemisphere, or has no clue how to read fiscal statistics.

But let’s suspend reality and assume that Brazil has a higher tax-to-GDP ratio. Would that somehow be proof that Brazil is a role model for class-warfare taxation? There is no precise definition of that term, to be sure, but high tax rates on the rich presumably are a necessary component of any class-warfare system. Yet Brazil’s top tax rate is 27.5 percent. That’s not exactly a low-rate system such as Hong Kong, and it’s 27.5 percentage points higher than the zero-percent rate in the Cayman Islands, but it also happens to be significantly lower than the 35 percent (soon to be 39.6 percent) rate in the United States. If that’s class warfare, sign me up for the Brazilian approach.

I suppose it’s possible that Brazil’s top tax rate recently has been boosted, but that didn’t show up in a Google search. And even if the rate was just increased, that would hardly be proof of Secretary Clinton’s strange hypothesis that high tax rates and/or high tax-to-GDP rates are a magical formula for growth. That would require looking at future economic performance with the higher top tax rate, not the recent growth rates with the 27.5 percent top tax rate.

But pointing out Secretary Clinton’s mistakes seems a bit rude and I do like to be a gentleman, so let’s at least give her points for consistency. Earlier this year, she urged higher tax rates on the so-called rich in Pakistan, so at least she doesn’t discriminate in her desire to punish success.

What’s the Future for Supply-Side Economics?

Kevin Williamson has a long-overdue piece in National Review making two essential points about supply-side economics and the Laffer Curve. First, he explains that tax cuts are not the fiscal equivalent of a perpetual motion machine. Simply stated, too many Republicans have fallen into very sloppy habits. They oftentimes fail to understand the difference between “supply-side” tax rate reductions that actually improve incentives to engage in productive behavior and social-engineering tax cuts that simply allow people to keep more money, regardless of whether they create more wealth. This does not necessarily mean the latter form of tax cuts are bad, but they definitely do not boost economic performance and generate revenue feedback. Moreover, even when GOPers are talking about supply-side tax cuts, they frequently exaggerate the positive effects by claiming that lower tax rates “pay for themselves.” I certainly think that can happen, and I give real-world examples in this video on the Laffer Curve (including Reagan’s lower tax rates on those evil rich people), but self-financing tax cuts are not common.

Williamson’s second point is that the true fiscal burden is best measured by looking at how much government is spending. I might quibble with his description of deficits as a form of deferred taxation since technically debt can be rolled over in perpetuity, but his main point is right on the mark. There is no doubt that most forms of government spending – regardless of the means of financing – harm growth by diverting money from the productive sector of the economy (technically, the economic damage occurs because capital and labor are misallocated and incentives are diminished, but let’s not get too wonky). Here are some excerpts from Williamson’s article:

Properly understood, there were no Reagan tax cuts. In 1980 federal spending was $590 billion and in 1989 it was $1.14 trillion; you don’t get Reagan tax cuts without Tip O’Neill spending cuts. Looked at from the proper perspective, we haven’t really had any tax cuts to speak of — we’ve had tax deferrals. …even during periods of strong economic growth, there has been nothing to indicate that our economy is going to grow so fast that it will surmount our deficits and debt without serious spending restraint. This should be a shrieking klaxon of alarm for conservatives still falling for happy talk about pro-growth tax cuts and strategic Laffer Curve optimizing. …The exaggeration of supply-side effects — the belief that tax-rate cuts pay for themselves or more than pay for themselves over some measurable period — is more an article of faith than an economic fact. But it’s a widespread faith: George W. Bush argued that tax cuts would serve to increase tax revenues. So did John McCain. …It is true that tax cuts can promote growth, and that the growth they promote can help generate tax revenue that offsets some of the losses from the cuts. …The problem with magical supply-siderism is that it gives Republicans a rhetorical and intellectual framework in which to ignore spending — just keep cutting taxes, the argument goes, and somebody else will eventually have to cut spending. The results speak for themselves: Tom DeLay and Dennis Hastert and Trent Lott and Bill Frist all know how to count, but, under their leadership, Republicans spent all the money the country had and then some.

Now that we’ve chastised Republicans, it’s time to turn our attention to the Democrats. We know they are bad on spending (I often joke that Republicans expand government out of stupidity, while Democrats do it for reasons of malice), so let’s focus on their approach to Laffer Curve issues. If the GOP is guilty of being too exuberant, the Democrats and their allies at the Joint Committee on Taxation (the bureaucracy on Capitol Hill that estimates the revenue impact of tax policy changes) are guilty of deliberate blindness. The current methodology used by the JCT (with the full support of the Democrats) is to assume that changes in tax policy – regardless of magnitude – have zero impact on economic performance. If you double tax rates, the JCT assumes the economy is unaffected and people earn just as much taxable income. If you replace the IRS with a flat tax, the JCT assumes there is no effect on macroeconomic performance. Sounds unbelievable, but this video has the gory details, including when my former boss, Senator Bob Packwood was told by JCT that revenues would rise year after year even if the government imposed a 100 percent tax rate.

