Why do total tax revenues go down when income tax rates go up (and vice versa)?

By: Joe Messerli

"It should be known that at the beginning of a dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments" --Ibn Khald�n

The S&P downgrade of the U.S. credit rating, a result of a near $15 trillion debt that is growing by almost $1.3 trillion per year with no end in sight, has brought national attention to a growing crisis that threatens to destroy not only the U.S. economy, but the world economy also. Most people would agree that out-of-control government spending is the main cause, as evidenced by the fact that spending has doubled in the last decade, while tax revenues have stayed relatively constant. However, most people would agree that total tax revenues will likely have to increase along with a drastic cut in spending in order to bring the budget back in balance. The specifics of growing that revenue is hotly under debate, however.

Many politicians and media pundits are calling for increasing tax rates, primarily on upper income individuals and businesses. But does this really increase total revenues? Total tax revenues have actually increased under the tax cuts of Reagan, Kennedy, and Bush. Annual revenues nearly doubled under Reagan's presidency, despite the fact the top tax rates were drastically cut! Nowadays, the government is finding every way under the sun to tax us, but total revenues aren't increasing. But why?!!! It can by boiled down to one simple equation:

TOTAL TAX REVENUE = TAXABLE INCOME * TAX RATE

For example, if taxable income was $10 trillion, and average tax rate was 20%, the total tax revenue would be $2 trillion. Simple, right? So why wouldn't total revenue increase to $3 trillion if you raised the average rate to 30%?! It's because this assumes the other number, taxable income, stays constant. But the fact is, it doesn't! Businesses and individuals change their behavior in response to changes in the tax rate structure. This partially explains why tax revenue actually increased under Kennedy, Reagan, and Bush (at least until the 2007 financial crisis), despite the fact they cut rates. Let's examine why that first factor, taxable income, goes down in response to an increase in the tax rate.

