But Hardly Anyone Pays it

Since World War II the standard reply to anyone proposing to cut a particularly high tax has been “but hardly anybody pays it.” John F. Kennedy looking at the then top rate of 91% was told not to worry about such a high rate because nobody paid it. The people pointing this out were absolutely correct. As Arthur Laffer showed with his “Curve” A graph running from 0 to 100% tax rate will raise no revenue at either extreme. Clearly 0 tax raises 0 revenue but people will do virtually anything rather than just giving all their hard-earned income to the government at 100%.  It made sense then at hide it, legally or not, or maybe only work to the level of a reasonable tax rate and no more. At 91% then it made perfect sense to write off all “expenses”  you could. Business people found ways to have their companies pay for everything from autos to country club memberships. After all the $1,000 of marginal income at the top rate meant you kept only $90. The investment industry found investments with 90-100% write-offs in the first two years.  These were structured so the investment would have a 0 cost basis and when eventually sold would pay only the capital gains tax then at 25%. Limited partnerships for high write-off endeavors such as Oil Drilling, Angus  Bull breeding and planting Pecan trees flourished.  After all, even if the investment was a loser and returned only $2 out every three invested you still came out. Out of your $1000 invested you only got back $675 on which you paid 25% capital gains tax netting $506.25.  A crummy investment to be sure but remember if you paid the tax rather than investing  you would’ve retained only $90.  Looked at from this prospective the investment returned more than 5 times as much. Even at lesser but still high brackets these kind of numbers led to capital moved diverted into mediocre or worse investments. Is this what any reasonable person want for this $1000? The high tax raised little or no revenue but caused vast sums to be into poured into poor or unproductive investments.  JFk and Reagan realized the waste entailed in avoiding confiscatory taxes caused a loss to the economy and worked to lower rates.

Look at the inheritance tax.  Again few pay it but only because many take strong measures to avoid it. Well off  people set up insurance or other exotic trusts that  like the limited partnerships above are expensive and may make little sense economically but given the high tax. prove irresistible.  Maybe just as bad, people with farms or businesses that would be better off sold in their lifetimes hold on to avoid being taxed twice. Picture an aging business or farm owner whose heirs have no interest in continuing in his or her venture. If this person sells he or she pays a capital gains tax and upon passing away maybe the next year the estate pays inheritance tax on the proceeds.  Better to pay only once even if it’s the wrong thing economically.  As we can see it’s not the actual money paid under high taxes that’s destructive, it’s the actions they provoke to avoid them.

What is a high tax can be comparative.  Our corporate tax at a combined federal and state 40% is among the highest in the world  and this again causes actions that wouldn’t normally considered economic. Profits stashed overseas and mergers with corporations in lower tax countries leading to an exodus of corporate headquarters to tax friendlier  nations are the norm. If it weren’t for the high tax little or none of this would be considered by the companies, but given the tax situation it’s a no-brainer. A self-inflicted wound that again doesn’t raise much revenue in relation to the harm done.

We should realize the purpose tax policy is to find the sweet spot on the Laffer Curve between 0 and 100% that actually yields the greatest amount of revenue. Just raising or lowering rates willy-nilly gives us little basis to estimate revenues. This is akin to pricing in the marketplace. You can have a high mark up on a product which if sold gives a great profit. The problem is if it doesn’t sell or sell few units you get little or nothing. Same with high taxes when nobody pays. Conversely some taxes can actually increase revenue when reduced. When under Clinton, the Capital gains Tax was lowered from 28 to 20% in unlocked frozen capital leading to a revenue gusher. Apparently a move to investments with better prospects looked better at 20% than 28%.  Lots of transactions at 20% in place to few at 28% yielded a lot more revenue. Richard W. Sears of Sears Roebuck fame understood moving a lot more units at a lower profit margin could yield a better bottom line than selling few units at a high margin. In 1997 everyone won. This contributed mightily to our last balanced budget. The government received more revenue and capital moved to perceived more profitable investments. Maybe we would be better served if marketing people made tax policy rather than bean counters. At least they’re attune to how people react in different circumstances and stimuli.

 

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