Interestingly, the European Central Bank just released a new study showing that there are substantial Laffer Curve affects and that lower tax rates generate large amounts of revenue feedback. In a few cases (Sweden and Denmark), the researchers even conclude that some lower tax rates would be in that rare category of self-financing tax cuts. But the key point from this ultra-establishment institution is that changes in tax rates do lead to changes in taxable income. This means it is an empirical question to determine the revenue impact. Here’s a key excerpt from the study’s conclusion:

We show that there exist robust steady state Laffer curves for labor taxes as well as capital taxes. …EU-14 countries are much closer to the slippery slopes than the US. More precisely, we find that the US can increase tax revenues by 30% by raising labor taxes but only 6% by raising capital income taxes, while the same numbers for EU-14 are 8% and 1% respectively. …We find that for the US model 32% of a labor tax cut and 51% of a capital tax cut are self-financing in the steady state. In the EU-14 economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing. We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.

Contrary to over-enthusiastic Republicans and deliberately-dour Democrats, the Laffer Curve/supply-side economics debate is not a binary choice between self-financing tax cuts and zero-impact tax cuts. Yes, there are examples of each, but the real debate should focus on which types of tax reforms generate the most bang for the buck. In the 1980s, the GOP seems to have the right grasp of this issue, focusing on lowering tax rates and reducing the discriminatory tax bias against saving and investment. This approach generated meaningful results. As Nobel laureate Robert Lucas wrote, “The supply side economists, if that is the right term for those whose research we have been discussing, have delivered the largest genuinely free lunch that I have seen in 25 years of this business, and I believe we would be a better society if we followed their advice.”

But identifying and advocating pro-growth tax reforms, as Williamson notes, is just part of the battle. The real test of fiscal responsibility if controlling the size of government. Republicans miserably failed at this essential task during the Bush year. If they want to do the right thing for the nation, and if they want to avert a Greek-style fiscal collapse, they should devote most of their energies to reducing the burden of government spending.

Real World Evidence for the Laffer Curve from the Government of Washington, DC

President Obama is proposing a series of major tax increases. His budget envisions higher tax rates on personal income, increased double taxation of dividends and capital gains, and a big increase in the death tax. And his health care plan includes significant tax hikes, including perhaps the imposition of the Medicare payroll tax on capital income – thus exacerbating the tax code’s bias against saving and investment. It is unclear why the White House is pursuing these punitive policies. The President said during the 2008 campaign that he favored soak-the-rich taxes even if they did not raise revenue, but his budget predicts the proposals will raise lots of money.

Because of the Laffer Curve, it is highly unlikely that all of this additional revenue will materialize if the President’s budget is approved. The core insight of the Laffer Curve is not that all tax increases lose money and that all tax cuts raise revenues. That only happens in rare circumstances. Instead, the Laffer Curve simply reveals that higher tax rates will lead to less taxable income (or that lower tax rates will lead to more taxable income) and that it is an empirical matter to figure out the degree to which the change in tax revenue resulting from the shift in the tax rate is offset by the change in tax revenue caused by the shift in the other direction for taxable income. This should be an uncontroversial proposition, and these three videos explain Laffer Curve theory, evidence, and revenue-estimating issues. Richard Rahn also gives a good explanation in a recent Washington Times column.

Interestingly, the DC government (which certainly is not a bastion of free-market thinking) has just acknowledged the Laffer Curve. As the excerpt below illustrates, an increase in the cigarette tax did not raise the amount of revenue that local politicians expected. The evidence is so strong that the city’s budget experts warn that a further increase will reduce revenue:

One of the gap-closing measures for the FY 2010 budget was an increase in the excise tax on cigarettes from $2.00 to $2.50 per pack. The 50 cent increase in the cigarette tax rate was projected to increase revenue but also reduce volume. Collections year-to-date point to a more severe drop in volumes than projected. Anecdotal evidence suggests that Maryland smokers who were purchasing in DC in FY 2008, because the tax rate in the District was less than the tax rate in Maryland, have shifted purchases back to Maryland now that the tax rate in the District is higher. Virginia analyzed the impact of demand when the federal rate went up by $0.61 in April and has been surprised that demand is much stronger than they had projected–raising the possibility that purchasing in DC has moved across the river.  Whatever the actual cause, because of the lower than anticipated collections, the estimate for cigarette tax revenue is revised downwards by $15.4 million in FY 2010 and $15.2 million in FY 2011. Given that cigarette tax rates in neighboring jurisdictions are now lower than that of the District, future increases in the tax rate will likely generate less revenue rather than more.

