So Do More Taxes Really Mean More Tax Revenues?

Whenever a government proposes to cut spending to fill a budget shortage, it seems guaranteed that you’ll hear protesters object that we ought to raise taxes to fill the gap, rather than defund our programs and lay off government employees. Such proponents usually carry one dangerous presumption into this discussion. It seems common to believe that an increased tax rate will bring in new revenue proportionally to the increase. If, for instance, a tax of twenty percent on an industry with a billion dollars in profits brings in two hundred million in revenues, raising it to thirty should bring in three hundred. In believing this, we overlook an age-old observation regarding the relationship between tax rates and tax revenues.

Economists have observed since nearly the beginning of the profession that taxation disincentivizes the taxed activity. All economic activity involves risk, and investors are willing to take risks only for the sake of profit. While governments have always believed they should have a share of your profits, they haven’t (historically) been keen on the idea that they should share in your risk and bail you out if your business goes under. Decreased opportunity for profit at the same level of risk tends to cool some businessmen from taking that risk at all. Now if someone closes shop on account of this skittishness, he won’t make any taxable profits selling taxable merchandise. From this we conclude that higher tax rates decrease the amount of transactions that can be taxed.

That conclusion has great significance for tax revenues, because tax revenues are equal to the tax rate times the total value of the taxed transactions. Accordingly, if raising the first value lowers the second value, at a certain point tax revenues will hit their maximum possible level and indeed begin declining if taxes rise above it. A tax above that point is called a prohibitive tax, and lowering such a tax will counter-intuitively increase overall tax revenues. Ibn Khaldun was probably the first man to write about this in the fourteenth century, but after Arthur Laffer raised this objection regarding Ford’s tax increases to a couple of Ford’s staffers (Rumsfeld and Cheney, incidentally) a Wall Street Journal coined the term that stuck: the Laffer Curve. There are four consequences of this that I want to touch on.

First, if you need to raise a certain amount or revenue, you cannot calculate the necessary tax hike based on the presumption that the transactions being taxed will still occur at the same rate as they did at the former tax rate. With a smaller tax base, your new taxes will certainly bring in less money than projected, and if tax rates become prohibitive, tax revenues will actually decline.

Second, if you intend to lower taxes, it will not cost you as much revenue as you project, and may even increase it if your taxes are prohibitive. Now on this point, it needs to be noted that if an economic downturn coincides with your tax cuts, you may find yourself in deficits worse than projected. Such was the case when the Bush tax cuts coincided with the general economic malaise of the better part of the last decade. However, this needs to be blamed on the downturn, not the tax cuts, since the higher rates, especially of the capital gains tax (tax on sale of stock, among other things), would certainly have scared away even more investors had they remained. When pundits argue that the deficits would be such-and-such an amount lower without them, they’re presuming the economy would not have fallen to even lower levels with them. Had the taxes remained where they had been, they would have still brought in extra revenue, just not as much as is often projected. This seems also to be a good place to point out: contrary to some who use the Laffer Curve to defend every tax cut, not every tax cut will increase revenues or be deficit neutral. This only occurs if taxes are lowered from above the point where tax revenues have been maximized. The US is probably not near this point at the moment. Nonetheless, at any point cutting taxes will increase the taxable income, such that at least some portion of the cost of the tax cut will be offset.

Third, if you are seeking a tax hike to fund social programs, you must be careful that the programs you pay for do not create more victims than they help. While tax increases suffer from diminishing returns, such that every one percent increase to the tax rate raises revenues less than the one before, the accompanying contraction of the economy puts more and more people in need of such programs. It is possible, depending on many factors, that an increased tax rate causes unemployment to rise and wages to fall to the point where your tax is harming the standard of living more than your program is helping it. This is certainly not a guaranteed consequence, but it’s a possibility, and it’s one I’d like progressives to investigate thoroughly before advocating the need for a new tax.

Fourth, if your tax only targets one specific kind of income or transaction, especially tax on goods that are regarded as non-essentials, it is least likely to approach anywhere near its estimated revenue. People will most likely choose to find alternative kinds of investments or transactions that aren’t subject to the tax. For instance: historically income has been taxed, but employer based health insurance hasn’t. For this reason, most employees try to get their insurance direct from employers, thus avoiding the need to pay income tax on that part of their wages. Now congress wants to get sixty billion dollars over ten years by taxing employer provided insurance plans worth over $10,200. If history is any indication, workplaces with such a plan should be rolling out new $10,199 plans any time now to avoid that tax, and the sixty billion dollars will never materialize.

Now, a caveat. There’s no simple formula for computing the point at which revenues have been maximized. Accordingly, this is somewhat difficult to put into practical use. Nevertheless, it remains a warning which we need to hear often when we determine our tax policy: tax rates and tax revenues have a complicated relationship and it is not easy to project the latter from the former.