Why We Can't Just Keep Raising Taxes on the Rich

One thing about taxes that most people don't find intuitive is that the higher they are, the harder they are to raise.  Due to the way that most of us process information, an increase in the income tax from 10% to 15% seems larger than an increase from 50% to 55%.  That's because we tend to think of increases as a fraction of the original number.  So an increase from 10% to 15% is a huge 1/2 increase in your income tax rate, while an increase from 50% to 55% is just a 10% boost--why, you'll probably barely notice it!

This is also why we become less price sensitive when we are already spending huge sums of money.  Think of car shopping.  When you are buying a new mini for which you are paying $32,000, and the salesman offers you $250 for an option that lets you plug your iPod into the car stereo system, you're very likely to say yes if you're an avid iPod user.  But if you were in Best Buy, you probably wouldn't pay $250 for a set of cables to hook your iPod up to the auxiliary jack of your stereo while charging it from the cigarette lighter--and you'd probably think harder about the option if you were buying a $16,000 Honda Fit.  This makes no sense economically, but it's very natural for us, as anyone who has ever planned a wedding can attest--the price shock starts to make you remarkably blase about spending $300 on some trivial improvement. (An instinct that I have been fighting at every turn, before you ask.)

This means that we fail to register the fact that a 5% tax increase is not less noticeable, but more noticeable, when it comes on top of a 50% tax rate, than when the prior rate was 10%.  Here's why:  people notice their taxes in terms of their after-tax income, not the pre-tax.  On a base income of $100,000 (to keep things simple), increasing taxes from 10% to 15% means reducing take-home from $90,000 to $85,000--a harsh bite, but probably doable.

Increasing them from 50% to 55% means reducing take-home from $50,000 to $45,000, which is a serious blow, and may push the budget well into the red.

Of course, there are important caveats.  First, I'm talking about average tax rates, when increases are usually of marginal tax rates.  True, but the people that we seem anxious to take all this money from pay most of their taxes at the highest marginal rate.

The second caveat is that for people rich enough to pay most of their tax at the highest rate, do we really care?  It's not like this is the difference between hamburger helper and catfood.  It might be the difference between Martha's Vineyard and Cape Cod, in which case cry me a river.

I think we do care, however.  First, we care because whatever their income level, people plan around it.  I can almost guarantee that if you are affluent enough to be reading this blog, there are a lot of people out there in America who feel that we could easily take away a quarter of your income next year without your feeling much pain.  Yet you know how badly that would hurt your budget, particularly if it was permanent.  You have a mortgage, school fees, car loans, or whatever, that were undertaken based on your take home, not your take-home minues 25%.  Even if you're an aggressive saver, you'd have to cut your lifestyle dramatically in order to keep your savings rate up.  In a world where people have a lot of fixed obligations, this is a problem.

But the larger problem is that whether we feel for them or not, as noted in an essay one of my commenters pointed to, a 50% marginal rate seems to be where people get really, really serious about tax avoidance.  Paying more than half their income in taxes violates most people's sense of fairness.  More importantly, the higher the marginal rate, the bigger the payoff from tax avoidance--and the more you can afford to pay smart tax lawyers while still coming out ahead yourself:

The point where things start to go wrong seems to be about 50%. Above that people get serious about tax avoidance. The reason is that the payoff for avoiding tax grows hyperexponentially (x/1-x for 0 < x < 1). If your income tax rate is 10%, moving to Monaco would only give you 11% more income, which wouldn't even cover the extra cost. If it's 90%, you'd get ten times as much income. And at 98%, as it was briefly in Britain in the 70s, moving to Monaco would give you fifty times as much income. It seems quite likely that European governments of the 70s never drew this curve.

Once the Bush tax cuts for the wealthy are gone, and the new surcharges in the health care reform bill take effect, a lot of people in high income states will be above the critical 50% mark just in income taxes.  If proposals like lifting the payroll tax cap are implemented, there will be a lot more in that group.  We're approaching the limit where "Tax the rich" is going to be a useful solution even in terms of raising revenue.  We're also approaching the point where it may make more sense to invest in tax avoidance than in productive new activity.