Top Tax Rate Fallacies

It looks like we have a deal on taxes for the next two years. While the long term deficit will need to be dealt with sometime in the intermediate term, the deal provides some policy stability on income tax rates, produces a reasonable compromise on the estate tax and creates some legitimate short term stimulus in the form of a payroll tax cut and extension of unemployment benefits. Overall, I view this to be a good deal that will stimulate the economy short-term and set up a debate on long term spending and taxes for the 2012 election.

I am someone who believes that in general the private sector is better at allocating capital (with some spectaular exceptions, like the housing boom) and that government spending and incentives can often create vast distortions in the allocation of capital (like the government policies that encouraged the housing boom). I also believe in the wisdom in the electorate as a whole. The people want a real debate over tax and spending priorities.  It is the politicians at the Federal level aren't yet mature enough to have that discussion.  In the meantime, I'd rather keep taxes low.  Evnentually we need to figure out the right level of spending, and then figure out how to generate the proper revenue to support that level of spending, preferably with some sort of overhaul that improves our competitive position internationally.

That overarching political/strategic argument aside, many of the arguments I hear from conservatives on TV supporting an extension of the top tax rate are pretty weak economically.  Below I discuss a few of these:

  • Tax hikes will hurt small businesses – It is true that most small businesses file taxes effectively as individuals. While it's hard to pinpoint the exact figure, somewhere between 50 and 97 percent of all small businesses would be unaffected by the tax rate change. Even if a small business is affected by the tax rate hike, that won't affect how they hire since employee salaries and benefits are tax-deductable. If anything, it would encourage the business owner to work less hard and hire employees instead.  (I'm not saying that's a good thing, just economic logic.)  Higher taxes would reduce the cash available to make business investments, but that too gets deducted from taxes over time, as would the interest used to finance the investment.
  • Tax hikes will hurt savings and investment – On the margin, reductions in the top rates do result in additional private capital to be available for private investment.  The problem is that tinkering with marginal tax rates only indirectly encourages savings and investment. Such tax cuts directly increase only the reward on investing.  More efficient would be to directly encourage savings and investment themselves. Make savings itself tax deductible and/or allow for the immediate expensing of business investment. Or replace the payroll tax with a consumption tax to reward work while discouraging consumption.
  • Tax hikes will hurt savings and investment (part II) – In addition, if tax rates are cut but not offset with spending cuts, any increased investment must flow into Treasury securities to finance the deficit. Thus no new net private investment is actually created. If the increased number of treasuries are purchased by investors abroad, by accounting identity the amount adds to the trade deficit.  The increased trade deficit directly reduces GDP, offsetting any increase in domestic investment.

It's time for this country to move past empty slogans and work together for the long term vitality of the country. I'm not encouraging tax hikes…just a mature, realistic conversation about taxes and spending.

One thought on “Top Tax Rate Fallacies

  1. These fallacious arguments are necessary because it is politically unfeasible for most politicians to go after the true spending problems: Boomers (medicare, social security) and defense.
    It is a general axiom in the US that young people are liberal and old people are conservative. This has a lot to do, I think, with the influence of our teachers.
    But if the old start to pull our economy down, could this trend reverse?


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