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.

ObamaCare 3.0: Higher Implicit Taxes, Quicker Death Spiral

In a recent paper, I showed that the health care legislation passed by the House and Senate would impose punitive implicit tax rates on low- and middle-income workers.  Those bills would also result in higher health insurance premiums over time because they would create large financial incentives for healthy people to drop coverage and only purchase it when they become sick.

The health care proposal that President Obama released yesterday essentially splits the difference on most areas of disagreement between the two bills.  But a preliminary analysis shows that ObamaCare 3.0 would make these perverse incentives even worse.  Families of four earning $22,000 under the Senate bill (100 percent of the federal poverty level) or $30,000 under the House bill or the Obama plan (133 percent FPL) would face the following effective marginal tax rates as they climb the economic ladder:

  • Senate bill - Average: 62 percent.  High: 73 percent.
  • House bill -  Average: 74 percent. High: 82 percent.
  • Obama plan - Average: 72 percent. High: 90 percent.

In other words, over broad ranges of income, families of four would see their take-home pay rise by an average of 28 cents of each additional dollar earned.  In some cases, it would rise as little as 10 cents for each additional dollar earned.  Using smaller changes in income reveals the Obama plan would create EMTRs as large as 200 percent or higher.  That is, earning more money would leave many families worse off financially.

In addition, by requiring insurers to cover all applicants without regard to illness, each of these health plans would remove any penalty on waiting until you are sick to purchase coverage.  Therefore – even after accounting for all relevant taxes, subsidies, and penalties – these plans would create large financial incentives for healthy people to drop out of the market, which would cause premiums to rise for those who remain.  That would in turn encourage more healthy people to drop out, which would cause premiums to rise further, and so on.  Those perverse incentives are much worse under the Obama plan than under the House or Senate bills.  Here are the maximum financial incentives to drop coverage that each plan would create for families of four:

  • Senate bill: $8,000
  • House bill: $7,800
  • Obama plan: $9,900

By increasing the financial incentives to drop coverage, the Obama plan would cause private insurance markets to unravel even faster than the House and Senate bills would.

Class Warfare Tax Policy May Be Emotionally Satisfying to Some People, but It Is Bad Economics

Barack Obama wants higher tax rates on the so-called rich, including steeper levies on income, capital gains, dividends, and even death. Along with other politicians in Washington, he acts as if successful taxpayers are like sheep meekly awaiting slaughter. I’ve explained in this video why class-warfare tax policies are misguided, and a new study from Boston College provides additional evidence about the consequences of hate-and-envy tax policy. The research reveals that high tax rates in New Jersey have helped cause wealthy people to leave the state, leading to a net wealth reduction of $70 billion between 2004 and 2008. Wealth and income are different, of course, so it is worth pointing out that another study from 2007 estimated that the state lost $8 billion of gross income in 2005. That’s a huge amount of income that is now beyond the reach of the state’s greedy politicians. Here’s a report from the New Jersey Business News:

More than $70 billion in wealth left New Jersey between 2004 and 2008 as affluent residents moved elsewhere, according to a report released Wednesday that marks a swift reversal of fortune for a state once considered the nation’s wealthiest. …The exodus of wealth…was a reaction to a series of changes in the state’s tax structure — including increases in the income, sales, property and “millionaire” taxes. …the report reinforces findings from a similar study he conducted in 2007 with fellow Rutgers professor Joseph Seneca, which found a sharp acceleration in residents leaving the state. That report, which focused on income rather than wealth, found the state lost nearly $8 billion in gross income in 2005. …Ken Hydock, a certified public accountant with Sobel and Company in Livingston, said in this 30-year-career he’s never seen so many of his wealthy clients leave for “purely tax reasons” for states like Florida, where property taxes are lower and there is no personal income or estate tax. In New Jersey, residents pay an estate tax if their assets amount to more than $675,000. That’s compared to a $3.5 million federal exemption for 2009. Several years ago, he recalled, one of his clients stood to make $60 million from stock options in a company that was being acquired by another. Before he cashed out, however, the client put his home up for sale, moved to Las Vegas, and “never stepped foot back in New Jersey again,” Hydock said. “He avoided paying about $6 million in taxes,” he said. “He passed away two years later and also saved a huge estate tax, so he probably saved $7 million.”

Still not convinced that high tax rates are causing wealth and income to escape from New Jersey? The Wall Street Journal wrote a very powerful editorial about the Boston College study, noting that New Jersey “…was once a fast-growing state but has now joined California and New York as high-tax, high-debt states with budget crises.” But the most powerful part of the editorial was this simple image. Prior to 1976, there was no state income tax in New Jersey. Now, by contrast, highly-productive people are getting fleeced by a 10.75 percent tax rate. No wonder so many of them are leaving.