Economics

If you must raise taxes …

President Obama is surrounded by plenty of smart economists. And plenty more are just a phone call away. Is no one telling him that he is trying to raise taxes in the worst possible way? I have frequently written why raising capital gains taxes by 60% and dividend taxes by 200% is bad for growth. But raising marginal tax rates on labor income should also be a last resort. E21:

The economic literature is quite clear that increases in marginal tax rates cause households to reduce their supply of investment and labor and result in a smaller economy. The adjustment to higher marginal rates is generally borne through three channels: (1) second earners drop out of the workforce or reduce hours, often due to the increase in the relative cost of child care services; (2) a reduction in the market production of services that could be performed at home, which depresses the demand for the services of housekeepers, mechanics, contractors, painters, and other service providers; and (3) an increase in tax-preferred investments, like municipal debt, rather than more economically productive investments.

More perplexing is the suggestion from some quarters that revenue gained from a limitation on deductions would somehow be less certain than an increase in tax rates. The idea is that if a household is motivated by taxes to take out a bigger mortgage, or opt for more expensive employer-sponsored health insurance (a tax exclusion), then reducing those tax benefits would result in less tax-favored activity, which would mean less revenue than previously supposed. The President has even argued that limitations on deductions could cause charitable organizations to collapse. So the President believes that taxes have no effect on hours worked or dollars invested but charitable contributions are perfectly elastic with respect to marginal tax rates?

This argument has it exactly backwards. Marginal tax rate increases are “riskier” from a revenue perspective because they encourage taxpayers to make greater use of these same deductions to reduce taxable income

If a policy choice has been made to increase the tax revenue collected from high income households, Congress should implement this choice in the least costly way possible. Limitations on deductions offer a mechanism to raise a given amount of revenue in a way that does not discourage an additional hour of work or increase the relative cost of consumption expenditures.

But apparently raising tax rates has talismanic properties for the current administration. Of course, they would argue that paring back or eliminating deductions would not raise enough tax revenue. All the more reason to break out of this tax trap and pursue deep, fundamental reform that would raise revenue and boost economic growth.

8 thoughts on “If you must raise taxes …

  1. The source is from a group that Bill Kristol sits on- who I believe has already caved on the issue.

    Let’s face it, Jim. Taxes are going up, and in the BEST way possible, one which will accrue more to the Federal side while lowering the cost of local taxes.

    Statements like “The economic literature is quite clear” are meaningless.

    You wanted to dance? Now pay the band.

  2. A Rasmussen poll indicates that 66 percent of the public thinks the “middle class” pays a higher proportion of their income in income taxes then “The Wealthy”. A very quick trip to the IRS data site shows that this isn’t even close to being true. If the public can be demagogued into believing a simple fact like this, what possible chance do we have of educating them about more complex matters of economics — especially when they won’t like the answer it provides.

    There is no dearth of information that confirms that the only way you can lose weight is to excercize more and/or eat less. Yet there are billions spent each year convincing people that there is another way.

  3. tell me why getting rid of tax loopholes is not a tax increase also?

    don’t the people affected have to pay more/higher taxes?

    why is that any different than marginal rates?

    • Yes, they would probably pay more total tax, but the amount of additional tax per additional dollar of income would be lower. Decisions are made on the margin, not the average. If I confiscated ALL of your first $100,000 in income, but took nothing after that, your behavior would be very different than if I took 50% of $200,000 of your income — although the tax collected would be the same.

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