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Dec 29, 2008

The Deadweight Loss of Taxes

Production and employment is reduced by increasing taxes, despite increased government spending. Raising taxes on anyone, especially the rich, lowers production in the U.S., and so lowers the number of jobs and pay levels. It is ironic that taxing the rich makes everyone poorer, the same effect as taxing the middle class. It makes us a lot poorer.

The term "deadweight loss" refers to what is lost or never produced because of some policy. A higher income tax rate produces responses that decrease investment and production (jobs).

The primary effect is to remove money from individuals who would invest it more efficiently than the government. People will also work less, earn less, and pay less tax, if they don't think the extra money they could keep after tax is worth the extra hours or risk.

The secondary effect is to give investments a lower rate of return after tax, so investors tolerate less risk and invest more in tax free bonds and legal advice to avoid taxes. This also lowers investment in new activities and reduces opportunities for better paying jobs.

As an extreme example, a 95% tax rate would convince most people to work less and spend more time and trouble on avoiding the tax. Any investment with even a little risk would be avoided.

In November 1999, Martin S. Feldstein was the George F. Baker Professor of Economics at Harvard University and former President of the US National Bureau of Economic Research. He investigated the current effects of income tax rates on the economy.

Tax Avoidance And The Deadweight Loss Of The Income Tax

[edited] Traditional analyses of the income tax greatly underestimate deadweight losses by ignoring its effect on compensation and consumption [jobs]. The full deadweight loss is easily calculated to be as much as 30% of total revenue.

The deadweight loss caused by increasing tax rates above current levels may exceed $2 per $1 of revenue increase.

I will restate this. Government activities and transfer payments had better be useful to the society, because economic output has already been lowered by 30% of the taxes currently collected. Further, $2 worth of production (jobs) will be destroyed for every additional $1 collected through increased tax rates.

To restate this, society begins with three units of production and jobs. After an increase in tax rates on the rich, those three units disappear, transferring just one unit to the purposes of the government. Two units just disappear, the deadweight loss of increasing the tax. The loss could be all three units if the activities of government produce nothing of value.

This is a severe loss, because there is no "stimulus" from that "extra" $1 in government spending. That $1 would have been invested or spent anyway. Taxes only move goods around from some people to other people, at great expense.

To transfer $1 to a needy voter, or bail out a public loss, the government will take $1 from a richer person, eliminating $2 in production of goods and services, also called jobs. By the same analysis, $1 of reduced tax from lower rates supports increased investment that in turn supports $2 in new production and jobs.

This easily explains why tax rate cuts under Reagan and G.W.Bush increased the prosperity of the U.S. And, it explains why the threat of tax rate increases under Obama has so frightened and lowered the stock market.

Government subsidies, guarantees, and bailouts kill prosperity because they require borrowing now and higher tax rates later. Higher tax rates usually produce increased revenue for government, while destroying twice as much income for the population in the bargain. Government spending today will be paid by printing money "out of thin air". This will cause inflation that will make everyone holding cash in a bank account pay for current spending as prices rise and their savings buy less.

The Myth of the Economic Multiplier
I consider why it seems there should be a stimulus that goes beyond each dollar of spending, and why this is wrong. Government spending is a banquet, not a stimulus.

Public Tax Meeting
A story about proposed tax policy. What is it like in a small town to raise taxes on the wealthy 35% and give a rebate check to the 65%.

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