Now it’s officially out: Joe Biden wants to tax the rich and use the money to pay for all kinds of middle and working class programs and benefits. This is his third giant spending proposal in his first 100 days—this following the COVID-19 relief plan and the infrastructure plan.
His speech last night wasn’t super heavy on the taxing details, but the new spending was laid out pretty clearly: education, childcare, and various other programs and credits to help raise families and assist the needy and elderly.
Because President Biden didn’t talk enough about taxes (yes, I said it) there will be a lot of push back about how taxing the rich will hurt the economy.
And it’s all a load of nonsense.
This was my field of study for my PhD, but I’ll try not to muddy this up with technical economist ramblings. To be clear, I am not saying taxes cannot be too high: they can. What I am saying is that the level of taxation Biden is talking about is not going to hurt the economy.
To understand this debate you first need to understand the Laffer Curve. I promise this isn’t technical; it was—or so the legend goes—drawn on a napkin at a dinner by economist Arthur Laffer, who would go on to help President Reagan design tax policy. The Laffer curve is just a simple graph that looks like this (I apologize in advance for the economist quality penmanship):
The concept is simple enough: for any given tax rate the government can raise a certain amount of revenue. However, if taxes get too high people won’t care about working hard because the fruits of their labors don’t match their effort when too much money is taken in taxes. So, at some tax rate we hit an apex where a higher tax rate actually raises less revenue because people work less. I haven’t talked to any economists who disagree with the concept. Yes, if you really want to get technical we wouldn’t see $0 revenue at a 100% tax rate. The Soviet Union proved this, and, at the same time, proved that a 100% tax rate is a terrible idea—so, let’s not get picky. We are talking about a napkin drawing after all.
The correlation to the economy is pretty simple. People either spend or save 100% of their non-taxed income. The government spends 100% (or lots more in recent years) of the income it taxes. So the economy will grow at its fastest pace below the apex, because everyone will work the highest number of hours they are willing to work.
The people who are really worried about higher taxes on the rich think the Laffer Curve looks like this:
You’ll notice this time I put in tax rates on the X axis. This is because, according to Laffer and his group, the optimal tax rate is in the mid 30 percent. So, any higher tax rate—like those proposed by Biden—will raise less revenue and hurt the economy. They also make the argument that cutting taxes will increase economic growth because people will do better things with their money than the government will.
Both of these claims are contradicted by data and a majority of economists (including me). I’ll start with the second claim, then get back to my magnificent drawings.
It makes a lot of sense to think, “private people know how to spend money better than the government, so letting them keep more of their money will help the economy grow.” The only problem is that, as much sense as this makes, it isn’t true. There really isn’t a strong correlation between the tax rate and the economic growth rate in either direction.
There is a good argument to make that the quality of growth might be different. For instance, if I keep more of my money that would ensure more growth for the golf industry; whereas the government taxing more of my money ensures more growth for infrastructure or education. But, the level of growth itself does not really seem to be effected.
You might remember, about a decade ago, California raised taxes at the same time Kansas cut them (Laffer helped design these tax cuts). The Kansas cuts were extreme, and a lot of folks thought Kansas would explode with growth and California would collapse. The opposite happened, because there is no real correlation between tax rates and growth.
Now, back to my soon-to-be million dollar NFTs.
Laffer and those in his group insist the ‘correct’ tax rate is in the mid 30 percent range. The best I can tell, they take this number by using a really old study that had terrible data: just three categories and a very small number of observations. For some reason, they aren’t interested in updating their information with newer data.
The best evidence, based on modern data, leads the majority of independent economists to think the apex is actually somewhere in the 70 percent range.
To be very clear: most economists are not saying that taxes on the rich need to be 70%. In fact, I think most would agree that is far too high. What this is saying is that the negative impacts do not take place until that rate.
The other thing to remember about income taxes in the United States is that they are marginal rates, not average rates. With average rates, the tax you pay is your tax bracket * your taxable income. So, if you are in a 30% tax bracket, 30% of your total taxable income is taken in taxes. But, this is not how the income tax works.
With marginal rates the bracket you are in is the amount of tax you pay on the next dollar you earn. So, in the United States (single filers), everyone pays 10% in taxes on their first $9,875 in taxable income. Then they pay 12% for dollars $9,876 through $40,125. The 12% does not apply to the first $9,875 just because you made more than that. Here is a good breakdown if you want to see how this works.
