WSJ: Arthur Laffer - Tax Hikes and the 2011 Economic Collapse

[FIREd]

When our income was lower, I used to think that higher taxes would be a deterrent. IIRC, I even envisioned quitting my job so that we could pay fewer taxes. But now that our income has doubled over the past 3 years, we have found that making more money is always an attractive proposition, regardless of the increased taxation that comes with it. It doesn't mean that I am happy to pay 6 figures in taxes each year. I am European after all and b*tching about taxes is as much a national past-time for us as soccer is. I will not let myself be plucked without using every legal mean at my disposal to lessen the pain (contribute to a 401K, make our portfolio tax efficient, manage deferred compensation for tax efficiency, etc...) but, even sitting in the top tax bracket, it's hard to feel much deterrence to try and make even more money.

Compared to my other reference points, I find the current American tax system very attractive. It will remain comparatively attractive for me despite next year's tax increase.

 

[BTravlin]

Compared to my other reference points, I find the current American tax system very attractive. It will remain comparatively attractive for me despite next year's tax increase.

I don't have a problem with our income tax rates but do get disgusted when I look at the sum total of taxes paid on everything under the sun. Just the other day I paid my annual business liability insurance premium and there was a 7.5% tax on the premium. Doesn't seem like much to some but I'm a one man operation and that hurts. I wish we could scrap all the taxes and replace them with a VAT. The more you consume, the more you pay.

 

[FUEGO]

Just the other day I paid my annual business liability insurance premium and there was a 7.5% tax on the premium. Doesn't seem like much to some but I'm a one man operation and that hurts.

Yes, I realized there are some sort of taxes on auto liability insurance in my state. I called to modify the policy coverage and they quoted me the premium as $232 with existing coverage. I said it is shown as $252 but thanks for the discount. Apparently their system shows the pre-tax amount and the post tax amount - the $20 discrepancy was taxes. They messed up and told me the pre tax amount by accident. These are hidden taxes since they never appear on the consumer's bill.

 

[ziggy29]

Yep, I started work in 1977, about the same time as you. We didn't have state income tax in Texas, but folks were still pretty crazy about tax rates. Funny thing though, few seem to remember the Tax Reform Act of 1986. Here are the rates and income thresholds.
15% $0 - $29,750
28% $29,750 - $71,900
33% $71,900 - $149,250
28% $149,250 -
source: The Tax Foundation - U.S. Federal Individual Income Tax Rates History, 1913-2010
Lemme tell ya, as a Dilbert type engineer, I did not appreciate paying a higher marginal rate than the president of the MegaCorp I worked for. It kind of soured me on politicians who promised to lower my taxes.

The reason the rate went from 33% back down to 28% was because the 33% bracket was a "phasing out of the 15% bracket".

If this form of taxation with a "phase-out bubble" causing many to pay higher marginal rates than "the rich" was wrong, then we seem determined to repeat it in the way the coming health insurance subsidy phase-out is being implemented.

 

[FIREd]

I don't have a problem with our income tax rates but do get disgusted when I look at the sum total of taxes paid on everything under the sun. Just the other day I paid my annual business liability insurance premium and there was a 7.5% tax on the premium. Doesn't seem like much to some but I'm a one man operation and that hurts. I wish we could scrap all the taxes and replace them with a VAT. The more you consume, the more you pay.

There are a lot of stealth taxes, it's true. And I think they will become even more numerous and insidious in the future. They learned that in a big way in Europe. Politicians love stealth taxes because they can be raised inconspicuously with little or no resistance from taxpayers. I doubt a VAT would eliminate stealth taxes.

Stealth taxes are usually regressive as well. So small increases multiplied by a large number of unsuspecting taxpayers = jackpot. Like in the movie "office space", skim 1 penny off of millions of transactions and you get real money.

