Monday, June 14, 2010

Why Raising Taxes Won't Fix Our Problems

In fact, raising taxes is likely to destroy any hope of recovery and hurt us badly.  It's not Laffer's law, as is being widely reported (read this; there's great stuff here).  It's a consequence of Hauser's Law. 

Hauser's Law is probably the least intuitive thing you will ever encounter in economics.  As a physical scientist, calling it a law makes me uncomfortable, so let's just say it's an observation that has not been disproved.

No matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5% of GDP.
That is, when the maximum tax rate was 90%  as it was from 1950 until about 1963, the revenue as percent of GDP was close to 19.5%, and when tax rates were at their lowest, under 30% in the late 1980s, the revenue was essentially the same.  This illustration from the Peter G Peterson Foundation shows the effect:

There's an in-depth article at a blog called Political Calculations here.  Let me give you a heuristic explanation (that's fancy talk for "seat of the pants") of how I see it working.  Let's say you're in the top tax bracket: 

When tax rates are at that 90% level, you give most of your income to the government to waste.  As a result you have only 10% of your income for your self, to live on, save, invest, play with.  The economy slows to a crawl.  Revenues go down.  When taxes are 35%, you give less of your income to the government to waste, and have much more of your income to live on, save, invest, play with.  As a result, you buy things, invest in companies so they can grow, the economy heats up and expands.  Although you're paying a smaller percent of your income the GDP goes up so taxes go up.  Either way, the government wastes about 19% of GDP; only one way, we get to be happier and have more fun. 

The difference between the two worlds is vivid.  The 35% tax world is a much more vibrant, growing, moving world to live in. 

Empirically, we know this works; why is there even any question that keeping taxes low is the right thing to do?  

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