Wednesday, February 20, 2013

Tax Hike Doesn't Increase Revenue

Greece has given us the latest example of something that has been obvious to people throughout time. Tax increases do not necessarily increase revenue.  Yes, it is true if tax rates didn't affect people's behavior and if no one took them into account, then increasing tax rates would increase revenue. But taking this logic to its extreme, a tax rate of 100% should bring in 100% of the revenue for the country.

This statement is true only if we consider "legal" revenue.  There are lots of other competing factors in any market (regardless of how much control the government has on it).  People don't work to support the government.  I haven't met one yet.  Warren Buffet and others may say they are not taxed enough, but they aren't beating down the doors of the Treasury department to give their excess money either.  Actions speak louder than words.

There is a cash economy that is completely untouched by federal taxes. This includes the kid who mows your lawn, your piano teacher, and even tipping at some restaurants. These people engage in legal business but don't report the income even though many of them are required to.  There is no way to track this money and the best that we can do is estimate how large it is. All of the estimates I have seen are in the hundreds of billions and in a few are $1-3 trillion (with GDP around $15 trillion, this is a significant amount).  Other than taxes these markets are relatively harmless.

Then there are the various black markets.  Markets of illegal activities. They exist for everything from drugs, guns, prostitutes, child porn, endangered species, etc. People in these markets are not subject to government regulation or the legal system to settle disputes.  They have lots of costs on society.  First, the law enforcement cost to find and prosecute these people, second the harm caused to people unrelated to the markets who are affected since there is no legal structure to insulate them.

Whenever tax rates/regulation changes money will flow to or from these other markets.  At a 100% tax rate, the black market would blossom (and probably involve more barter) and the cash economy would also flourish (although those who formerly received all of their income from this economy may take a significant hit because now nearly everyone would be involved in the cash economy). No one would want to work for "legal" money since they wouldn't keep any of it. So, traditional business would grind to a halt overnight.  This would not be good for the economy.

Changing tax rates (particularly targeted to wealthy people or on voluntary transactions) also can have large effects as their behavior changes. For instance, when the capitol gains tax rate was reduced, more capital gains were taken, so much so that the reduction in tax rate ended up generating more revenue than the higher rate did.  Conversely, luxury taxes on things like yachts did nothing but destroy the yacht building industry.  Sure the middle class and poor don't buy yachts, but they work for the yacht manufacturers.

Governments use a static model for projecting tax revenues. This is wrong.  Sure it would be a lot more complicated to use a dynamic model that actually takes peoples actions into account, but lots of things are difficult and complicated and we still do them.  We put a man on the moon for crying out loud. With slide rules.

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