As our nation’s leaders consider the possibility of raising income tax rates, we need to be aware of the negative impact of higher marginal tax rates on the economy and make sure we resist the lure of higher taxes. This is especially important even if the new higher tax rates are confined to to the rich.
The concept of marginal tax rates is important to understand, as it holds the key to understanding how we can drive economic growth, and how we can kill it, too. President Barack Obama believes he has already cut taxes in the name of economic growth. These tax “cuts” — I use quotes deliberately — are part of the stimulus bill passed in February 2009.
So what are the Obama tax cuts? There was one program that qualified — sort of — as a “cut,” and several tax credit programs. The largest item that benefited most people is the Making Work Pay Tax Credit, a two-year program that rebates $400 per year to individual taxpayers, or $800 per year for married couples.
It’s important to note that this is not a reduction in marginal tax rates, which is the tax rate that people pay on the next dollar they earn. That’s what people focus on. The program will, however, reduce the average tax rate that people pay.
This bears repeating: People can’t control the tax on income they’ve already earned. But they can decide whether to submit themselves to the marginal tax rate: The tax rate the government charges on the next dollar they may — or may not — earn.
So why isn’t Obama’s Making Work Pay Tax Credit a stimulus boon to the economy? It’s not associated with any positive effort or activity by the recipients other than doing what they already do. (This applies to the Bush tax rebate in 2008, too.)
For tax cuts to be productive in growing the economy, they have to be associated with something positive, namely with work, saving, or investment. What many people positively respond to is a reduction in marginal tax rates, that is, the tax that must be paid on the next dollar earned.
Programs that reduce the average tax rate like Obama’s Making Work Pay Tax Credit and the Bush tax rebates of 2008 aren’t effective because they don’t affect the marginal rate — the rate paid on the next dollar earned. This is not to say that I am not in favor of these programs. Anything that reduces the burden of taxes is welcome. But they are not the type of tax cuts that spur economic growth.
Why are low marginal tax rates important to economic growth? First, high marginal tax rates discourage people from producing. As people get to keep less and less of what they produce after they pay higher tax rates, many decide to produce less. Some stop producing anything.
Second, high marginal tax rates encourage people to invest in economically unproductive investments like tax shelters simply to avoid tax, without regard to the underlying wisdom of the investment. Or, people decide that since government takes so much of the money they earn, they might as well spend it on tax-deductible expenses that they might not buy otherwise. A company might hold an engineering conference at an expensive luxury resort instead of a modestly-priced facility — or instead of holding it electronically.
Who responds most positively to reductions in marginal tax rates? First, with about half of American households paying no federal income tax at all — although they do pay payroll taxes — the idea of marginal tax rates doesn’t apply to them. That leaves high-income workers, or as Jeffrey A. Miron explains, the most economically productive members of society that are positively affected by marginal income tax rates:
The Bush cuts provided lower taxes on ordinary income, especially for taxpayers at the high end of the income distribution. These are some of the most energetic and productive people in society; raising tax rates would discourage their effort and entrepreneurship. High-income taxpayers also have multiple ways of avoiding high tax rates, so any revenue gain from raising rates would be modest. The Bush cuts also lowered taxes on dividend and capital gains income; maintaining these lower rates is even more important for economic performance. Capital is mobile: when it is taxed heavily here, it flees somewhere else, meaning lower investment and employment in the United States. And because capital income taxes discourage investment or drive it overseas, they generate little if any tax revenue. (Jeffrey A. Miron, “Why the Bush Tax Cuts Worked”)
It is these “energetic and productive” people that are responsible for a great deal of economic activity and job creation. When these people take steps to avoid taxes it means less productive economic activity and more unproductive tax shelters.
In Slaying Leviathan: The Moral Case for Tax Reform, author Leslie Carbone explains the harm of high marginal taxes, especially progressive taxes, where rates become higher as more income is earned:
The discouragement of earning money by working, saving, or investing inherent in any income tax is exacerbated by progressivity. While any high tax rates are economically destructive, high marginal rates are even worse, because high marginal rates particularly discourage productivity and inhibit economic growth. … By lowering potential pay off, high investment taxes especially discourage risky investment. Discouragement of risky investment squelches technological advancement, because new technologies are the most risky. This means our progressive tax system actually reduces progress and inhibits improve quality of life.”
If the goal of the Obama Administration is to create private sector economic growth instead of growth in government, it needs to keep the Bush tax cuts in place and avoid increases in marginal tax rates for everyone, especially the most productive members of society. A better strategy would be to reduce these tax rates farther to create even more economic growth.
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