 

[ziggy29]

There are a lot of stealth taxes, it's true. And I think they will become even more numerous and insidious in the future. They learned that in a big way in Europe. Politicians love stealth taxes because they can be raised inconspicuously with little or no resistance from taxpayers. I doubt a VAT would eliminate stealth taxes.

I think this is why property taxes are so despised compared to other taxes. They aren't hidden, they aren't "unnoticed" in payroll deductions and you get socked with one large, conspicuous bill that reminds you of how much government costs instead of being nickel and dime. And many in government would rather you not realize how much it costs.

 

[BTravlin]

I've often thought of of truly watching all of my spending for a year and accurately calculating the total taxes paid but always end up not doing it because it's too much work and I'm afraid of what I'd find out.

 

[FIREd]

I've often thought of of truly watching all of my spending for a year and accurately calculating the total taxes paid but always end up not doing it because it's too much work and I'm afraid of what I'd find out.

I actually did it one year (on a bet). Of course, some taxes are so embedded in the price of goods and services that it is nearly impossible to tally all taxes paid with any significant accuracy. But based on taxes (and "federal fees") we paid directly (income, payroll, sales, property, auto, gasoline, cable, phone, alcohol, utility, air travel, etc...), I found out that less than 30% of our gross income went to direct taxes of all sorts. I thought it reasonable given our income level. Of course, the largest tax expenses were income and payroll taxes for us (25% of gross). Because, in our case, we consume less then 20% of our income, stealth and consumption taxes represented mostly a rounding error. As always, YMMV.

 

[ejman]

I think it just adds credence to the strategy of living simply, being debt-free, saving until it hurts, learning to enjoy a simple lifestyle and such so you can be one of the few people who have the option to "starve the beast."

+1 - Last year I finally achieved tax nirvana - Paid zero in Federal and State taxes, No sales tax ( I live in Oregon) and property taxes were $990 on my 7 acre little ranch (I guess there had to be a fly in the ointment). Probably won't last...

 

[Shawn]

IMO, it is foolish to think that high taxes don't create strong disincentives to work. And unfortunately, these disincentives are primarily directed at the most productive members of society.

While my official federal tax bracket is currently 28%, my marginal tax rate is about 45% (32.5% federal AMT, 9.55% state, 1.45% medicare, 1.07% state deduction and exemption phaseouts). This doesn't include other taxes (non marginal 6.2% social security and 0.9% state SDI, $3K property for a small home, 9.75% sales taxes, gas taxes, utility taxes, embedded corporate taxes, etc). My marginal rate would be over 50% if the social security cap was eliminated. Last year, my total taxes were 3 times my non-tax expenses. How has this impacted me (besides the motivation to retire)?

- I turned down a promotion at my present employer because the *tax-adjusted* salary increase was not commensurate with the additional work.

- I turned down a part-time teaching position at a community college for the same reason. While financial reward is obviously not the primary reason to teach, the after-tax compensation did not motivate the extra work.

- Last year, I turned down a dream job opportunity at another company. Since the salary would have been on top of a taxable pension base from my present employer, the effective salary would have been reduced by about 50% due to taxes. The incentive wasn't there.

One could argue that "other people filled these positions," but presumably these people were less qualified since I was first offered the position (in fact, they didn't hire for two of the above positions because they specifically targeted me). A decline in productivity.

Businesses often pay (hourly) employees extra for additional work. A productive employee who normally earns $20/hr may be offered $30/hr to work overtime. This is an incentive. Our tax system is exactly the opposite. Our tax system offers the same employee $10-15/hr to be more productive. This is a disincentive.

Small changes *do* impact behavior. If this was not true then Wal-Mart would seek higher revenue by raising prices 5-10% . They don't do this because they know which side of the "Laffer Curve" their prices (taxes) are on. I don't know where on the curve the US tax system falls, but considering the high marginal rates (50+%) of those who will be most impacted by tax increases, I suspect it's over the top.

