HOW Does Lowering Taxes Increase Revenue

Great Debates
1

Damuri Ajashi currently has a thread titled, “Resolved: Tax cuts do NOT result in higher tax revenue.”

Several dopers have asserted that this statement is not correct, meaning that lowering taxes can (or will) increase revenue.

What I would like to know is how.

The way I resolve this issue in my head is to use first year micro economics. Businesses work to adjust the price of an item to maximize their revenue. Lowering it will increase demand, meaning more sales, meaning more revenue. Until you go too low, at which point you are losing money on each sale.

Go the other way, raising the price means more profit off each sale, but might reduce sales, meaning lower revenue.

So if we’re talking about taxing the rich, which is what I think we’re doing, what happens with the money?

I’d really like to build this up from the most very basic concepts, consider this an in vitro analysis, and we’ll send it out into the field later.

Take an example: A person making $2mil is taxed at 35%, so right now government revenue is $700,000. We’ll consider this system at steady state, right now everything is good, GDP is growing slowly, inflation is modest (perhaps 1%). What happens if we change this tax rate to 30% or 40%? Government revenue initially goes down or up $10,000 respectively.

What is the next step? If that person has an extra $10,000 next year, how does the government eventually get it back. And that’s the important point, xtisme’s argument is that some how the government will make MORE than $10,000 within a year (or some other time frame). At the very least, how does the government get exactly that $10,000 back?

Help me out here. Where does that $10,000 go, and where does the $10,000 in revenue get made up? Tag it with a radio isotope and follow it through the market, and show me how it gets back into the government coffers such that the tax decrease at the very least is revenue neutral.

The liberal side of the argument is that if the government takes an extra $10,000, they can spend it in a way that won’t mean $10,000 lower revenue revenue from some where else. The government has raised the tax rate, and expects to make more than $700,000 at the end of the year.

Like I said, the money is still there. The millionaire could invest the $10,000 or the government could invest the $10,000. What is the difference? As I said in the other thread, both could invest it in toilet paper.

What is the actual justification for giving it to one or the other? And how does tax revenue CHANGE as a result.

2

As in physics, it helps to begin with the simplified extreme cases. With a tax rate of zero, revenue is zero because anything multiplied by zero is zero. With a tax rate of 100%, revenue is zero because a rational person won’t bother to work if all his pay is going to the gummint – ergo, nobody earns any income, yielding 100% of zero.

This implies that the function of revenue versus tax rate rises to a peak somewhere between 0% and 100%, and that cutting taxes if current rates are above that peak will thus increase revenue. The problem is demonstrating whether or not this condition holds (and that’s assuming that there is just one rate function rather than eleventy zillion of them for various sorts of economic activity).

3

The answer is that taxes are a cost of doing business. When they rise above a certain point (10-14%), it becomes profitable to spend money to either avoid taxation (legal) or evade taxation (illegal). Tax avoidance is a perfectly legal activity, and businesses spend billions on tax lawyers, in order to do this-the generation of tax shelters, overseas accounts, tax credit solicitation, all cost money, but have the effect of lowering the taxes paid.
Tax evasion is illegal, but one must weigh the savings vs. the chances and penalties of getting caught. One popular way to evade taxes is operation on a cash basis, and keep no records-this is the fast growing “underground economy”.
If tax levels are very high (>50%), business activity either ceases or moves to the underground economy.
The real problem in the USA is the size and expense of government-it is simply too big and costs too much.

4

I believe the Underpants Gnomes have something to do with it.

5

Where are you getting your percentages?

6

I’m beginning to think you’re right.

7

What taxes are you talking about? And what does that have to do with the last sentence?

Crap, I forgot to mention that I wanted to discuss Federal Income tax.

**We are talking about Federal Income Tax. **

And addressing the example in the OP. How does revenue change as a result of changing the tax rate?

8

The part that’s missing from your mental model is the behavior of the $2mil man can change dynamically in response to a different tax rate.

You tax more, he can change his behavior to “earn less” money (that’s subject to taxation) either by exerting less effort, or pursuing different revenue or spending strategies that are more favorable to the new tax situation (legally or illegally.)

