“Low” Tax Rates Often Mask Much Larger Tax Burdens

by
Gary Galles
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Discussions about the incentive effects of taxes can be misleading. The focus is usually on the tax rates imposed. But one’s incentives are not best measured by tax rates, but by how much value created for others (reflected in consumers’ willingness to pay) is retained by the creator, which I refer to as take-home income.

These two variables — tax rates and take-home income — are reciprocal in the sense that the higher the marginal tax rate, the smaller the take-home income relative to the value created. But the latter is a more precise tool, because it reveals how much incentives change as a result of a tax change.

This is a key to supply-side economics, because the higher the existing marginal tax rates, the greater the improvement in incentives with a decrease in tax rates. That is why the 1981 top tax rate reduction from 70 percent to 50 percent, which led to a two-thirds increase in take-home income at the margin (from 30 cents to 50 cents per dollar of value generated), had such a large effect on behavior — resulting in higher tax revenues from that tax bracket — but reducing the bottom rate a slightly lower proportion from 14 percent to 11 percent, which led to take-home income at the margin increasing by roughly 4 percent (from 86 cents to 89 cents per dollar of value generated), had a small effect on behavior and resulted in lower tax revenues from that group.

Thinking in terms of take-home income is also key to understanding how seemingly low tax rates can impose more substantial burdens than typically recognized. An excellent example is the 2.3 percent tax on medical devices imposed in 2013 as part of Obamacare and just repealed by the recent omnibus spending bill. 2.3 percent doesn’t sound like much, but it did not leave 97.7 percent of the value created in the pockets of the creators. That is because it was not a tax on earnings, but on gross sales. So, if a medical device maker earned $1 million in profits on $10 million in sales, the tax would be 2.3 percent of $10 million, $230,000. That is equivalent to a 23 percent tax on earnings, which leaves a much smaller fraction of the gains created in the hands of the creator. In Congressional testimony, one such company reported that the tax acted as a 79 percent tax rate on their earnings. Added to other taxes (e.g., corporate taxes) and the fact that the tax kicks in as soon as any sales are made, long before profits are typically made in the industry, that is a massive disincentive, far worse than what a 2.3 percent tax rate suggests.

A similar version of lowballing tax burdens is the property tax. Say there is a $100 million property generating a 10 percent rate of return, or $10 million annually. If there was a 2 percent property tax, which doesn’t sound like much, it would cost $2 million per year. But that is equivalent to a 20% tax on the income generated by the property, which reveals far more adverse effects on incentive.

Another way that referring to tax rates downplays the extent to which taxes damage incentives is when multiple taxes are imposed on the income stream involved. That is because it is the cumulative marginal tax rate that dictates what fraction of value creation becomes take-home income (as well as the excess burdens, or welfare cost — over and above the tax revenue generated for government — roughly proportional to the relevant tax rate).

For instance, corporate earnings must bear the burden of property taxes (on the value of the property, not the income it generates), then federal as well as state and even local corporate taxes, then any gains going to owners must also bear personal income taxes. And regulatory burdens, which act like taxes, add to the disincentives. The disincentives and burdens on society are far greater than any one tax rate reveals. And since 2013, if you were a medical device maker, you were also burdened by that tax.

The moral of this economic story is that whenever someone who has an incentive to lowball the burden of a tax is speaking or writing, be careful to look at what happens to take-home income as a better guide to policy. That will help inoculate you against bogus attacks on supply-side economics, from misleadingly “low” tax rates that burden people much more heavily than most realize, and from the far greater burdens and disincentives imposed when multiple taxes (and regulations) are applied to the same stream of income.

This approach can also make sense of a major reason why Anti-Federalists so strongly opposed the Constitution’s ratification (absent a bill of rights). As Brutus wrote of taxes, the cost side of expanded government powers,

This power … will introduce itself into every corner … it will take cognizance of the professional man in his office, or study; it will watch the merchant in the counting-house, or in his store; it will follow the mechanic to his shop … it will be a constant companion of the industrious farmer in all his labor … it will light upon the head of every person in the United States. To all these different classes of people, and in all these circumstances, in which it will attend them, the language in which it will address them will be GIVE! GIVE!