Thoughts on Taxes on Tax Freedom Day

Here's an article courtesy of Marotta Asset Management that gives some interesting thoughts on taxes:

Tax Freedom Day arrives on Monday, April 30th this year. That's when we stop working for the government and start working for ourselves. For the average worker, all of the earnings of the first 119 days go to pay taxes to the federal, state, and local governments. Starting May 1st, we are free -- at last -- to take care of our own family's needs.

The 2007 report, published this month by the non-partisan Tax Foundation based in Washington, D.C., measures the tax burden on Americans. According to the report, the 2007 federal tax freedom day comes more 12 days later than it did in 2003, though it is still five days under its all-time high in the year 2000.

However, the overall Tax Freedom Day falls two days later than it did last year, even with the absence of tax increases. Gross Domestic Product has been strong, growing by at least 6.3% per year for the last three years. More wealth for Americans means an increase in Uncle Sam's share.

Due to our progressive tax system, Uncle Sam actually collects more taxes as inflation rises due to 'bracket creep.' If your pay is adjusted each year to keep up with inflation, the dollar figure you make increases but your net purchasing power remains unchanged. However, inflation may actually drive you into a higher tax bracket despite the fact that your buying power has not increased!

On average, taxes still take nearly 33% of a worker's gross income – 22% for federal taxes and 11% for state and local taxes. Only since 1992 have Americans paid more for government programs than they spend on food, clothing, and medical care combined. For the amount of money we pay in taxes, government should already be able to provide universal health coverage and feed and clothe us as well.

For every eight hour day we work, 2 hours and 35 minutes of our work goes to paying taxes. Without taxes, you could leave work at 2:25pm.

At the state level, tax freedom day varies from state to state. California has the 7th highest taxes with its Tax Freedom Day delayed until May 7th. Virginia places 17th in the race for the highest tax state rate even though its Tax Freedom Day arrives on April 30th, exactly the national average.

The Virginia tax rate continues to climb higher each year despite claims of no new personal taxes because of both bracket creep and the significant increase in state business taxes. This has been a national trend. Business tax receipts have risen more than 20% over the past year.

Most non-economists vastly underestimate the negative impact of tax rates on the U.S. economy. Taxes encourage every American to do things themselves, outside of the taxable economy, even if specializing and working together would have produced higher productivity. If you add the costs of complying with the complex web of regulations, the government costs Americans over 50% of our wealth.

Imagine three builders who, by themselves, could each build a house in a year. Three builders could build three houses working separately. Now image that because of their specializations they could build six houses by working together. It may seem incredible that these builders would not take the opportunity to double their productivity, but with any tax rate higher than 50% they have no incentive to choose the more productive partnership. Just imagine the economic boom if the other half of worker's labor were set free!

Imagine a highly paid and highly skilled doctor whose marginal tax rate is over 50%. Everything that she pays someone else to do costs her twice as much because she pays for that service with after-tax dollars. It may be very inefficient to society for her to waste her time mowing her own lawn, changing her own oil or painting her own house, but specifically because she is in a high tax bracket, she can save more money than the average American by doing those chores herself. Another way to look at it is that without taxes, she could afford to pay those who provided her services twice as much.

Economist Arthur Laffer recognized that the law of diminishing returns applies to tax rates as well. According to Laffer, there comes a point beyond which increased taxation actually yields fewer tax dollars being collected. For example, a 100% tax rate would drive commerce into the ground, resulting in zero taxes being collected.

Many economists believe we are already well beyond that point for the most Americans. In other words, tax cuts would actually result in increased economic growth and more taxes being collected.

Presidents Kennedy and Reagan understood the Laffer Curve well. In 1964, Kennedy reduced the top tax rate from 91% to 70% and, to the surprise of many, tax revenues increased! Seventeen years later, the Reagan tax cuts reduced the top marginal rate from 70% to 50%. Revenues soared again. Between 1980 and 1997 the share of federal income taxes paid by the top 1% rose from 19% to 33%. The share of taxes paid by the top 25% increased from 73% to 82%.

Economists understand that the optimum rate of taxation is zero. The second most optimum rate of taxation is as low as possible. In contrast, many Americans seem to have the attitude that tax rates should be increasingly punitive.

The top 1% pays 35% of the taxes in the United States. The top half pays almost 97% of income taxes. These two statistics have increased despite all the complaints that tax cuts have favored the rich.

Low taxes should not be a political issue that divides us. Every American should agree with the goal of keeping taxes as low as possible. In 2011, all of the federal tax cuts enacted since 2001 are scheduled to expire. In the words of John F. Kennedy, "An economy hampered by restrictive tax rates will never produce enough revenues to balance our budget - just as it will never produce enough jobs or profits."

Comments

[Nick]

I'd be very interested in hearing from the economists that actually claim that a 0% tax rate is optimal (and I find it interesting that the 2nd most optimal tax rate is the same as the first, since 0% is obviously as low as possible). I guess it depends on what you are trying to optimize. The Laffer Curve suggests raising tax rates beyond a certain point decreases tax revenues. It also suggest decreasing tax below a certain point has the same effect. As far as the Laffer Curve is concerned, the optimal tax rate is absolutely not 0%.

[Nick]

Also, while it is fun to complain about progressive tax rates, even if we had a flat tax rate the top 50% of earners would pay the vast majority of total income taxes. That's because the top 50% of earners earn alot more than 50% of all the income earned.

[EMF]

Bracket creep is not a problem with Federal taxes as the tax tables are adjusted for inflation.

[taxman]

You state the top 1% pay 50% of the taxes. But you don't state how much wealth is owned by the top 1%. Nobody ever does. I wonder why?

[Lord]

This is rather marred by selective facts. Federal income tax brackets are indexed for inflation, but the AMT, capital gains, and a few others are not. Food and clothing has been falling for a century. Healthcare is up but is still a relatively small part of spending. Certainly he means 50 percent of our income, not our wealth, but since much of that is transfer payments, much of that is someone else's income. The productivity examples are flawed. They would still have the incentive to partner, they would double their income after all and taxes would only take half of that 100 percent increase. As businesses, they would have available all manner of other deductions as well. A modest doctor may make $40/hr after tax, certainly more than enough for a gardener or painter. They would be fools if they thought it worth their time. Sure the wealthy are paying more in taxes, they are making oodles and oodles more money, the top 0.1% about 100 times as much.

I applaud Marotta for taking the initiative to write some fodder for your blog, but some of these Marotta Asset Management articles give me pause. Are they deliberately presenting only one side of the picture?

I'm a big proponent of the Laffer curve as a simple means to understand the underlying theory. But this is a soft science and the system is much more complex than can be conveyed in that curve. And as Nick mentioned above, we need to know which side of the curve we're on now!

How about some counter-examples? What are the most wealthy states in the nation? (Hint, look for the highest tax rates eg it's also how the taxes are spent, and most likely good, cheap state education is a good start.) To paraphrase, the "good" use of tax revenue is returned, pressed down and overflowing. I'm not claiming a causation relationship in all cases, but the correlation should make one think twice.

I think they also have some numbers wrong. When Reagan cut federal taxes in the early 80's, federal tax revenues actually fell as a percentage of GDP, but when he gradually raised them later, revenues rose. (Marotta is probably confusing the hike in SS taxes that increased total govt revenues with vanilla fed tax revenues - a common mistake.)