While I don't believe higher taxes will cause economic collapse, I do believe they will negatively impact the economy. People will adjust their investments and compensation. Two income families will become one income families. There will be added incentives to retire (this is on the mind of many people at my workplace). Unintended consequences will occur.

Originally, my plan was to early retire when I turned 50 and became eligible for lifetime health benefits through my employer pension. This was 6 months ago. My DBP pension would have provided $45K/yr of income (with COLA) me paying $1.5K/yr in premiums for health coverage. Good deal. But government health reform now offers me a much better deal at taxpayer expense. While I'm waiting to see how this all plays out, my new plan is to leave my job but delay taking the pension until my full retirement age at 60. At that time my pension will provide me with $100K/yr of income (plus the COLA between now and then). In the meantime, I'll live off my assets and my income will be negligible. I'll be eligible for fully subsidized health care. It's not clear to me why hardworking taxpayers should pay my health care costs when I am perfectly able to do this myself. But this is government incentive in action. Unintended consequences.

IMO, taxes don't need to go up. Spending needs to go down. Taxpayers should not be subsidizing the health care costs of able-bodied "multimillionaires" who choose not to work. But that's just me.

 

[kyounge1956]

Not necessarily. A large cut that moves you from Point B to Point A is revenue neutral, according to the graph. I think that's what we did in the 80's.

Of course!

That would also explain the big swings in revenue from both the Clinton increases and the Bush cuts (whereas a move along a horizontal line would produce little change in revenues). Judging from the impact recent tax changes have had on receipts, it seems we're on a very steep, upward sloping point on the curve. That means we should have little economic cannibalization of tax increases from current levels.

Would you explain? I don't understand what economic cannibalization is.

 

[Gone4Good]

I don't understand what economic cannibalization is.

I used the term "economic cannibalization" to reference the degree to which higher taxes discourage economic activity. It's the basic mechanism by which the Laffer Curve comes into existence. If tax increases cause the economy to shrink, then there is less overall income to be taxed, and the new higher rates may generate less revenue then the older, lower rates. It can be said that because of the resulting lower economic activity, higher tax rates actually "cannibalize" some of the tax revenue.

There is probably some cannibalization going on at all tax levels, as highly marginal investments are abandoned by even the slightest change in economics. But because those highly marginal investments are not expected to generate large amounts of income, and therefore taxes, killing those projects doesn't hurt government revenue or GDP that much. It's only when projects that would be reasonably profitable if not for taxes get killed off by even higher taxes that both the economy and government revenues suffer. So the tax level needs to be relatively high for that to happen.

But nobody knows what "relatively high" is, precisely. One crude way to judge is to look at how government receipts respond to changes in taxes. If a 1% increase in taxes results in a 1% increase in revenues, then we know the negative impact on the economy (the economic cannibalization) is small. If that is the case, you can raise taxes to some degree without much fear of harming the economy. If, on the other hand, a tax increase causes revenues to decline, then the amount of economic damage done to the economy is large, and the best course of action is to cut taxes (this is always, and everywhere, the default position of "Supply Siders" but, as you can see, it is only conditionally true).

In short, if there is direct positive correlation between tax rate changes and revenue, then we are to the left of the kink in the Laffer Curve, and if there is an inverse relationship, we are to the right of the kink. As the last two large changes to the tax code have had a demonstrably positive correlation with revenue, it seems very likely that we are to the left of the kink . . . and perhaps meaningfully so (in other words, modestly higher taxes should not significantly harm economic activity).

 

[kyounge1956]

I used the term "economic cannibalization" to reference the degree to which higher taxes discourage economic activity. It's the basic mechanism by which the Laffer Curve comes into existence. If tax increases cause the economy to shrink, then there is less overall income to be taxed, and the new higher rates may generate less revenue then the older, lower rates. It can be said that because of the resulting lower economic activity, higher tax rates actually "cannibalize" some of the tax revenue. (snip)

Aha! So economic cannibalization is what is also sometimes called "killing the goose that lays the golden eggs".