Investors shift money from taxable investments (such as stocks and bonds) to non-taxable ones (such as municipal bonds). All investors, from millionaires to fixed income retirees, seek to maximize their annual investment income. Tax-free investments like munis naturally pay a lower rate of return. Taxable investments like corporate bonds, pay a higher rate. Since the government taxes a chunk out of taxable income, the after-tax return changes in response to a change in rates. For example, say a $1000 corporate bond pays 10 percent, leading to a $100 interest payment. A marginal tax rate of 30% means the after-tax return is $70 ($100-$30 tax). If the municipal bond pays a rate of 6 percent, the after-tax return is $60 ($1000*6%). So because $70 is higher than $60, the investor stays with the corporate bond. Now assume the marginal tax rate is raised to 50%, the after-tax return of the corporate bond is now $50 ($100-$50 tax). Since the municipal bond now pays $10 more, investors are likely to shift money from the corporate bond to the non-taxable muni. Consequently, that first factor, TAXABLE INCOME, drops to $0, and the tax revenue from the bond is completely eliminated. Sure, this is a simplified example, but remember investors nowadays are more sophisticated, especially wealthy individuals that can hire expert accountants and lawyers to squeeze out every penny of income. Computers are making this easier every day.
There is less incentive to work extra hours given the smaller after-tax wage rate, meaning taxable wages decrease. While almost everyone has to work to some extent to pay the bills, the decision to work a second job and/or overtime hours is often one of choice. Do you really need the extra income enough to give up much of your leisure and relaxation time? At $100 per hour, you might say "No doubt"! At $50, probably yes. At $25, maybe. At $10, no way. Everyone has their threshold where the extra money just isn't worth it. By raising tax rates, the hourly rate of take-home pay drops, pushing some below their acceptable threshold. The threshold exists at all levels, from the factory worker that declines taking an additional shift, to the doctor who sees fewer patients. The bottom line is that their is less productivity and taxable income.
A smaller potential return means investors & venture capitalists are less willing to risk their money, meaning less business & capital gain income. Everyone with savings has a choice where to put his or her money. We want to earn as much of a return as possible, but we don't want to put our savings at excessive risk of loss in the process. Higher risks, therefore, must be accompanied by higher potential return. If you know the government will take a substantial portion of your earnings if an investment happens to pay off, you know the potential return is limited. Therefore, you may instead decide it isn't worth the risk, and instead put your money in a safer investment like a money market, where you won't lose any money. The net effect on society is that fewer people are willing to start new businesses, businesses are less willing to expand, venture capitalists are less willing to put up money into new opportunities, and investors are less willing to put money into stocks. Business tax income as well as individual capital gains & dividend income are limited as a result. Keep in mind that lower risk investments like CD's are taxed only once, while corporate income is effectively taxed twice--once at the business level and once when it's distributed to owners as dividends. Thus, it generates much more taxable income if investors put their money in stock.
Total economic activity slows as a result of money being taken out of the private sector, where it is spent more efficiently, where capital is pumped into more productive parts of the economy, and where the fiscal multiplier effect is much greater than it is in government. Everyone knows how inefficiently government operates. We've all seen news stories about $500 hammers, bridges to nowhere, duplicate work processes, government employees lounging on the job, and on and on. Not only is government wasteful, it's corrupt, as politicians frequently load bills with pork that pays back campaign contributors and bring business back to their states. Due to the massive government waste, the economic multiplier effect of a $1 of government spending isn't nearly as high as a $1 of private spending. Government is the only place where a miserably failing program or agency could continue to get funding. Conversely, in the private sector is placed into the most efficient and in-demand places. Poorly-run businesses that don't earn more than they spend go out of business.
Citizens have greater incentive to cheat on taxes, use risky tax shelters, or hide their income. Imagine you were making $250,000 per year in before-tax income. If the government was taking 40%, or $100,000, would you look for risky or potentially audit-triggering deductions? Would you report some extra cash income you made working a side job? Would you go to an accountant to find deductions or tax shelters? Would you try to hide some of your income in foreign accounts or in some other way cheat on your tax return? What if the rate went up to 60%, costing you an additional $50,000 per year? What if the rate went up to 80%, costing you $200,000 per year in taxes? Most people have a threshold where they no longer are completely being law-abiding citizens as far as taxes are concerned. At a low tax rate, people may think, "It's not worth the risk of jail, fines, or an audit." At higher rates, that can change quickly. Look at it from the perspective of a billionaire. Assume he makes $250 million in income per year. A simple tax rate increase of 5% amounts to $12.5 million per year! Do you think it's worth that much to hire expensive accountants or lawyers to stretch the law in their quest for keeping taxable income as low as possible?
The underground economy, consisting of bartering and off-the-books cash transactions, grows bigger in size, reducing on-the-books taxable income. This relates to the same kind of thinking as with cheating on taxes; i.e. there is more incentive as tax rates increase. For example, an independent computer consultant needs help with his tax return; an accountant needs help setting up QuickBooks on a network. Rather than charge each other a $100/hr rate as they might with other customers, they simply trade each other services without reporting anything to the IRS. Another example, a lawn service quotes you two prices: 1) $40 per hour if paid by check, 2) $30 per hour if paid by cash. The cash deal is better for them since they can keep the transaction off the company tax return, while a check can be traced. As taxes increase, more people are willing to work out these off-the-books type of deals, which lead to less taxable income and revenue.
People are more likely to contribute money to 401k's and IRA's in a higher-tax environment. It's definitely not a bad thing that people are saving for retirement, but contributions do lead to a reduction of taxable income and revenue to the government. Most people don't contribute the maximum to these accounts since they can't access the funds until retirement without penalty. However, as tax rates get higher, more and more people will decide the limited access to the funds isn't worth the tax cost, so they increase their contributions.
Corporations and wealthy individuals eventually leave the country, taking all their income with them; this is especially true nowadays in a world where technology makes it easier to live or do business overseas. There are hundreds of nations around the world that would love to play host to businesses and individuals with wealth. And in an age of advancing technology, you can get your sports, music, TV, movies, etc. anywhere as long as you have an internet connection. Consequently, if the U.S. keeps raising taxes, eventually the people of wealth will get fed up and simply leave the country. It's ironic that citizens from all over world used to seek sanctuary from such things.

For a more detailed explanation as to why tax revenue and tax rates can go in opposite directions, Google the Laffer Curve.

Bar Stool Economics

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100.
If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the
arrangement, until one day, the owner threw them a curve. He said, "Since you are all such
good customers, I'm going to reduce the cost of your daily beer by $20. Drinks for the ten now cost
just $80."

The group still wanted to pay their bill the way we pay our taxes, so the first four men were unaffected. They would
still drink for free. But what about the other six men -- the paying customers?

How could they divide the $20 windfall so that everyone would get his "fair share"? They realized that $20 divided by
six is $3.33. But if they subtracted that from every body's share, then the fifth man and the sixth man would each end
up being paid to drink his beer. So the bar owner suggested that it would be fair to reduce each man's bill by roughly
the same amount, and he proceeded to work out the amounts each should pay!

And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33% savings).
The seventh now pay $5 instead of $7 (28% savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free.

But once outside the restaurant, the men began to count up are their savings.

"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"

"Yeah, that's right,' exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I!"

"That's true!!"shouted the seventh man. "Why should he get $10 back when I got only $2? The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it
came time to pay the bill, they discovered something important. They didn't have enough money between all of them
for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the
highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they
just may not show up any more. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

Why do total tax revenues go down when income tax rates go up (and vice versa)?

TOTAL TAX REVENUE = TAXABLE INCOME * TAX RATE

Bar Stool Economics

Links