Likewise, you tax less and he can use more of his income for productive purposes. Those productive purposes (new factories, new jobs) can lead to more tax revenue.

That would be an incorrect assumption.

Your simplified model depends on the $2mil guy being a static automon that behaves exactly as he did before even as your change his (potential) tax burden. That’s unrealistic.

9

In the case of Federal Income Tax, as opposed to the tax code as a whole, the answer is slightly different: it’s because at a certain point on the tax rate continuum it becomes cost effective to stop drawing a salary entirely and start accepting stock options and the like.

Obviously, this isn’t an option for Joe Public, but the superrich pay the majority of federal income taxes, so it certainly is for them.

10

Leaving aside those in poverty who have little choice but to work their asses off daily in order not to starve, most people will do less work when they are being paid less, and if they have less money, they invest less.

The flip side is that people who take home more money will work harder, longer and invest more. The idea is that the government gets to tax the higher earnings from the extra work and investment which will counteract the lower tax rate.

11

I’m not sure either of these actually make sense.

Consider the guy making $2mil, being taxed at 35%. If we wants more money, he has to do more work. If he wants less, he has to do less work.

If we lower a person’s income taxes, we are effectively raising his salary. Wouldn’t that encourage him to work less? He was fine on his previous course, now he has $10,000 more.

Likewise, if we increase his taxes, he’ll work harder have less money, and want to work hard to get more money.

And as to your last sentence: “The idea is that the government gets to tax the higher earnings from the extra work and investment which will counteract the lower tax rate.”

So what you’re saying is if we lower his taxes from 35% to 30%, he’ll work hard enough to bring his income up to $2.3mil so that the government will still make $700k?

And that if we raise his taxes, he’ll simply work less (or hide more income) so that he earns $1.75mil?

12

I think where you are missing out here is how real people operate in the real world. If you raise someone’s taxes to a certain point then they aren’t going to keep working at the same level, so effectively you are going to get LESS taxes out of them. It’s basic human nature. If I’m making your $2 million and you tax me at 90% in a graduated tax, then that means I’m only going to bring home $180k. Sounds like a lot, but I’m working pretty freaking hard to bring home only a very small fraction of what I’m actually making. So…why should I? Just to provide you, the government with more money? There are diminishing returns here…a point at which working harder or investing more or expanding my business really isn’t worth the trouble.

I guess this isn’t as intuitive as I thought it was, since it seems obvious to me that after a certain point raising taxes actually lowers revenue, and as you continue to raise them it actually brings in less and less. Conversely, if you have taxation to those levels, lowering it will eventually stimulate growth and increase revenue. Someone who has stopped expanding their business or working harder will suddenly find both an incentive to actually expand or work harder AND more capital to do those things with. Which will translate into more jobs and more tax revenue from the government.

The real thought experiment is to set taxation to 100%. Do you really think you’d actually GET 100% of someones income as tax? No? Why not? How much will you realistically get? What with the actual, honest to god real person DO at those taxation levels? Do you have a realistic expectation that they will simply pay the money, or will they try to work around the system in order to pay less…or pay nothing? In the real world, if you make it worth peoples while to get around the taxation levels you set then they will figure out ways to do it.

-XT

13

Incredible.

You go through the trouble of putting a thoughtful sentence like this:

Your OP already had the hints of looking at the economy/market as a whole and yet your comeback to DrCube is to put up a strawman that restricts the taxation analysis only to that single $2mil person as if he was the only person in the whole world that could make up that tax revenue!

You have a very strange way of debating.

14

Here’s where this argument loses me. Say your taxes go up and you decide you “don’t want to work as hard.” So…what do you do? Do you start slacking off at work? Sounds like a good way to get fired. Do you ask your boss for a demotion? I suppose that’s plausible, maybe if you say you want less responsibility and are willing to accept a commensurately lower salary. But how long do you think your old position is going to stay open, particularly in a job market like the one we have today?

15

xtisme, I’m still not sure what you won’t answer the question in the OP, why did you switch from my 35% to your 90%?

Is the answer simply: People won’t work as hard if you raise their income tax.