 

[samclem]

One crude way to judge is to look at how government receipts respond to changes in taxes. If a 1% increase in taxes results in a 1% increase in revenues, then we know the negative impact on the economy (the economic cannibalization) is small. If that is the case, you can raise taxes to some degree without much fear of harming the economy. If, on the other hand, a tax increase causes revenues to decline, then the amount of economic damage done to the economy is large, and the best course of action is to cut taxes (this is always, and everywhere, the default position of "Supply Siders" but, as you can see, it is only conditionally true).

In short, if there is direct positive correlation between tax rate changes and revenue, then we are to the left of the kink in the Laffer Curve, and if there is an inverse relationship, we are to the right of the kink. As the last two large changes to the tax code have had a demonstrably positive correlation with revenue, it seems very likely that we are to the left of the kink . . . and perhaps meaningfully so (in other words, modestly higher taxes should not significantly harm economic activity).

If only it were possible to have real "control conditions" in the field of macroeconomics, it would surely be more of a science. In the real world, when tax rates change and government revenues go one way or the other, economists argue for decades about the underlying causes. Without accurate models (i.e. ones that respond as the real world does) or the ability to control other variables, things will always be murky.
I think many folks arguing for lower taxes aren't motivated by a desire to increase overall government revenue through greater economic activity. They would probably say that anyone trying to increase the absolute amount of money the government takes from the economy is on a fundamentally different quest than they are. Yes, reduced tax rates can sometimes increase government revenues, but the overall performance of the economy (as measured by higher growth rates) is the more important metric if we want to know if our lot is improving.

 

[Gone4Good]

They would probably say that anyone trying to increase the absolute amount of money the government takes from the economy is on a fundamentally different quest than they are. Yes, reduced tax rates can sometimes increase government revenues, but the overall performance of the economy (as measured by higher growth rates) is the more important metric if we want to know if our lot is improving.

I guess my point is that these two things are related. The degree of "economic cannibalization" is a function of how much tax increases negatively effect the economy. If cannibalization is small, then the economy isn't much effected by changing taxes - higher or lower, at least within some tolerance. In other words, if we're far to the left of the kink on the Laffer Curve, the "Supply Side" impact of tax policy is small. Many seem to think the impact is a constant (and constantly large), but that reflects linear thinking in a non-linear situation . . . it isn't called the Laffer Curve for nothing.

And while I'll agree that we can't run control studies and achieve scientific precision, we can actually use data to inform our opinions.

 

[ziggy29]

But nobody knows what "relatively high" is, precisely. One crude way to judge is to look at how government receipts respond to changes in taxes. If a 1% increase in taxes results in a 1% increase in revenues, then we know the negative impact on the economy (the economic cannibalization) is small. If that is the case, you can raise taxes to some degree without much fear of harming the economy. If, on the other hand, a tax increase causes revenues to decline, then the amount of economic damage done to the economy is large, and the best course of action is to cut taxes (this is always, and everywhere, the default position of "Supply Siders" but, as you can see, it is only conditionally true).

I agree with this in principle, but I also don't see that the "top" of the curve is static in all situations. It also doesn't account for the cyclical nature of the economy, where an increase in boom or bust may have been starting anyway, regardless of tax rate.

 

[Gone4Good]

It also doesn't account for the cyclical nature of the economy, where an increase in boom or bust may have been starting anyway, regardless of tax rate.

I don't think this is much of a problem because large tax changes happen so infrequently. It certainly is possible to compare the Clinton tax regime and the Bush tax regime over two complete business cycles.

 

[Hamlet]

I fully agree with this.

Given that the budget of the Federal government is made up mostly of SS, Medicare, Medicaid, and the Defense budget, which of these four areas would you like to make very large cuts to?

IMO, taxes don't need to go up. Spending needs to go down. Taxpayers should not be subsidizing the health care costs of able-bodied "multimillionaires" who choose not to work. But that's just me.

