A central aspect of the policy debate underneath both the impending fiscal cliff and taming the federal debt is the role of higher marginal tax rates in raising revenue.  This short paper reviews the logic showing the damage from high marginal tax rates.   

 

There are four basic lessons:

• Higher marginal tax rates make the economy progressively less productive;
• Higher marginal tax rates trump consumers ability to send market signals;
• Unequal and high marginal tax rates harm lead to the misuse of workers, capital, and technologies; and
• Revenue is best raised with the lowest rates and broadest base possible.

 

High Marginal Tax Rates Make the Economy Less Productive

 

Higher marginal tax rates stop productive investments.  Suppose that in the absence of taxes, it takes a 10 percent return to cover maintenance, depreciation, and the cost of raising funds.  A 10 percent tax rate would require a pre-tax return of 11.1 percent in order to pay tax, and then meet the other investment factors.  However, as the marginal tax rate rises, the impact becomes progressively larger as shown below.

 

 

It might be relatively easy to identify projects that provide 11, 12, or even 17 percent returns.  But eventually, higher marginal tax rates will eliminate large amounts of feasible investment, lower the productive capacity of the economy, and damage employment, income, and the standard of living.

 

The same kind of damage occurs if marginal tax rates are not even across the economy.  Suppose that investments in the untaxed sector yield 10 percent, in the taxed sector yield 15 percent, and the marginal tax rate is 40 percent.  Looking at the table above, the yield in the taxed sector is not high enough to attract capital; it is better for dollars to flow to the untaxed sectors. 

 

Clearly this creates winners (untaxed activity) and losers (taxed activity).  But it is a loser for the economy as a whole because the taxes cause the economy to lose an investment that yields 15 percent in favor of one that only produces 10 percent.  The loss is 5 percent per year as far as the eye can see.

 

The example is far from hypothetical, as different rates of tax exist for state-local investments (exempt from tax), corporation investments (double-taxed), housing investments (subsidized by the tax system), and so forth.  A tax system with more uniform and lower marginal rates would be more productive.

 

The impact of taxes extends far beyond the decision to buy equipment or build a warehouse.  All across the economy there are investments in innovation, new technologies, schooling, and other ways to acquire skills.  Each day individuals must decide whether to invest their precious time in work or other activities.   

 

The upshot is that high marginal tax rates have a damaging impact on investment, the competition for investment funds, saving, household portfolios, schooling decisions, the decision of one or both spouses to work, the hours of work, the intensity of work, that decision to pursue a promotion, and myriad other economic decisions.  In each case, progressively higher tax rates have increasingly large damage.

 

High Marginal Tax Rates Trump The Will of the Consumer

I love Twizzlers – especially the re-sealable, 2-pound pack.  But if they were suddenly a $5 tax per bag, I’d be eating Skittles in a heartbeat.  Notice two important things about this tax policy: (1) it collects no revenue from me, because I switch to Skittles, and (2) it still makes me worse off, because I prefer Twizzlers to Skittles in the absence of the tax. 

 

Now, suppose that the Twizzler tax starts at $0.10 cents on the first bag and rises by $0.10 per bag purchased each year.  I’d certainly eat the first bag, the second bag, and would probably start thinking hard about the 30^th bag and quit after 35 bags.  In this case, I’d be worse off in two ways.  First, the tax would raise $63.O0 from me.  And second, I’d still be forced to switch to Skittles for February to December. 

 

Not everyone is as crazy about Twizzlers as I am. Some would exit the market at a $0.10 tax because they are essentially indifferent between Twizzlers and other nutrients.  Still others would exit at $0.50 because they see real dietary advantages to Twizzlers, but at some point the tax drives them to an inferior alternative.  And so forth. 

 

Why does that matter?  It means that at low marginal tax rates ($0.10) there is little revenue extracted from the private sector, and only minor damage to the households’ preferred arrangements of economic affairs.  But at high ($3.50) marginal tax rates there is both a lot of income taken from household and there substantial damage done to those who place a very high value on eating Twizzlers.

 

The latter point has an important corollary: if you can raise the same revenue with higher versus lower marginal tax rates, the latter are preferable because they do the least tax-induced damage to the tastes, purchases, work, saving and other decisions of households.