November 4, 2010
Soak-the-Rich Taxes: Fail!
by Robert P. Murphy on November 4, 2010
This week’s episode of 60 Minutes featured a 13-minute segment on “taxing the rich” in order to cure the government’s debt problem. In addition to being an outrageously biased story, the coverage was filled with more economic fallacies than I can address in a single article.
“Progressive” Income-Tax Codes Lead to Volatile Revenues
In the opening moments of the segment, correspondent Lesley Stahl explains that “eight states have increased so-called millionaire income taxes so far as a way of avoiding drastic budget cuts.”
Of course, many readers of Mises.org really mean it when they say theft is wrong, and that a majority cannot justly take an individual’s property, even if they plan on doing something nice with it. On this score, raising taxes is wrong for purely ethical reasons. Unfortunately, most Americans don’t endorse this way of thinking, and so, in the present article, I’ll focus on pragmatic arguments.
In the first place, Stahl had to use the qualifier “so-called millionaire income taxes” because not all of the high surcharges kick in at that level. According to this compilation, only two states — California and Maryland — actually have a bracket for people making at least $1 million. The term in practice simply means a high tax rate for people earning big incomes. For two examples, Connecticut’s income tax has three brackets: 3 percent on incomes below $10,000, 5 percent on incomes between $10,000 and $500,000, and 6.5 percent on incomes above $500,000. New Jersey has a similar state-income-tax code, with the first five brackets jumping modestly up through $75,000 in income, but the sixth and highest tax rate kicking in at $500,000.
To be sure, someone making, say, $550,000 per year is not on the verge of starvation. Yet it’s not clear that such a person is a “millionaire” either, especially if he is young, has kids, and works in a big city with a high cost of living. The very term “millionaire tax” — which conjures up landed aristocrats who sip martinis on their yachts instead of going to work every day — is misleading.
Beyond the deceptive terminology, the policy of “socking it to the millionaires” actually exacerbates the boom-bust cycle in state-government revenues. As I explain in this policy paper, what are called progressive income-tax codes increase the volatility in revenues. During boom times, people in a state tend to earn higher incomes. But with a progressive (or graduated) tax code, the revenues flowing into state coffers increase more than proportionally. This is because the average taxpayer is earning a higher income and is paying a higher proportion of it in taxes.
On the other hand, revenues tend to crash much harder during recessions in those states that rely on steeply graduated income taxes. Not only are taxpayers in the state earning a lower income, but many of them slip into lower brackets and hence pay a lower percentage as well.
Democratic governments are notoriously short-term in their planning. During the boom times, when state coffers are overflowing with revenues, the state legislatures ramp up spending programs. When the bottom falls out during the next slump, the legislatures are caught in a difficult position. It is no coincidence that California and New York — states with very progressive income-tax codes — also have recurring difficulties in balancing their budgets.
Bill Gates Sr. Needs to Study More American History
At the 4:30 mark of the interview, Stahl explains that Washington State is one of the few without any income tax. Proposal 1098, crushed 2 to 1 at the polls, would have placed a 5 percent tax rate on individuals earning more than $200,000 ($400,000 for couples), and a 9 percent rate on individuals making $500,000 ($1 million for couples). Again, note the rhetorical trick: earlier in the piece, Stahl focused on how many millionaires and billionaires would be hit by the tax. The innocent viewer would be surprised to learn that the tax kicks in at $200,000.
To drive home the point of how modest this piddling tax increase is, Stahl then asks Bill Gates Sr. — a very public proponent of Proposal 1098 — what a couple earning $500,000 would pay. When the father of the software guru explains it would be a mere $5,000 (that’s 5 percent of the $100,000 above the $400,000 threshold), Stahl is amazed at the low tax liability.
Washington State voters — unlike Bill Gates Sr. — apparently learned their lesson from American history.
Back when the federal income tax was instituted in 1913, Americans were also promised that it would forevermore remain a slight irritant to the super wealthy. Initially it imposed a mere 1 percent tax on those making under $20,000, and a top rate of 7 percent on those making more than $500,000 — a fantastic sum in those days.
Yet in 1917, a mere four years later, the bottom rate had doubled from 1 percent to 2 percent. Someone in the $500,000 bracket now faced a tax rate of 54 percent. And the highest bracket, applicable to incomes exceeding $2 million, faced a tax rate of 67 percent. (The history of federal income-tax rates is available here.) Needless to say, Americans would not have agreed to a federal income tax in 1913 had they realized what the politicians would do with it.
Spending Cuts Impossible?
In order to demonstrate the “necessity” of massive new taxes on the wealthy, Stahl interviewed former Reagan Office of Management and Budget Director David Stockman, as well as Washington State Governor Chris Gregoire. The message from Stockman was that spending cuts are politically impossible, because neither Republicans nor Democrats have the courage to tell voters no. For her part, Governor Gregoire argued that cutting spending to close her state’s deficit would mean heartless cutbacks in crucial services.