The point I’m making is that raising taxes on someone making more than $400,000 does not increase their taxes at all on the first $399,999 in taxable income. What this does is move their tax payment for every dollar over $400,000 up from 37% to 39.6%
The same marginal rate of 39.6% would also apply to all long term capital gains over $1,000,000 in Biden’s plan. Because the wealthy make most of their income though capital gains, rather than through labor income, this is where the proposal is likely to raise the most revenue.
Now we can move away form the economics and into the behavioral stuff—what most people call “the fun part”.
The Laffer lovers will argue that this will disincentivize investment, and people won’t be able to create jobs. This is, again, not supported by data.
Disincentivizing investment — let’s look at a generic, small dollar venture capital investment. Suppose your buddy comes to you and offers you a one percent share of ownership in a company he is starting for $250. You feel like the idea is good, but it’s risky. If you were able to put numbers on it, let’s say there is a 50-50 chance of the company failing, or going gangbusters.
Where in this scenario does the tax rate come in? It doesn’t. If the company busts, you pay nothing in taxes, and can even claim that $250 investment as a loss. This lowers the rest of your tax bill—just ask Donald Trump.
If, instead, your buddy rivals Jeff Bezos, and your one percent stake grows to $2,500,00 in five years, only then will the tax man come. But, tell me this: are you going to turn down the chance to make $2,500,00 just because you would have to pay more in taxes? Of course not! Whether you pocket $1.9m or $1.6m won’t matter, because no reasonable person will decide they don’t want $1.6m just because Uncle Sam won’t let you keep $1.9m.
In the end, this means you will have less for your next investment. But there will certainly still be places for you to invest $1.6m. If you don’t believe me, give me $1.6m and I’ll show you.
Won’t be able to create jobs — Perhaps some rich people decide to give poor people jobs out of the goodness of their heart; but this isn’t how it works most of the time.
A new job is created when the demand for a product or service grows enough that the current number of jobs in that company cannot meet the demand. The tax rate is again irrelevant. If a business cannot meet demand then they are leaving profits on the table. A new worker is hired to help meet demand so the business can realize those profits. They may keep less of the profits with a higher tax rate, but who is gonna turn down higher profits just because they have to give up another couple pennies per dollar?
The counter-argument to all of this is that if I only have $1.6m instead of $1.9m I cannot make as large an initial investment in my company, and I create fewer jobs. This is a paradigm born of the excesses of the 1%. It is only in recent years that the idea of starting a successful company requires millions in seed money—and it is because there are too many monopolistic companies that would buy out or destroy the competition. That is a problem that can be fixed with more antitrust enforcement to make the market more capitalistic.
If you think you have to have millions in seed money to succeed, you might want to have a chat with Jeff Bezos, Bill Gates, Steve Jobs, or Mark Zuckerberg. They have all made billions, and created millions of jobs, and they didn’t need heel-high tax rates to do it.
Quite the contrary. Higher tax rates actually incentivize reinvesting in your business. Jeff Bezos become one of the wealthiest men in the world, and Amazon become one of the biggest companies in the world, all while making tiny profits.
Their profits are so small as a share of their revenue that they often pay $0 in taxes. Why? Because they can avoid taxes (legally) by using the money to build their business. So, next time someone tells you that higher taxes will mean businesses cannot invest, laugh at them. If anything higher taxes make business investment more attractive because you can buy or build more stuff, and write it off as a business expense. This is what Amazon has done—constant high level investment even as revenues soar, which kept profits low. Investors have even rewarded Amazon for this with huge growth in their stock price. They saw that the company was massively valuable despite it’s low profits. It’s hard to deny the argument that people thought the Amazon’s stock was worth buying because Amazon kept reinvesting revenue, rather than take huge profits.
If taxes are low it is easier for the executives to keep more their revenue in profits and buy a newer yacht because their 100 footer got “too small”.
All of this behavioral stuff are the real world reasons why economists don’t see higher tax rates hurting. And we shouldn’t expect them to hurt unless we get much, much higher.
So, at the end of the day Biden’s tax plan will not hurt growth. The rich people will be just fine. But, this will help millions of children, workers, and families with increased investment—like the government used to do back when America didn’t need to be made great again.
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