New Study Shows Why ‘Taxing the Rich’ Isn’t So Straightforward

A man carries placards that read "Free education. Tax the rich" and "Communism" in a file photo. Justin Tallis/AFP via Getty Images

Commentary

A common rallying cry on the left is that we can fund our social programs if we just “tax the rich.” While popular, this slogan is far from a real solution for the country. As has been pointed out elsewhere, if you confiscated all the wealth of every billionaire in the United States, you wouldn’t even have enough money to run the government for a year. Our fiscal problem is a spending issue, not a revenue issue.

However, this isn’t the only problem with the proposal. It turns out that “tax the rich” is easier said than done.

A new working paper put out by the National Bureau of Economic Research (NBER) examines the impact of a tax system targeted at the rich. Researchers Nicolas Ajzenman, Guillermo Cruces, Ricardo Perez-Truglia, Darío Tortarolo, and Gonzalo Vazquez-Bare examine a new progressive property tax in Tres de Febrero (a city in Argentina), a system that effectively increased taxes on the rich while decreasing taxes on the poor.

How does this study show an issue with tax-the-rich sloganeering? To understand, we’ll have to consider the work of economist Art Laffer.

The Real Political Economy of Taxes

It’s simple to say, “I want to increase taxes on the rich.” Art Laffer’s work highlights how that desire may be easy to hold but hard to implement.

Laffer was famous for plotting a curve (famously called the Laffer curve) that showed the relationship between tax rates and tax revenues. Laffer’s insight was simple: as tax rates increase, tax revenues increase—at first. However, once tax rates go high enough, people are increasingly incentivized to avoid paying them, with the result being that tax revenues might actually start going down as rates go up. In other words, a tax rate of, say, 40 percent, might bring in more money to the government than a rate of 60 percent.

The Laffer Curve. Bastianowa via Wikimedia, CC BY SA 2.5

Avoiding taxes comes in many forms. One way is simply to earn less income. If you get taxed at an extremely high rate, such as losing 80 cents of every dollar you earn, you’re unlikely to work as much as if you only lose 20 cents for every dollar. If tax rates are pushed high enough, tax revenues will fall because people will engage in less income-generating activity.

Economic laws are simple. If you tax something, you get less of it. If you tax work, people will work less.

Another way to avoid taxes is to minimize your taxable income. This can happen legitimately or illegitimately. A legitimate way to lower your taxable income is to take advantage of accounting maneuvers like deductions. An illegitimate way to lower your taxable income is by not reporting income to the government. We can think of this as “non-compliance” with tax laws.

As tax rates increase, people will invest more resources into avoiding their taxes both legally and via non-compliance. Thus, when tax rates go high enough, this leads to lower tax revenue. This is the fundamental insight of the Laffer curve.

Non-compliance and Fairness

With this in mind, we can understand the results of the study of the Argentinian city. The authors report, “We find that reducing taxes for poorer households increases their compliance while increasing taxes for richer households decreases their compliance.” The logic behind the Laffer curve holds up. Higher taxes means lower compliance.

Specifically, they find that “a 1 percent reduction in the tax rate for the poor increases their compliance by 0.17 percent … Conversely, a 1 percent increase in the tax rate for the rich reduces their compliance by 0.36 percent.”

Interestingly, in the conclusion of the paper, the authors refer to this as an asymmetric response between the rich and the poor:

Our analysis reveals asymmetric responses to tax rate changes across income groups: tax reductions for lower-income households significantly increase their compliance rates, while tax increases for high-income households lead to decreased compliance.

However, there is nothing asymmetric about this from the perspective of economic theory. Both the rich and the poor households’ behaviors are perfectly consistent with the economic logic that underlies the Laffer curve. As you increase the tax burden on people, they have a larger incentive to avoid taxes. As you decrease tax burdens, the risk of non-compliance becomes larger relative to the benefits.

The authors go beyond examining compliance alone. Another part of the working paper is what people do when they are informed about the effect of the tax change.

As you’d expect, not all taxpayers in the study are politically informed enough to know that there has been a change. So the researchers examine the effect of informing voters that the new tax system is progressive. The results are interesting.

First, both rich and poor households claim to recognize the change as one that improves the fairness of the tax system. Furthermore, being informed of this change in and of itself appears to improve the tax compliance rates of poor households. However, the same is not true of rich households.

According to the paper, the authors found no significant increase or decrease in rich-household tax compliance upon receiving information about the progressive nature of the new tax system.

Taxing the Rich Is Harder Than It Looks

The study’s findings are interesting for a few reasons. First, they highlight that talk is cheap when it comes to taxes, and this highlights one major issue with progressive tax policies. Many supporters of taxing the rich in theory will increase their non-compliance when the bill comes due. In fact, it may be the very richest of the group who are most able to do so.

This last point highlights a major issue with the plan to bring prosperity to the masses by taxing the most well-off. Ultimately, the government can decide the rate at which they want to tax rich households, but they can’t determine the revenue they collect from them.

Presented with these facts, it’s likely that the tax-the-rich crowd will just argue that we need to crack down on the rich to ensure compliance. But this is no silver bullet. Cracking down is expensive, so any attempt to increase revenues by increasing compliance is going to be offset (at least to some degree) by the associated expenses.

Furthermore, even if you eliminate some forms of non-compliance, others will arise. When you impose costs on people, there is a profit opportunity for those who find a way around the costs.

Finally, even if you could close off all avenues at low cost, the last method of tax avoidance is unstoppable. People can always stop working—and rigorous enforcement will push more people to take that option. As such, there will always be a tax rate beyond which you lose tax revenue. The Laffer curve lives.

From the Foundation for Economic Education (FEE)

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.