In the wake of Washington’s unsavory fiscal cliff deal, Americans, unsurprisingly, will be taxed more—particularly wealthier Americans. Politicians have determined that income taxes should be raised on those earning more than $400,000 annually. Other changes—for example, eliminating some deductions and exemptions—could still raise taxes for people making $250,000 or more. Many Americans believe that such tax increases are “good policy” or “fair,” and a good percentage of those Americans are happy for someone else to pay the bill. President Obama has stoked this sentiment.
But get ready: There are several unavoidable problems with increasing tax rates.
One and All
The most important thing to note is that it’s impossible to isolate the costs of any tax. Most people think each person pays his tax, but this belief is demonstrably false. Whenever government imposes a tax on incomes, employers and employees compete to see who will actually bear that burden. That is, some upper-income workers will negotiate higher salaries or wages. Some employees will be more successful than others in shifting tax burdens to their employers, but employers incur higher labor costs when income taxes rise. Higher labor costs increase the prices of goods and services. Therefore, some percentage of taxes levied against higher earners will be passed on to all consumers—and often to the least well off.
An omnipotent tax authority could achieve a specific target for increasing taxes on a group. But without such authorities, any tax increase on one group will be shared by everyone. There is nothing that any state official can do to change this fact. Upper income Americans will pay only some part of any increases in “their” tax rates. This important insight is seldom recognized. And it’s just one way that a tax on one is a tax on all.
The second problem with increasing taxes is that some people simply avoid paying higher taxes. Gerard Depardieu just left France to avoid paying this nation's 75 percent tax rate. This instance is not the first one of self-imposed tax exile. Two decades ago the British Parliament increased taxes on high-earning Britons. The Parliament raised the highest income tax rate to 83 percent. The British government also raised taxes on investment income by an extra 15 percent. What was the result of this tax?
Ringo Starr and Roger Moore moved to Monaco. David Bowie moved to Switzerland. The Rolling Stones roamed the world in search of tax havens. Phil Collins, Michael Caine, Pink Floyd, Led Zeppelin, Freddy Mercury, Sting, and Sean Connery left the United Kingdom, at least temporarily, as tax exiles.
Monaco alone has thousands of British tax exiles. It is already the case that some Americans renounce citizenship to avoid taxes. The fact of the matter is that the people with the highest earning potential are also the most mobile. Efforts to shift tax burdens to high-income persons will drive more of these persons out of America.
Leaving a country to avoid taxes is a drastic measure. There are less drastic ways of avoiding income taxes. People with high incomes can work fewer hours per year, use tax loopholes, and retire earlier. There is evidence that people do act this way. Most European nations have higher effective tax rates and shorter average work weeks than the United States does. The first and second problems here are two sides of the same coin. Some people withdraw labor from a labor market that is heavily taxed. Withdrawal of some labor from a labor market gives those remaining increased bargaining power, and this advantage raises their before-tax incomes. It is naive to think that high-income persons will simply accept and pay any tax rate.
Spending and Debt
The third problem with raising tax rates is that politicians have run up debts that American taxpayers cannot pay. The annual federal deficit has been over $1 trillion during each of the past few years. The official national debt is approaching $17 trillion. Economist Lawrence Kotlikoff originally estimated the present value of the real long-term debt at $202 trillion. The projected debt has swelled to $220 trillion in just the past few years. Real national debt includes costs of unfunded entitlements, federal pensions, and veterans’ benefits. Who will pay for all of this? Who can pay for all of this? $1.6 trillion of extra revenue over a decade might seem like a large tax increase, but it is quite small compared to our real fiscal problems.
Annual federal spending is close to $4 trillion. The federal government has been wasting money on inefficient programs throughout its history. Why should anyone pay more while State officials spend recklessly? Waste should never be tolerated, but our waste is nearing crisis levels. Proposals to raise taxes on wealthy individuals are, as the saying goes, “rearranging the deck chairs on the Titanic.”
The three aforesaid problems with tax increases have at least two important implications:
First, efforts to “make the rich pay their fair share” are futile. It is all too easy for people to either shift the burden of legal tax rates or to avoid taxes altogether. Some people like to believe that taxes can be used to achieve “social justice,” but the reality is that we do not know how real tax burdens are borne; we only know that markets shift such burdens around according to relative bargaining power. Social justice is itself an elusive notion, because true tax burdens are unknowable.
Second, efforts to solve our fiscal problems with tax increases are futile. Tax rates are not too low; projected spending is far too high. The only realistic solution to our long-term fiscal situation is to enact severe cuts in federal spending programs and to privatize Social Security and Medicare. In short, efforts to solve fiscal problems with tax increases are futile.