Marginal Taxes and Incentives

From the Deseret News, February 4th, 2013.

Taxes are in the news lately. French film star Gerard Depardieu announced in December he would be moving from France to neighboring Belgium to avoid an increase in taxes that would've taken 75 percent of any new income he earned. More recently, golfer Phil Mickelson suggested he might leave California to avoid a combined state and federal income tax that takes 60 percent of any new tournament winnings.

And in mid-January, the Sacramento Kings of the NBA announced their intent to move to Seattle. According to Forbes, one of the major reasons for the move is the lack of a personal income tax in the state of Washington, which will benefit both the owners and the players.

Fiscal problems in France, California and around the world in general induce governments to find ways to increase revenues and decrease expenditures. The most obvious way to raise revenues is to increase taxes, but exactly how taxes are raised is of crucial importance.

When tax rates rise too high, overall revenues can actually fall. This insight is often associated with economist Art Laffer, who popularized the notion in the 1980s. He reportedly sketched a diagram on the back of a restaurant napkin that showed tax revenue rising as tax rates rose for low levels of tax, but falling when tax rates rose beyond some threshold level. This relation is now known as the Laffer curve and it undoubtedly holds at the two extremes.

If the government levies a tax of zero percent, it clearly gets zero revenue. On the other extreme, if it levies a tax of 100 percent on income, people will cease earning income. After all, why work if the government is going to take everything you earn? In this case too, the government ends up collecting zero revenue.

The importance of taxes is the incentive effects they have on behavior at the margin. Economists use the term "margin" to refer to the decisions involving just a little more of an activity. Hence, marginal tax rates are the percent of a new dollar earned that is taxed away by the government.

In France, for high incomes this is 75 percent, meaning Gerard Depardieu would keep only 25 cents on an extra dollar of income he earned. For Phil Mickelson, the combined federal and state marginal tax rate is 60 percent. This does not mean Depardieu and Mickelson actually pay 75 percent and 60 percent of their income in taxes, since both the French and U.S. tax systems are progressive and place a higher burden of tax on higher incomes.

The O.J. Simpson case offers a good illustration of the effects of high marginal tax rates. In 1997, Simpson lost a wrongful death suit brought by the families of Ron Goldman and Nicole Brown. The jury's award was large enough that it effectively awarded any future income Simpson would earn to the families of the deceased. This amounted to a 100 percent marginal income tax rate.

Simpson's predictable response was to refuse almost all offers to earn income. In purely financial terms, the families would likely have been better off with an arrangement where O.J. was allowed to keep some of the income he earned.

A problem with progressive graduated income tax systems is that they place a higher marginal rate on people who tend to be the most productive and discourage production of goods and services that could be consumed by others. Hence raising tax rates can significantly depress economic activity.

A flat tax is an alternative tax system that imposes a constant tax rate regardless of income level. Flat taxes are often viewed as regressive since they place the same percent burden on the poor as the wealthy, and this burden is harder for the poor to pay. Interestingly, it is possible to devise a progressive flat tax. For example, a fixed refundable tax credit of $1,000 per person with a 10 percent tax rate would impose no net burden on anyone with an income less than $10,000. At the same time, it would allow any taxpayer regardless of income to keep 90 percent of any new dollar earned.

If our economic goals are to achieve fiscal balance and simultaneously encourage economic growth, it is wise to avoid tax policies that create large disincentives to work and investment.