Wednesday, April 26, 2017

A Tale of Two Curves

The difference between government revenue and personal remittance

A tweet by wealth manager Barry Ritholtz led me to a New York Times article by Peter Baker and the Trump administration's renewed interest in a theory and curve drawn by economist Arthur Laffer more than 40 years ago.

The Laffer curve is a graphical representation of the relationship between tax rates and government revenue. Mr. Laffer drew the curve showing only rates of zero and 100 percent but he seemed to imply that incoming revenue would start to fall when tax rates exceed 50 percent. For the layman it's easy to understand that at 100 percent tax rate people might barter to avoid taxation. But research doesn't support the 50 percent implication and, instead, suggests that revenue decreases don't occur until very high tax rates.

(Before I get to the point of this post, let me tell you that I don't support high tax rates. However I think Mr. Laffer and many people miss a vital point of view: taxes are a fee for service. Whether you want the services that are provided are another matter. If you view taxes as a taking, you'll disagree with me. But "good government" aspires to "good value" for the services it provides. Again, whether we have "good government" is a point of contention. Now ... on with the post!)

I'm going to suggest that instead of barter a much more complicated mechanism arise. Barter is a form of tax avoidance; so is the cash economy where transaction occur without record or tax. But tax avoidance can also be had through policy and legislation, namely through tax exemptions, deductions, and preferences also known as tax expenditures

Look at it this way: wage earners have little legislative sway or engagement; owners of capital and companies have immense influence and access to legislators. Taxes on wage earners are primarily Social Security and Medicare (FICA) and may be viewed as the promise of a pension and senior healthcare. (Why this view is wrong is the topic for another discussion.) As income rises and income taxes kick in after the personal exemption and standard deduction, overall tax rates at the Federal level (FICA plus income tax) increase and the the tax system become progressive (that is, rates rise with income).

But as rates rise so do the number of tax deductions above the standard deduction: employer-provided health insurance, mortgage interest, state and local taxes, and so on. The increases in deductible income offset progressive tax rates. And as income from capital increases and wage income decreases, the overall tax rate falls as contributions to FICA wane. The increasing number of tax preferences (red) laid on top of the Laffer curve (rotated counterclockwise in green with the axis renamed) might look like this:

So that's my thought this morning: not much of a theory and someone has probably thought of it already. But we know that President Trump has said in some years he paid no tax because the type of income he had and the tax preferences he used to avoid any tax obligation. All perfectly legal.

When you get something for nothing you might be called a free rider. When you pay no tax legally you might be called Mr. President or Chairman of the Board.