Supply Demand Balance Taxation Economics

"The “really rich” have plenty of money and they don’t necessarily need to receive more in the form of ordinary, taxable income at any point in time. They have lots of ways and good advisors to help them arrange their financial affairs to their best advantage."

As the 2020 presidential election cycle begins to gear up, it’s predictable that there would be a spate of “free programs” being advanced by a number of the Democratic candidates. And it’s equally unsurprising that their solution to pay for them is taxing the “ultra-wealthy,” a wonderfully popular idea among “progressives,” but one that makes no sense economically.

I recently came across an analogy that helped explain this fact to my wife. Perhaps it will help others to understand that the concept of taxing the rich won’t work, even though it resonates well with their sense of “fairness.”

Here goes…

I asked my wife how many pairs of shoes she had in the closet. While she wouldn’t divulge the exact number, I wasn’t surprised that she admitted it was more than 25 pairs. My next question was, “How many did you buy at full retail price?” Proudly she said, “I didn’t pay full price for any of them. I bought them all on sale. In fact, I waited until some of them were on closeout before I purchased them.” Then I asked, “If there was a pair of shoes you had to have that weren’t on sale now, would you buy them?” After some thought, she replied “No, I would wait until they went on sale.” She went on to tell me that part of her reasoning was the fact that she already had plenty of shoes and she wasn’t going to go barefoot if she didn’t buy this new pair right away.

“That’s the perfect analysis,” I said.  “And it’s exactly the way the rich deal with income.”

The “really rich” have plenty of money and they don’t necessarily need to receive more in the form of ordinary, taxable income at any point in time. They have lots of ways and good advisors to help them arrange their financial affairs to their best advantage. Therefore, just like my wife, who wouldn’t buy a pair of expensive shoes when she already has plenty of shoes to wear, they won’t take income when the price of it (i.e. the tax rate) is too high. However, when income goes on sale (i.e. tax rates are lowered) they will take the income and pay the taxes…just like my wife buying that next pair of shoes once they go on sale.

In fact, real life bears this out. The so-called “Bush tax cuts” of 2001 and 2003 and the Reagan tax cuts in the 1980s, said by liberals to overly benefit the rich, generated unprecedented amounts of revenue for the government. In 1981, the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes. The absolute real dollar amount of their taxes increased substantially as well. In 1981, the total tax dollars paid by the top 1% in 2005 dollars was $94.84 billion. In 2005 it was $368.13 billion. Lowering tax rates generated an increased amount of revenue and made the income tax system more progressive.

The recent tax rate cuts enacted by the Trump administration have produced similar results. Individual income taxes have risen 6% in the just-ended fiscal year 2018. Individual income tax collections for FY 2018 totaled $1.7 trillion. That’s up $14 billion from fiscal 2017, and an all-time high. And currently the top 10% of wage earners pay 71% of all income taxes.

On the other hand, middle-income and working Americans don’t have the flexibility of deferring income or taking it in other ways to manage their after tax returns. Most of their income is in the form of wages and salaries from their employers and has tax withholding applied to it. They have mortgages to pay, food to buy, and gasoline to purchase, all of which take current income.

If there were an economic downturn, raising taxes, even on the rich, will exacerbate the problems. Many of the rich are small businesspeople and family farms. Raising their taxes will cause them to eliminate jobs that employ the middle class. And, since higher tax rates on the rich don’t result in increased revenues for the government, finding the money (without borrowing it or printing it) to pay for the Democrats’ “giveaways” will be even more difficult. In addition, higher taxes dampen overall economic activity because they reduce the incentives to work, produce, save and invest.

A better solution than raising taxes would be to simplify the tax system further and lower rates, while at the same time developing ways to increase economic activity and the GDP. History demonstrates that will produce the largest amount of tax collections.

And with an expanding economy, who knows, my wife might not have to wait until that new pair of shoes goes on sale.