Yes, this is an important point. Here's an example of counterproductive policy:
I was running the numbers on an $800k inherited IRA and the incentives and consequences generated by the government's requirement that it be cashed out and taxed over the next eight years (instead of over my remaining life).
If I continue working, the government will take more than 40 cents on the dollar from the disbursements of this IRA, a total of $320k; on the other hand, if I retire early instead, the tax bill will be 20 cents on the dollar as my taxable income will be much lower and I'll get to keep an additional $20k/year. The difference is enough to pay for healthcare off the exchange for the eight years of my early retirement until Medicare kicks in. That's a substantial incentive to retire early.
And if I do so, the substantial drop in my taxable income leads to reduced federal, state, and local tax collections from me in excess of $100k per year, or a total of $800k+.
Correction: the healthcare bill under the early retirement scenario would drop as well: I'd save another $100k total over the 8 years of early retirement because about 1/3 of the health care costs would be subsidized. So the government would be picking up another $100k in costs over the eight years.
Total reduced taxes and increased government costs of pushing one family to retire early: $160k + $800k + $100k = $1m+
Geez, wait, we need to add another another $20k in annual reduced taxes to the government as my income wouldn't be subject to social security any more, so another $160k the government doesn't get to collect.
High taxes on people with low marginal propensity to consume reduce savings and investment even when they don't change behavior: Simply by virtue of paying a lot in taxes, they have less money left to save and invest.
This is why things like taxes on wealth or unrealized asset appreciation are especially destructive: They're heavily skewed towards people with low MPC, and thus result in a greater reduction in investment per dollar of revenue raised than taxes on consumption or even income.
I think your view of the world is often that of an overly enthusiastic 1st year econ studen that just learned about supply and demand and the invisible hand and thinks it directly applies to all things, no real-world adjustements needed, people can be accurately modelled as rational economic agents, etc.
But here I think this simple but useful framework would work better than your somewhat contrived "some people are cheap, some corporations are cheap" point. If you increase taxes or regulatory burdens, you decrease the benefit that economic agents (be they individuals or corporations) derive from their economic activity (all things being equal), and as a consequence they lower the amount of energy or money they invest in this activity — they simply do less. The supply curve shifts left!
All nice theory here. Except for the fact that people's behavior does not bear this out and never had. The people who are taxed the very most also work the very most. Your theory has no support. The people with lower tax rates work far less. Those are the actual facts so why are you talking about imaginary theories that are terrible at predicting actual behavior (unless it's to predict the opposite of what the theory says).
I'm always surprised that, in this discussion, marginal utility hasn't come up. The usual pro-tax argument is that the marginal utility of a dollar to a poor person is much higher than to a rich person, so taxes should transfer dollars from rich to poor. The usual objection to this is that you can't compare interpersonal utility. But even if you could, the argument has another gaping weakness.
The problem is that, for rich people, marginal dollars have relatively low utility - but marginal time has relatively high utility; the rich are invariably run off their feet. The fact that they're rich means that a lot of economic activity - multiples of their marginal income - depend on... their decision whether, at the margin, to work or go to their kids' ballgames.
As a society, we want - we NEED - them to work. And offering them money isn't as strong an incentive as it would be for the rest of us (who can't - or don't - create the same kind of economic value with an additional hour of work). So, BECAUSE marginal dollars have relatively low utility to them, taxing them can be disproportionately expensive to the rest of us.
In other words, the marginal tax rate on the rich should probably be - I hate to say it - lower than it is for the rest of us.
It's not just a problem of earning less and doing less though. Even if a rich person is willing to bear an additional burden, their loss of income implies that in the near future they will have to (1) reduce their consumption expenditures, (2) reduce their investment expenditures, and/or (3) reduce their cash balance.
Of course, the government and its beneficiaries get to use additional tax revenues to increase their expenditures and cash balances, but the situation isn't symmetrical with respect to investment expenditures. Whenever a government attempts to "invest" in its own production, or in subsidies of private production, it is not being guided by profit-and-loss considerations, and often in the absence of price information altogether. Governmental "investment" lacks any meaningful market test of its fitness for maximizing consumer utility.
A key point that even many mainstream economists fail to grasp is that private thrift doesn't merely supply the financing for investment expenditures, it also furnishes the labor and other factor inputs needed for lengthening the time lag available for transforming inputs into outputs by restraining present consumption, thus enabling producers to take advantage of additional opportunities for boosting factor productivity. It is bad enough that high income tax rates deter private thrift, but the diversion of incomes towards the government consumes whatever savings are available.
Soaking the rich isn't the only source of this problem. Nowadays, printing fiat money and handing it out as entitlements is the more common fiscal procedure, but note that reducing real pre-tax interest rates and promising future old age benefits, etc. also deters thrift, while deficit financing also consumes the available savings. In fact, the empirical data over the past sixty years show that increases in the GDP share of government (which is almost entirely due to increases in Social Security and Medicare) come entirely at the expense of private investment, not at the expense of private consumption. It is the spending (especially spending on entitlements), not the tax rates, that has inhibited growth and reducing capital intensity of the economy (with all its negative consequences for productive sector workers and others not on the fiat money gravy train).
Yes, this is an important point. Here's an example of counterproductive policy:
I was running the numbers on an $800k inherited IRA and the incentives and consequences generated by the government's requirement that it be cashed out and taxed over the next eight years (instead of over my remaining life).
