On Tax Policy

During a debate on tax policy, someone made this comment:

A tiny tax increase on a small percentage of the population is not “overruling the will of the individuals and satisfying governmental priorities.” It’s sane fiscal policy, and it used to be perfectly acceptable before lunatics and their useful tools like you took over.

I decided to give a full explanation of why raising taxes to generate revenue doesn’t make sense:

See, based on the fundamentals of economic theory which have stood the test of time over the last 200 years, I disagree that “raising taxes is sane fiscal policy.”

Here, let’s take a step back to a point where we can agree. Sane fiscal policy means collecting more revenue than we spend. Now, I know you’re not particularly fond of reducing spending, so let’s just ignore that option for now and assume that all that spending is absolutely necessary, and is a function of population. Bear with me, because this train of thought will take a little bit to lay out.

So, if we raise taxes on businesses and wealthy individuals, do you think the IRS will collect more revenue in the long run? Hauser’s Law empirically demonstrates that no tax rate in the US, from 28% to 90%, has ever generated revenue exceeding 20% of the GDP. To explain this effect, on a theoretical level, I can point to the Laffer Curve, and on a practical level, I can point to all the different ways by which wealth-creation mechanisms disintegrate in a country where it’s too expensive to do business (outsourcing, expatriation, decreased investment incentives, decreased trade due to the expense, etc.). But regardless of its cause, it’s a safe assumption to say that Hauser’s Law, for whatever reason, cannot be broken.

So, in fiscal year 2009, this country spent $3.518 trillion. The GDP for that year was $14.266 trillion. That means for that year, the government spent 24.66% of the GDP. If we freeze spending at that absolute level (meaning no increases in the dollar amount), we need to raise the GDP at least 25% in order to match revenues to costs without breaking Hauser’s Law. Additionally, the Reagan era showed us that we maintain revenue at the upper limit imposed by Hauser’s Law, even with a 28% top tax rate. Hence, the debate over what will balance the budget (and therefore, the question of what constitutes “sane fiscal policy”) comes down to a matter of what will raise the GDP the quickest, the most efficiently, and the most sustainably. This significantly simplifies our problem.

To answer this question, we have to decide where the wealth should be allocated in order to generate the most new wealth, dollar for dollar. If we raise the tax rate, then we’re putting a larger percentage of the wealth produced by investors and businesses in the hands of the government. If we decrease the tax rate, then we’re leaving a larger percentage of that wealth in the hands of the people who created it. So who is able to more efficiently create new wealth? The government, or the private investors who originally generated that wealth.

To answer this question, we need to consider the mechanism of wealth-generation. The following explanation is what you’ll learn in any introductory economics class. Every time you buy something without being deceived or forced through the threat of violence/incarceration, you are gaining something which is of greater value to you than the price you paid for it. Otherwise, you wouldn’t buy it. Hence, even though you’re giving up monetary wealth, you are becoming more wealthy in the general sense every time you buy something which is worth more to you than its price. Generalize this over the entire population, and you have the basis for wealth generation in an economy. Workers labor for an amount of money which they feel is worth more than their time, and they in turn spend that money on goods and services which are worth even more to them. Likewise, business owners give up a product for a higher price than the sum of the monetary cost and their investment of time. Investors give up their money for a more valuable opportunity to make money later.

What this means is that the more effectively money is being used to satisfy individual desires for value-increasing exchange, the faster the economic growth. Whoever knows an individual’s value system best is going to have the greatest capability to bring wealth to that individual through exchanges. And really, nobody knows a person’s value system better than the person himself. There is no possible way for the government to know more about the values and incentives for trade of the entire populace than the sum total of the individuals within that populace. Thus, every time the government takes money from individuals and spends it, instead of letting the individuals spend it on their own, some people will be less happy than others, and some may even gain negative utility as a result of the exchange. Hence, the government cannot possibly generate wealth off of money faster than the sum total of the individuals if that money is left with them. Friedrich von Hayek got a Nobel Prize for formalizing this idea (known as “The Knowledge Problem“).

Coming back to tax policy, what this means is that taxes higher than 20% (the limit from Hauser’s Law) are self-defeating. You actually decrease revenue if you raise taxes above that threshold for more than one year. On the other hand, the lower the tax rate (i.e. the more money we leave with the individuals in the economy), the faster wealth is generated, and the more efficiently the GDP will grow. This faster GDP growth, in turn, results in higher revenues (as an absolute dollar figure) for the government if you’re still collecting 20% of the GDP. This is what people are talking about when they discuss the “Revenue-Maximizing” and “Growth-Maximizing” points on the Laffer Curve. A flat tax of 20% puts you at the revenue-maximizing point on the Laffer Curve. The growth-maximizing point is somewhere even lower. Then, the fastest way to increase the revenue collected by the IRS (and therefore, by your admission, the sanest fiscal policy) is to set taxes somewhere between the growth-maximizing and revenue-maximizing points. When we need money fast, we should set it at the revenue-maximizing rate. When we are looking more towards long-term prosperity, we should set it closer to the growth-maximizing rate.

So that’s where my stance on tax policy comes from. I hope it sounds rational enough.

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One Response to “On Tax Policy”

  1. World Spinner Says:

    On Tax Policy « Tristan's Journal for a Free Society…

    Here at World Spinner we are debating the same thing……


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