Addressing mythology about Tax Rates and its relationship with Tax Revenues

One of the biggest misconceptions about taxes, whether on income, corporations or capital gains is that there is a linear relationship between tax rates and tax revenues. This view posits that revenues follow the direction of tax rates so that if tax rates go up, so does revenue, and as tax rates go down, a lower revenue must follow. On the surface, the belief appears to be sound and logical, which for many is enough to qualify it as “fact” despite evidence that indicates the contrary. But once you consider how people respond to those different conditions in which a lower tax rate is obviously more attractive than a higher one, it shouldn’t be surprising to find that tax rates can sometimes have an inverse relationship with tax revenue.

In Thomas Sowell’s essay “Trickle Down theory and Tax Cuts for the Rich” he points out “there were 206 people who reported annual taxable incomes of one million dollars or more in 1916. But, as the tax rates rose, that number fell drastically, to just 21 people by 1921.”[1] After tax cuts during the 1920s, Sowell writes “the number of individuals reporting taxable incomes of a million dollars or more rose again to 207 by 1925.” This of course, resulted in greater revenues under a lower tax rate.

Over the course of Ronald Reagan’s presidency the federal income tax for the highest earners went from 70 percent to 28 percent by 1988 and the capital gains tax went from 28 percent to 20 percent by 1983. Yet in the former case, federal income tax revenues increased from $244 Billion to $445 billion by 1989[2] and for the ladder, capital gains revenue increased from $12.5 billion in 1980 to $18.7 billion by 1983 [3] In 1986, capital gains taxes were increased back to 28 percent, causing revenues to decrease from “$44 billion a year to $27 billion a year by 1991.”[4]

In 1997 President Bill Clinton eventually lowered the capital gains tax back to 20 percent, causing revenues to skyrocket to $79.3 billion and, by 1998, to $89.1 billion.[5]

To make sense of this defiance of conventional wisdom, let’s start with examining capital gains which are simply profits realized from the selling of an investment in a capital asset, such as a stock or a bond that was purchased at a lower price. Investors can choose when to realize their capital gains, and thus have an incentive to do so under a more favorable tax climate. As Brian Kingston a former Canadian federal government economist noted, “If you increase tax rates, it creates an incentive to lower the amount of taxes that you’re paying.”[6]

This turbulent relationship between tax rates and tax revenues seem to be the norm rather than the exception. John F Kennedy lowered taxes on the highest income bracket from 91 percent to 70 percent because he believed “tax rates are too high today and tax revenues are too low” such that “the soundest way to raise the revenues in the long run is to cut the rates now.”[7]

Four years prior the increase, federal income tax revenues increased an average of 2.6 percent. Four years following the tax cut, federal income tax revenues increased 8 percent annually.[8] And, like the example of capital gains, John Kennedy invoked the same line of reasoning, suggesting that high tax burden makes ““certain types of less productive activity more profitable than other more valuable undertakings.” The implicit argument is that lowering taxes would induce investors to make investment decisions whose returns would be greater under a lower tax rate.

In 2016, Canada’s federal income tax on the highest income bracket were increased to 33 percent from 29 percent. The annual financial report of Canada noted that high income earners recognized “additional income in the 2015 tax year” and “lower income in the 2016 tax year” both of which, the report suggests were in response to anticipated tax increases.[9]

Despite the available evidence, journalists, pundits and politicians have emphasized the need to tax the rich so that they pay their “ fair share.” But what’s worse than not paying their “fair share” is not paying anything at all.

Matthew Yglesias, co-founder of vox reported that Trump’s income tax cuts for “millionaires and billionaires” would result in a budget deficit of 2 trillion due to foregone revenues. Except federal income tax revenues increased by 9 percent[10] in 2018 after the tax cuts went into effect.

In another article, Yglesias extols Alexandria Cortez’s wanting to increase income taxes to 70 percent, suggesting that it “represents cutting edge empirical research on how to maximize federal revenue.” [11] Perhaps her position represents cutting edge evidence of the power of unverified rhetoric.

Yglesias however acknowledges the diminishing “returns” of higher tax rates. A marginal tax rate of 90 percent on inheritance over 10 million he writes “would probably raise little revenue due to rich people instead giving money to tax exempt charitable institutions.” But he maintains his position, arguing that it would “break the doom loop of oligarchy whereby concentrated wealth breeds political power breeds concentrated wealth.[12]” His “reasoning” is flawed. If rich people, which will always exist, can influence political institutions, then the problem is political institutions. But he admits inadvertently, that his position on taxes has nothing to do with optimizing revenue or economic growth, which generally are whole point of the taxes. Rather they serve to achieve a conception of fairness that has no practicality and is not reinforced by evidence — — just like the history of many ostensibly reasonable ideas that ended as monumental failures. .

Opponents of tax increases have often mentioned the “trickle down theory” which they claim doesn’t work. According to their interpretation of this theory, the consequent savings the rich make will somehow trickle down to the poor, which they then insist would not happen. But no such theory, Sowell argues has ever been proposed as a defense of tax cuts.[13] Instead the theory was a straw-man argument set up by those with no conception of the actual rationale behind tax cuts.

Ironically, Yglesias justifies a marginal tax rate of 90 percent for reasons that embody the faulty logic attributed to the trickle down theory. According to his theory, rather than paying confiscatory tax rates of 90 percent, corporate CEOs have an incentive to pay more to its workers which would “turn around the deplorable stagnation in earnings that typical households have faced over the past several decades.” In other words, he believes in a literal version of the trickle down theory in which the rich CEOs end up paying higher salaries to their employees so as to avoid such high tax rates. History often repeats itself, only because idiots repeat themselves.