 

[ejman]

I fully agree with this.

Given that the budget of the Federal government is made up mostly of SS, Medicare, Medicaid, and the Defense budget, which of these four areas would you like to make very large cuts to?

As I understand it, the US Defense budget is about equal to the combined defense budget of the next ten Major countries ( That is China + France+ UK+Germany+Russia etc) If that is in fact so, and just to be fair, what if we propose that the US defense budget be equal to say the next 5 countries?

 

[Gone4Good]

Given that the budget of the Federal government is made up mostly of SS, Medicare, Medicaid, and the Defense budget, which of these four areas would you like to make very large cuts to?

We've had this discussion on this forum before. It went something like this . . .

"We don't need to raise taxes, we should cut spending"
"What specifically would you like to see cut?"
"Waste"
"But what specifically"
"Waste"
"You understand that we have a $1.3 Trillion deficit? That's a lot of waste to cut. Could you identify some specific things. It seems like with that much waste, we should be able to come up with some biggies."
"Cut waste."

As I understand it, the US Defense budget is about equal to the combined defense budget of the next ten Major countries ( That is China + France+ UK+Germany+Russia etc) If that is in fact so, and just to be fair, what if we propose that the US defense budget be equal to say the next 5 countries?

That would save about $300B (which is a pretty good start). But we still have about $1 Trillion to go . . .

 

[ejman]

That would save about $300B (which is a pretty good start). But we still have about $1 Trillion to go . . .

Piece of cake. Cut military expenditures as explained above. Increase SS retirement age to reflect expanded lifespan and remove limit on earned income. Eliminate Medicare and Medicaid as separate health care cost reimbursement programs and start a comprehensive single payer system in the manner of the Canadian system (but allow for continuation of private medicine option), return tax rates to Clinton era levels. Voila budget deficit resolved. Next question?

 

[FinanceDude]

As I understand it, the US Defense budget is about equal to the combined defense budget of the next ten Major countries ( That is China + France+ UK+Germany+Russia etc) If that is in fact so, and just to be fair, what if we propose that the US defense budget be equal to say the next 5 countries?

Well, if those countries would EVER step up in conflicts around the world, we could. However, those countries have sat on their hands and let us do the dirty work for years.

Cutting national defense has not worked well in the past. maybe the retired vets on here can comment on this?

 

[Independent]

Piece of cake. Cut military expenditures as explained above. Increase SS retirement age to reflect expanded lifespan and remove limit on earned income. Eliminate Medicare and Medicaid as separate health care cost reimbursement programs and start a comprehensive single payer system in the manner of the Canadian system (but allow for continuation of private medicine option), return tax rates to Clinton era levels. Voila budget deficit resolved. Next question?

I believe that Gone4Good's point was that we can't balance the budget by cutting "waste".

Your a approach of cutting defense spending, cutting SS benefits, raising SS taxes, introducing a new tax to fund a single payor health plan, and reversing the Bush era tax cuts seems like it should work (in the sense that the numbers add up).

 

[ejman]

I believe that Gone4Good's point was that we can't balance the budget by cutting "waste".

Your a approach of cutting defense spending, cutting SS benefits, raising SS taxes, introducing a new tax to fund a single payor health plan, and reversing the Bush era tax cuts seems like it should work (in the sense that the numbers add up).

You're right. Gone4Good point is good and well stated. Waste is a few pennies on the deficit dollar at best. But in the spirit of solving the problem, let's cut waste too and that way along with my other proposed changes we'll generate a surplus! Now thats a legacy to leave to future generations

 

[samclem]

Given that the budget of the Federal government is made up mostly of SS, Medicare, Medicaid, and the Defense budget, which of these four areas would you like to make very large cuts to?

I suggest we maybe give priority to functions that are explicitly mentioned in the Constitution as being the responsibility of the federal government. That's not a guide to how much to spend, per se, but it might be a guide to what should be considered "Job 1."