Here we go again in Washington D.C.
The next fight, so we are told, will be over tax policy. The President wants more “revenue”, and revenue equals taxes, right?
It depends on the time frame.
As I showed some months ago, both the Left and the Right are wrong about taxes. Republicans want taxes to be too low and Democrats want taxes to be too high. Typically the argument is framed in terms of fairness. So I’ll offer a nice fair starting point of 50%:
Is it right to take more money from someone than we leave to his own family?
No, it isn’t. I don’t deserve MORE of your money than your own children do. If you decide to adopt me, that’s another matter. But assuming that you don’t adopt me, your kids should rate at least as well as I do. That means that I, as a citizen, do not have a moral right to tax you more than 50%. So then, on a strictly moral level, the combined local, state, and Federal tax burden for any given person should never exceed 50%.
The only exception would be Warren Buffett. I hear that he doesn’t intend to give the bulk of his fortune to his kids – so he is welcome to give it to me if he so chooses.
In any case, let’s leave that 50% up there as an anchor and take a look at how LONG I can get away with taking 50% of someone’s money before I start getting LESS money:
Now, this is a weird chart, and it will take some explanation. The vertical axis is the combined tax rate, and the horizontal axis is the number of years you are collecting.
If you want to go full Communist and just tax everyone at 100% rate, you can get away with that nonsense for about 30 years before the government starts getting LESS than it could get at lower rates.
So, 0-30 years, and you can get as much money as possible at 100%.
By 35 years, even 90% is too much.
By 40 years, even 60% is too much.
At 50 years, even 40% is too much.
After that you finally get a permanent long term optimal tax rate of between 30% and 40%. As I wrote in earlier posts, 35% is the optimal rate.
If you lower it then you collect less money. If you raise it you ALSO collect less money. You might get “more” for a few years, but it’s temporary.
We’ve been down this road before. In the 1940s the maximum Federal income tax rate was a whopping 94%! They did that to win a world war, and such high rates were justified by the need to survive a global threat.
By the time of John F. Kennedy, the temporary threat of the Axis power was well behind us, and it was time to take a look at how tax rates should be optimized for long term government revenue. JFK lowered taxes from the 90% range to the 70% range.
Under Reagan the taxes were further lowered until the maximum tax bracket was down to 28% in 1988.
George H. W. Bush was forced to raise rates because they were collecting less money than was needed to fund the programs they neglected to cut.
Under Clinton the maximum rates were higher than now, and he was able to balance the budget before the economy finally blew up.
Under George W. Bush the maximum Federal rate was lowered again to 35%.
We’ve been too high, then too low, then too high, then just right – and now we are too high again and clamoring for more.
Government does this by trial and error, and it’s mostly error.
The problem is that when you raise taxes you DO get more money – in the short term. Then after a couple of years you realize you need to raise them again, and again you get more money – in the short term. Then after a couple of years you realize you need to raise them again, and again…
Get the picture? It’s like a drug habit. It takes more and more to get less and less of a high – until you are no longer getting high at all, but just feel bad all the time and take a fix to feel semi-normal.
All of which reminds me that I need another cup of coffee…
Ah… now… where was I?
The way to see how tax rates affect revenues, we’ll go back to revenues the government would accumulate off of capital gains taxes on the S&P since 1950. We’ll look at rates from 1% to 100% based on 10 to 50 year sequences:
The running account starts at 16.66 on 1/3/1950, and is taxed according to the rates on the horizontal axis. The vertical axis is the amount of money the government could accumulate off of that account if it were taxed for 10 years to 1960 (the orange line). You can see that for the first thirty years the maximum amount of revenue is accumulated at 100%!
So we should raise taxes at will, right?
Well, no, because by the time we reach 40 years the peak is now at 55%, and by 50 years the peak is at 33%.
As I’ve noted before, the optimal point stabilizes around 35%. For any given measure past 50 years, it will stay in a tight range between 30% and 40%.
The shock of that graph, however, is the huge difference between 40 and 50 years. We get that shock because our brains aren’t hard wired to think in terms of compounding returns. We logarithmically DISCOUNT time as it gets larger, when instead we should do the opposite. Here is the EXACT SAME graph on a logarithmic scale:
Once again we can see that the first three sequences from 10 to 30 years max out at 100%, while 40 years maxes out at 55%, and 50 years maxes out at 33%. But now we don’t experience the same shock.
As far as I can tell, no one has ever graphed this difference in time frames before now – so I’m naming this “The Clontz Curve.”
Politicians, like all humans, think in the short term. Ordinarily that works out for us, because we don’t live that long anyway.
But COUNTRIES don’t live in terms of months and years. They live in terms of centuries, and they only come to an end when too much short term thinking gives them unsustainable policies that cause them to collapse.
THAT is what we are facing now – not just in the United States, but in the entire developed world. If we are Conservatives, we think that lowering taxes will create some kind of instant boom. It doesn’t happen that way. Yes, Reagan did the right things by tax and regulation policy, but he also came in at the crest of the baby boom economic wave. Clinton didn’t owe his boom to his raising taxes (as he ludicrously claimed in the 2012 campaign), but rather he enjoyed the fruits of the elder Bush’s accidentally too LOW rates in the opening year of that decade.
So, sorry Republicans, taxes do NOT have an IMMEDIATE effect. It takes time for them to help or hinder the economy – time in terms of decades instead of days.
But Democrats are ALSO wrong when they notice no immediate effect and assume the coast is clear. It isn’t. Tax policy is a long slow process. One cigarette won’t kill you. Ten won’t either. But ten every day for a few decades WILL.
Tax rates must be set in terms of maximum accumulation calculated over at least 50 years. Anything less and you are not running a country – at least, not any kind of country your great grandkids will enjoy.
To set optimal tax policy, then, we need to look at the entire tax burden. The AVERAGE tax burden for local, state, and federal COMBINED should be set at 35%.
That usually breaks down to 15% for local and state taxes and 20% for federal. A progressive federal rate that gives an average burden of 20% would progress from 0% minimum to 35% maximum income tax rates, as I detailed in earlier posts:
I also gave additional measures of the effect Federal rates had on state rates here:
All of these explored the true Laffer Curve based on actual Federal revenues at different rates. What is new today is the explanation of how short term thinking prevents policy makers from truly maximizing tax revenues.
The PROBLEM we face is a Federal debt in excess of 17 trillion. We can no longer afford to collect less than the absolute maximum that can be collected, which is, again:
State and local = 15%
Federal = 20%.
Any more will ultimately get less money. Wild eyed Republicans have promised trickle down prosperity, and Democrats have promised a Great Society. Both are wrong. The economy DOES do better at lower rates, but only in long term calculations.