Phil-osophically Speaking – September 24, 2010

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When Does Taxation Do More Harm Than Good?

Taxes — we shudder at the very sound of the word. In fact, we do more than shudder: We complain about it, we dread it; we vow to throw out the bums in elected office who copiously impose them on us. We also argue amongst ourselves about them: Do we keep the Bush tax cuts or do we dispose of them like last night’s trash? Taxation, like marriage, is for better or worse, we live with it, as we do with the shadow of death, the only other guarantee in life, according to Ben Franklin.

Another sage, Oliver Wendell Holmes Jr. noted that taxes are the price we pay for civilization. Since civilization is a good idea, shedding a few of our dollars on its behalf seems reasonable. The question is how much do we need to lighten our wallets to keep a good thing going? When does taxation do more harm than good? On this question let’s not forget the redoubtable John Marshall who memorably opined: “The power to tax is the power to destroy.”

Ominous words indeed. So the question becomes one of balance, delicate or otherwise. Long ago, a Frenchman named Jean Baptiste Colbert hit the proverbial nail on the head when he said the “art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” That colorfully sums up the dilemma of modern politics since feathers and hissing can be seen and heard everywhere these days. To frame the argument more cogently, let us consider the two taxation rates that produce no revenue for the government: The first would be 0 percent taxation, since no taxes are being collected, there is no revenue. The other non-producing rate would be 100 percent taxation on all that we earn. Under the latter scenario, people would either stop working (what’s the point?) or conceal their revenue.

This schematic resulted in economist Arthur Laffer drawing a graph on a napkin depicting how high marginal tax rates reduce rather than increase revenue (because while the government is collecting more revenue it is losing the revenue that would have resulted from an expanding economy that allowed more investment) a proposition known as supply-side economics that was adopted by Ronald Reagan — the theory that the first George Bush called ‘voodoo economics’ during the 1980 Republican primaries. Call it what you will but the black magic (really nothing more than a little common sense) worked provoking an economic explosion in the 1980s as did the Mellon tax cuts in 1920 and the Kennedy tax cuts in 1963.

There was a time, however, when one could make a case for increased taxes. It’s a case you don’t have to read or hear about; you just have to see it. Go to Newport Rhode Island and tour the mansions built by the titans of finance in the latter part of the 19th century. I refer to it as “monuments of wealth” — those extravagant enterprises the super rich sunk their money into because they had so much of it. Of course, the very rich can still be profligate, but wealth accumulation is much more restrained today. Bill Gates, the founder of Microsoft, is a case in point. In 2000, before the tech bubble burst, his personal wealth reached a 100 billion. How much is a 100 billion? Put this in perspective — if you can: Bill Gates could have purchased every house in Nassau County and every automobile on its roads and still be unimaginably rich.

Despite this incredible wealth, Fortune Magazine estimated that, compensated for inflation, Gates would have been only the seventh richest individual in American history, all the others having been born somewhere around the mid-19th century. John D. Rockefeller, for example, was worth 198.5 billion (about twice as much as Bill Gates at his richest) and Andrew Carnegie and J.P. Morgan, Rockefeller’s greatest rivals in the money sweepstakes, only a few billion behind.

The 19th century barons of wealth were so much wealthier than their moneyed descendents because of the passage of the 16th Amendment, which gave the federal government the constitutional power to impose an income tax (that did not exist before 1913) as a measure to redistribute the wealth under the auspices of good old Uncle Sam. This amendment not only made individuals less wealthy; it would, in effect, enable Congress to evade constitutional limits placed on its power by allowing it to effectively bribe states to do its bidding with federal funds that originated, in part, from the states’ own respective residents. Money from New York, for example, goes to Washington, to be circulated back to New York in what is now called federal funds that can only be spent for federally approved projects. That is why I’m fond of saying there are no federal funds, no state funds, only taxpayer funds.

The Federal Income Tax also gave government the ability to spend money in a way that was not only unprecedented, but unimaginable. The latest health care bill is the latest example in a long line of social legislation that has turned Washington into an ATM machine, the depositors of this tidy bank account being the taxpayers of the U.S. Even those enormous sums cannot keep pace with the government’s voracious appetite to spend as evidenced by the ballooning of the national debt that China is helping to finance. As the brilliant Austrian economist Frederic Hayek pointed out back in the 1940s, every dollar government confiscates is a dollar not spent in the private sector or a dollar not saved by the taxpayer. America has among the lowest saving rates of any industrial country. If banks have large reserves of private capital, interest rates will be kept low (money, like everything else, is subject to supply and demand), which helps borrowers borrow and investors invest and, all things being equal, will drive employment and wages up because employers don’t have to spend as much on financing capital.

The counter argument, excogitated by John Maynard Keynes, is that a dollar spent by the federal government has, unlike one spent privately, a multiplier effect resulting in more dollars. Without boring one with theory, the practical effect of this idea suffered another hit with the recent, nearly one trillion dollar strong stimulus bill that seemed to multiply nothing but unemployment. But things go merrily on in our nation’s capital, the blind leading the blind, many of our lawmakers epistemologically disadvantaged, for in Washington the learning curve never straightens itself out.

So where do we go from here? Business as usual means more spending, which translates into more taxes, which results in a paralytic economy. I’m also troubled by the new estate, or death tax, being pushed by Congress, which will hurt productivity, further victimizing the American economy. The wealthy save, the government can’t, the wealthy invest their money more wisely because it’s their money, where government invests money more carelessly because it’s not their money.

That people respond to incentives is a fact of life and the more we ignore them the more we continue to pull at doors that are marked push. If we let resourceful, talented people spend their time making, investing and saving their money instead of paying accountants and lawyers to find ways to squirrel it away, whether through loopholes or imaginative estate tax planning, the whole economy will benefit. The same is true with taxation in general. The architects of the Federal Income Tax never conceived that it would exceed 10 percent for the top income brackets. When government over-regulates the economy, you can be sure that the unintended consequences will nearly always prevail over the intended objectives.

So what should our tax policy, as a general rule, be? It seems sensible to me that government should tax spending and not tax working and saving. This doesn’t mean that we should scrap the Federal Income Tax, but it does mean that its rates need to encourage investment and savings, the very oil that greases the economic engine. Allowing people to keep more of what they earn is not only an incentive for people to work harder, not only a mechanism to benefit everyone else, but it is also the moral and sensible thing to do.

 

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