In their interview, Stockman and Stahl share a laugh over irresponsible politicians who merely “kick the can down the road” instead of facing tough realities. This is rather ironic, since Stockman’s own “solution” is at best a temporary stop-gap measure. The federal debt exploded under the Reagan years not because the government was starved by tax cuts; on the contrary, federal revenues (in nominal dollars) almost doubled during the 1980s.
“It is no coincidence that California and New York — states with very progressive income-tax codes — also have recurring difficulties in balancing their budgets.”
Likewise, federal revenues were 25 percent higher when George W. Bush left office than when he was first elected. So what makes Stockman think that DC politicians would suddenly become committed to a perpetual balanced budget — let alone long-term surpluses — now? If Stockman’s confiscatory proposals go through, it would merely keep the game afloat for a few more years. With the massive influx of new revenue, the politicians would jack up spending more than they otherwise would.
The only true solution to the federal and state fiscal crises is to cut government spending. Governor Gregoire can pretend that this would return people in her state to the Dark Ages. In reality, the total operating and capital budget for Washington State grew from $53.5 billion in the 2003–2005 budget period to $68.5 billion in the 2007–2009 budget period. That 28 percent growth over a four-year period works out to a growth in spending of 6.4 percent per year. Now some of the increase could be blamed on price inflation, and some on population growth, but even so, Washington State could trim its spending merely by returning to its budget of a few years ago.
People who are concerned about the genuinely needy should keep in mind that government doesn’t create resources, it merely takes money from one group and hands it to another. In the process, the government actually makes the total pie smaller, because of the disincentives of taxation. If the government reduced its parasitism on the productive classes, then private charitable giving would increase. And let’s be honest — state governments have plenty of ways to cut down on their spending.
Thinking on the Margin
Tax hikes on “the rich,” especially at the state level, are not nearly as effective at raising revenue as most people think. High-income earners and businesses really do take into account a state’s tax policies when deciding where to locate. It’s true, any particular individual might not sell his house and leave just because of a new tax. But on the margin, a new tax will push more people over the edge. (Or, going the other way, a new tax hike will deter people from moving into the state who otherwise would have.)
In the aggregate, with millions of people moving within the United States each year, the effects of differential tax codes add up. To see a particularly striking illustration of this phenomenon in the case of California — which surprised even me as I compiled it — see figure 4 (page 11) of this paper.
In the 60 Minutes piece, Stahl tries to trap one of the representatives of the antitax position. (To repeat, the entire segment is incredibly biased: Stahl lobs softballs to the famous protax people, and paints the two unknown antitax guys as foolish and greedy, respectively.) When the businessman argues that jobs would be lost as some firms relocate to other states, Stahl asks him which states? Since some of his answers involve states with their own income taxes, Stahl thinks she’s caught the guy in an absurdity.
Yet this is silly. As the businessman responded, each state has its own competitive advantages and disadvantages. For example, there are plenty of reasons a very productive individual would want to move to California. But one major disadvantage is its top state-income-tax rate of 10.55 percent. People might move to Washington, rather than California, because of this difference. But take that advantage away from Washington, and more people would be inclined to favor California with all of its other perks.
To see how silly Stahl’s rhetorical strategy is, suppose Nicholas Cage is reading a part for an action script. He loves it, and tells his agent to jump on it. The producer offers Cage $1 million to play the leading-man role. Cage insists that his agent ask for $2 million.
The agent tries to talk him down, explaining that at such a high price tag, the producer will look elsewhere. “What other actor could they pick?” Cage demands to know. The agent throws out names like Tom Cruise, Brad Pitt, Robert Downey Jr., Will Smith, and Daniel Craig. Cage dismisses this notion as absurd, because after all, some of those actors insist on being paid more than $1 million themselves. Therefore it is inconceivable to Cage that he could lose the part if he insists on more money.
The flaw in Cage’s (hypothetical) logic is that he thinks movie producers care only about money. On the contrary, there are all sorts of factors they must consider when picking a leading man for an action role. Not every movie casts the biggest star in Hollywood, because the biggest star commands the highest paycheck. Obviously, some producers opt for actors who will draw in smaller crowds, but they do this to contain their own expenditures.
The situation is analogous when it comes to state income-tax rates. Any particular individual — especially a business owner — decides where to locate for a variety of reasons, including the location of family, love of certain weather, and proximity to cultural activities. But not everyone moves to California or New York. Some people settle for “less cool” places, because of the savings in taxes.
For those who believe in private-property rights, soaking the rich is an immoral policy. But it is also economically counterproductive. The federal and state governments won’t solve their fiscal problems until they cut spending. At best, confiscating more from the wealthy will simply postpone the day of reckoning.
 In fairness to those excoriating “irresponsible tax cuts for the rich,” we should note that federal revenues were lower during the first Bush term than when he first came into office. But by his second term, there were clearly plenty of revenues flowing in, so that the deficits were the fault of spending.
 To see Washington State’s expenditures, go to this link and select “Statewide Summary” under the heading “Biennial Expenditures” on the right-hand side.