Friday, July 19, 2013

A Few Points on Taxes

I thought I'd weigh in on the tax policy debate with my views and why I hold them:

1.) Investment income should not be taxed at all. This is mostly for efficiency reasons. Taxes on capital are extremely inefficient for a variety of reasons and tend not to raise nearly as much as projected mostly due to behavioral responses. There is also an element of not punishing virtue, as investment taxes add an extra layer of taxation for those who choose to save and invest.

2.) The federal tax code is fairly progressive. However, this mostly offsets the regressive taxation at the state and local levels. In total, our tax system is slightly progressive, and that is about where it should be (in my opinion).

3.) Very few people don't pay taxes. A significant number don't pay INCOME taxes, but these folks do tend to pay payroll and sales taxes (among others).

4.) For all the talk about tax reform (which I support), people oftentimes overestimate the ability of the political system to achieve real tax reform. They also overestimate the efficiency gains to be had here. They are certainly real, but much smaller than many would like to imagine. Tax reform (reducing rates and getting rid of credits and deductions to keep it revenue neutral) will lead to a more efficient tax system, but it won't be a panacea (and it probably won't even happen).

5.) Tax hikes on "only the rich" go well beyond the rich. Let's say we raise taxes on anyone making more than $250,000 a year or the top "2%". Well, that isn't the top 2% everywhere. In New York, where the cost of living is high, $250,000 is the top 5%. So, if you live in New York, the tax hike that was supposed to hit "only" the top 2% is actually hitting the top 5% in your city. This is an unavoidable problem when it comes to federal taxes in a large country. It is also true that trying to adjust tax brackets for cost of living in each state or city would add a lot of complexity to the code and is likely not a goal worth pursuing. Still, the fact that so called tax hikes on the rich affect a lot more folks in some areas than others is relevant.

6.) On the same note, tax hikes on today's rich is a tax hike on tomorrow's upper middle class. Take the Buffet Rule. The Buffet Rule raised taxes on those making above $1 Million per annum. But, it was not adjusted for inflation. Over time, inflation and real income growth (growth after inflation) would lead to the "Buffet Rule" hitting a much larger swath of the population than originally intended (or supposedly intended). We have a real world example of this happening with the AMT which was originally designed to soak the rich. This is a manifestation of the saying "If you try to soak the rich, we'll all end up taking a bath". Even tax hikes for the rich that are adjusted for inflation still affect larger and larger segments of the population over time due to "real" bracket creep (incomes grow even after inflation over time).

7.) Debating whether or not tax hikes "kill jobs" has little to do with the actual negative economic impact that taxes have. High tax rates do tend to have a depressing effect on GDP per capita over time through supply side channels. The effect is hardly noticeable unless you look at relatively comparable countries over relatively long periods of time. We do, for instance, have evidence that taxes on labor do reduce labor supply over time. This has more to do with the efficiency-equity tradeoff than anything else. This, not the effect on job creation, is the main economic reason to limit tax rates along with the fact that taxes move resources from the private sector to the less efficient public sector.

8.) Sweden and Denmark have high taxes and high standards of living. Hong Kong and Singapore have low taxes and high standards of living. There are big asterisks with all of these countries (many other pro market policies in Sweden and Denmark and lots of forced savings in place of taxation in Singapore), but the point remains. Standard of living has a lot to do with the economic policies a country chooses, but things like culture and geography matter a lot too (perhaps more). Taxes need to be at a level where they can fund basic public services and below a level where they are so confiscatory that they destroy incentives to engage in productive behavior. But, between those two extremes, there is a good deal of leeway. In other words, if taxes are within this wide range, culture and other economic policies unrelated to taxation (no policy or culture is totally unrelated to their tax policy of course) account for most of the differences in standard of living between countries.

I suppose this list is a combination of my reading of the empirical evidence and my personal feelings with regards to tax policy.

In summary, taxes that are not confiscatory don't have devastating economic consequences, but the equity-efficiency tradeoff still applies with regards to redistributive taxation, we should use utilitarian considerations when considering the level of taxation on various groups but still set a cap on how high we are willing to let taxes go for the sake of preserving a free society, simplistic proposals to tax the rich often have the effect of hitting significant swaths of the upper middle class at least at some point in the future (and don't raise a whole lot of revenue which I didn't mention above), there are a lot of successful low tax and high tax countries which suggests non tax factors matter a lot when it comes to determining how high a nation's standard of living.

PS: I sort of wrote this off the cuff, so I didn't include links for many (or any) of the claims I made. Obviously, many of the points were my personal opinions (or deductive logic) and thus don't need links. However, I also made many empirical claims. If anyone wants to challenge one of these claims, please speak up and I will happily provide the evidence.
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