Carpe Diem

Taxes 101: Tax Rates, Tax Base and Tax Revenue

Especially in an election year, we hear a lot of talk about “raising taxes,” “lowering taxes,” “tax hikes for the rich,” “tax cuts for the middle class,” etc. etc. and as a result of an epiphany earlier today while driving to the university, I think I finally figured out why there is so much confusion about taxes. As a result of imprecise language, we interchange the terms “raising (lowering) taxes” and “raising (lowering) tax rates,” assuming that increases (decreases) in tax revenues are always associated with increases (decreases) in tax rates. Let me digress to clarify the confusion.

1. Standard economic theory tells us that Price (P) X Quantity (Q) = Total Revenue (TR). Now, notice that all three variables (P, Q and TR) have different names, so that there would be absolutely no way to confuse, mix or interchange the three completely different variables!

2. We also know that if P changes, Q changes in the opposite direction, according to the Law of Demand, and further, TR changes, but in an uncertain direction. If demand is elastic (inelastic), quantity will change by a greater (smaller) percentage amount than the percent change in price, and TR will change in the opposite (same) direction of the price change. If P goes up, TR may either go down or up, depending on the elasticity (price sensitivity) of demand.

Back to tax rates and tax revenues.

We also know that THE TAX RATE x THE TAX BASE = TAX REVENUE, and here is the source of the confusion: each of the three key terms have the word “tax” in them, which results in the common, but often incorrect, assumption that changes in “tax rates” lead to changes in “tax revenues” in the SAME DIRECTION. We also frequently forget, or ignore, the inevitable fact that changes in the tax rate will cause the tax base to change, IN THE OPPOSITE DIRECTION!

For example, underlying the common phrase “tax cuts for the rich” is the incorrect assumption that reductions in tax rates necessarily leads to a reduction in tax revenue. Reason? We incorrectly interchange the terms “tax rate cuts” and “tax revenue cuts” because both terms have the word “tax.” In reality, tax rate reductions usually lead to an increase in tax revenues, because the tax base increases in response to lower tax rates!

Most people have a much greater understanding that significant changes in prices might either raise or lower sales revenue, and would readily accept the suggestion that if McDonald’s offers a $1 menu, its sales revenues might actually increase! But those same people don’t always understand that reducing tax rates might actually increase tax revenues!

Bottom Line: When it comes to basic economic theory and the Law of Demand, economists have a much greater chance of getting the public to understand the effects of price changes, and the dynamic interaction among P, Q and TR, largely because the three key variables all have different and distinct names.

When it comes to basic tax theory, the general public, media and even politicians gets confused about the dynamic interaction among Tax Rates, Tax Base and Tax Revenues, because the three variables sound too much alike! Oh, and politicians always seem to ignore the reality that the Tax Base ALWAYS CHANGES when tax rates change, in the OPPOSITE DIRECTION (the “Law of Demand” applied to taxes). That is, they use static tax analysis (incorrectly assuming the tax base is unaffected by tax rate changes), instead of dynamic analysis (correctly assuming that the tax base changes in response to tax rate changes).

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