If I continue working, the government will take more than 40 cents on the dollar from the disbursements of this IRA, a total of $320k; on the other hand, if I retire early instead, the tax bill will be 20 cents on the dollar as my taxable income will be much lower and I'll get to keep an additional $20k/year. The difference is enough to pay for healthcare off the exchange for the eight years of my early retirement until Medicare kicks in. That's a substantial incentive to retire early.
And if I do so, the substantial drop in my taxable income leads to reduced federal, state, and local tax collections from me in excess of $100k per year, or a total of $800k+.
Correction: the healthcare bill under the early retirement scenario would drop as well: I'd save another $100k total over the 8 years of early retirement because about 1/3 of the health care costs would be subsidized. So the government would be picking up another $100k in costs over the eight years.
Total reduced taxes and increased government costs of pushing one family to retire early: $160k + $800k + $100k = $1m+
Geez, wait, we need to add another another $20k in annual reduced taxes to the government as my income wouldn't be subject to social security any more, so another $160k the government doesn't get to collect.
Total loss to government: $1.2m+.
Call me crazy, but I’m starting to think you should retire early.
You're not crazy. But that also means forgoing income. The government doesn't take all of it :)
Had I but a bit more stashed away, it'd be a no brainer.
High taxes on people with low marginal propensity to consume reduce savings and investment even when they don't change behavior: Simply by virtue of paying a lot in taxes, they have less money left to save and invest.
This is why things like taxes on wealth or unrealized asset appreciation are especially destructive: They're heavily skewed towards people with low MPC, and thus result in a greater reduction in investment per dollar of revenue raised than taxes on consumption or even income.
Bryan,
I think your view of the world is often that of an overly enthusiastic 1st year econ studen that just learned about supply and demand and the invisible hand and thinks it directly applies to all things, no real-world adjustements needed, people can be accurately modelled as rational economic agents, etc.
But here I think this simple but useful framework would work better than your somewhat contrived "some people are cheap, some corporations are cheap" point. If you increase taxes or regulatory burdens, you decrease the benefit that economic agents (be they individuals or corporations) derive from their economic activity (all things being equal), and as a consequence they lower the amount of energy or money they invest in this activity — they simply do less. The supply curve shifts left!
All nice theory here. Except for the fact that people's behavior does not bear this out and never had. The people who are taxed the very most also work the very most. Your theory has no support. The people with lower tax rates work far less. Those are the actual facts so why are you talking about imaginary theories that are terrible at predicting actual behavior (unless it's to predict the opposite of what the theory says).
You make a good point. Unfortunately, our host rarely reads comments, so he is unlikely to see it. Maybe you should email him directly.
I think he is oversimplifying a bit. Earning or doing less is not the only way to respond defensively to tax increases.
I'm always surprised that, in this discussion, marginal utility hasn't come up. The usual pro-tax argument is that the marginal utility of a dollar to a poor person is much higher than to a rich person, so taxes should transfer dollars from rich to poor. The usual objection to this is that you can't compare interpersonal utility. But even if you could, the argument has another gaping weakness.
The problem is that, for rich people, marginal dollars have relatively low utility - but marginal time has relatively high utility; the rich are invariably run off their feet. The fact that they're rich means that a lot of economic activity - multiples of their marginal income - depend on... their decision whether, at the margin, to work or go to their kids' ballgames.
As a society, we want - we NEED - them to work. And offering them money isn't as strong an incentive as it would be for the rest of us (who can't - or don't - create the same kind of economic value with an additional hour of work). So, BECAUSE marginal dollars have relatively low utility to them, taxing them can be disproportionately expensive to the rest of us.
In other words, the marginal tax rate on the rich should probably be - I hate to say it - lower than it is for the rest of us.
It's not just a problem of earning less and doing less though. Even if a rich person is willing to bear an additional burden, their loss of income implies that in the near future they will have to (1) reduce their consumption expenditures, (2) reduce their investment expenditures, and/or (3) reduce their cash balance.
Of course, the government and its beneficiaries get to use additional tax revenues to increase their expenditures and cash balances, but the situation isn't symmetrical with respect to investment expenditures. Whenever a government attempts to "invest" in its own production, or in subsidies of private production, it is not being guided by profit-and-loss considerations, and often in the absence of price information altogether. Governmental "investment" lacks any meaningful market test of its fitness for maximizing consumer utility.
A key point that even many mainstream economists fail to grasp is that private thrift doesn't merely supply the financing for investment expenditures, it also furnishes the labor and other factor inputs needed for lengthening the time lag available for transforming inputs into outputs by restraining present consumption, thus enabling producers to take advantage of additional opportunities for boosting factor productivity. It is bad enough that high income tax rates deter private thrift, but the diversion of incomes towards the government consumes whatever savings are available.
Soaking the rich isn't the only source of this problem. Nowadays, printing fiat money and handing it out as entitlements is the more common fiscal procedure, but note that reducing real pre-tax interest rates and promising future old age benefits, etc. also deters thrift, while deficit financing also consumes the available savings. In fact, the empirical data over the past sixty years show that increases in the GDP share of government (which is almost entirely due to increases in Social Security and Medicare) come entirely at the expense of private investment, not at the expense of private consumption. It is the spending (especially spending on entitlements), not the tax rates, that has inhibited growth and reducing capital intensity of the economy (with all its negative consequences for productive sector workers and others not on the fiat money gravy train).