So then is this just an exercise in psychology? How much can we tax people before they stop working?

I was sort of hoping we could address my thought experiment first, instead everyone just answers with the 0% or 100% concept.

And for the record, if people were being taxed at 100%, wouldn’t we assume the government is provide everything for that person (food, housing, entertainment)? Or are we back to the idea that government hordes money? If I’m taxed at 100%, and everything is provided for me on the condition that I keep working, we’ll I guess I’ll keep working.

If the scenario is set up that I’m taxed at 100% regardless of whether I work on not, obviously I stop working.

If this is all just a psychology game, and nothing to do with economics, can we admit that and address it as such?

16

I’m frustrated, and this wasn’t supposed to be a debate, I’m looking for information. I was really hoping to hear more, I figured that if people believe “lowering taxes increase revenue” that they’d have an answer.

Allow me to try again:

With the tax rate steady at 35%, people making $2mil will continue to work hard and earn more money. There is an incentive to advance their career because it will mean more take home pay. They are willing to take risks because there is potential to earn. More pay means more revenue for the government.

As the tax rate increases, individuals lose the drive to earn more. They won’t ask for a demotion, but they won’t have a desire to take on more responsibility. Their appetite for risk is diminished with the diminishing returns.

The best example of this occurs at income tax boundaries. Going from $171,851 to $171,852 means your taxes go from 28% to 33%. So the first person takes home $123732.72 the second $115140.84 (over $8000 difference). A $10 raise could cost you $8000.

Is this the answer to my question?

17

The theory, as I understand it, is that if you have an income tax rate of x percent, you collect x percent of all the income in the nation. If you lower the income tax rate, you only collect x-y percent of all the income in the nation. But supposedly people will take the extra money they now have, invest it, and the national income will go up to x+z. And the theory is that x-y percent of x+z income might be higher than x percent of x income. A smaller slice but a bigger pie.

18

So your argument is that if tax rates go up, and worker’s incomes decline, they will find ways to work less so that their income declines even more.

“Oh, my, Uncle Sam just raised my taxes. My paycheck just went from $2,500 to $2,250. I’ll show him! I’ll work fewer hours so my paycheck will be $2,100, and I’ll be laughing all the way to the bank! Ha-ha-ha!”

19

Steve MB got it right with the first reply, but I’ll repeat what he said.

A tax rate of 0% produces 0 revenue.

A tax rate of 100% also produces 0 revenue because there’s no point in working.

So if we start at 0% and start increasing the rate, revenue will go up.

And if we start at 100% and start decreasing the rate, revenue will also go up.

It’s clear that there must be some point in the middle where these two trends cancel each other out. That’s the sweet spot that generates maximum revenue. However, we don’t know for sure where it is. It might be at a 20% tax rate, or it might be at an 80% tax rate. And it almost certainly varies based on social factors and economic class. The sweet spot for people making $20,000 a year may be totally different than the sweet spot for people making $20,000,000 a year.

20

Psychology is a key part of economics. Incentives are psychology. Economics is the study of how people exchange items or services of value and the incentives behind them.

Both you and hobscrk777 seem overly focused on this one dimension: work hours… work more… or work less.

That’s not how wealthy people think. Yes, it’s possible for a $500/hour lawyer to bill less hours and hence pay less taxes. But that’s just one technique. The lawyer can choose to keep the revenue as retained earnings in his company (firm) and not pay out as high a salary. He can accelerate or re-prioritize some tax writeoffs (donate to charity in year 2010 instead of 2015). Instead of billing 50 extra hours to make up the extra tax burden, he can spend 50 hours consulting with a sharp tax accountant and restructure his portfolio into more (legal) tax havens. His cost-benefit analysis tells him he’ll get more “net” income spending that 50 hours with the accountant rather than 50 hours billing a client.

There are dozens of things he can do to maximize how earns or (doesn’t earn) that marginal income.

I believe that people don’t realize these methods because the typical Joe Blow punches in a timeclock or works for a straight salary. To him, the only dimension he sees is “working harder or not working harder.”

You need to add another factor to the thinking: tax avoidance and all strategies related to it.