Dec. 6 (Bloomberg) -- If I were to learn on Dec. 31 that my taxes are going up next year, I would do ... absolutely nothing.
Granted, I’m a salaried employee, not an entrepreneur or small-business owner. I don’t have the option to adjust my hours and take more leisure when the after-tax return on work declines.
If my response, or nonresponse as it turns out, to changes in marginal tax rates is typical of the average worker, then all this talk about the negative impact of raising tax rates on the top 2 percent must be a bunch of malarkey, right?
Not exactly. The effect on labor supply -- on our willingness to work -- is small. Most of us, especially the primary earner in a family, don’t have the option to work less.
That doesn’t mean we have no options. The effects of higher tax rates may not be apparent in the short run, according to Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University in Arlington, Virginia. But they manifest themselves over a lifetime: in our next job choice, in perhaps electing to join the underground economy and in deciding when to retire.
There is one group that can respond quickly and decisively to changes in top tax rates, according to economist Arthur Laffer, chairman of Laffer Associates: the rich.
“The rich can change all sorts of things when it comes to their income,” Laffer said. “A bricklayer can’t.”
For example, the rich can change where they earn their income by moving to a low- or no-tax state, which is what Laffer did when he left California for Tennessee. They can change the timing of their income (defer it or shift it forward), the volume (quit work), and the composition.
OK, but if the government insists on fiddling with top tax rates even though historically it manages to snag a pretty constant share -- 18 percent -- of gross domestic product, what’s it to me?
It isn’t that simple. “The tax impact of a tax-rate change is not exclusively on the person being taxed,” Laffer said. “How much more the rich pay in taxes is minor. It’s the secondary and tertiary effects that matter.”
What are those effects? Everything from what they spend to how they structure their investment portfolios to whether they invest in new enterprises to how many jobs they create. Remember, “the rich don’t create jobs because it’s good social policy,” Laffer said. “They do it to make money for themselves.”
Wait a minute. Research by Nobel laureate Peter Diamond and Emmanuel Saez, an economist at the University of California at Berkeley, finds that the revenue-maximizing top marginal tax rate is 73 percent.
In their econometric model, maybe. These guys need to get out in the real world. Two-thirds of the U.K.’s millionaires vanished -- either left the country or sheltered their income -- after the imposition of a 50 percent top-tax rate in 2010, according to the U.K. Telegraph. French Socialist President Francois Hollande announced a 75 percent income-tax rate on millionaries this year, along with other levies, only to hear the French respond, “C’est trop.”
Even on a theoretical level, Diamond and Saez focus on the short-run effect and ignore the long-run behavioral response, according to a critique of their work in the Nov. 19 Tax Notes, a publication of the nonprofit Tax Analysts. Nobel Prize-winning economist Edward Prescott, a senior monetary adviser to the Federal Reserve Bank of Minneapolis, stresses the long-term effects as well. When he looked at the question of why Americans worked 50 percent more than Europeans, he was surprised to find that marginal tax rates, not cultural differences or unemployment rates, explained virtually all of the difference.
You mentioned real-world effects. What do we have to show for the 2001 and 2003 tax cuts? The decade was mediocre in terms of economic and employment growth.
Bingo! That’s probably the best argument for letting the tax cuts expire. The cut in marginal rates was minimal compared with earlier reductions from 70 percent to 50 percent to 28 percent.
If both parties agree that additional revenue must be part of any budget deal, why not allow the top rates to revert to the Clinton era’s 39.6 percent and 36 percent?
Don’t confuse U.S. President Barack Obama’s “tax fairness” with real revenue. “About three-quarters of the revenue loss from the Bush tax cuts came from everything below the top two brackets,” said Michael Darda, chief economist at MKM Partners LLC in Stamford, Connecticut.
You mean, from the cherished middle class?
Yes, the very same middle class Obama says it’s his mandate to protect.
The math doesn’t work! Raising top tax rates will produce about $800 billion of revenue over the next 10 years, compared with a $3.7 trillion revenue loss from all the Bush tax cuts.
Shhh! The dirty little secret, which everyone seems to know but no one is willing to utter, is that middle-class taxes will have to go up. Not this year, or even next year, but eventually. There aren’t enough rich folks to finance the promises the U.S. has made to the elderly. Both parties have chosen to maintain this fiction a while longer.
Which brings us back to our theme. If the supply of labor is slow to respond to tax-rate changes, and the rich are good at avoiding taxes, who gets hurt?
I’m glad you asked. The wannabe rich. On this, Laffer is passionate (actually, he’s passionate about everything).
“Higher marginal tax rates prevent poor people from becoming rich,” he said. “The only way they can get rich is by earning income, which is taxable. Once you become rich, you have ways around it.”
Viewed in that context, a tax increase on the rich is really a tax increase on the poor and the middle class, the wannabe rich. Why, it gives new meaning to the term “trickle down.”
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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