Why Taxing 'The Rich' Doesn't Work

Financial Struggle

If you want to understand politics, all you have to do is think back to third grade. Even at 8 years old, it was probably clear to you that the only reason the class bully picked on weak kids was because they were unable to defend themselves. That’s exactly the strategy driving proposals to raise tax rates on corporations and “The Rich.”

Never mind that you’re barely scraping by if you’re trying to raise a family of four on $250,000 a year in places like Long Island, N.Y., San Bernardino, Calif., or the suburbs of Chicago. The folks in Washington, D.C., consider you wealthy. Thanks to Obamacare you’re going to see your income taxes go up on Jan.1.

It’s Not Fair! (No Kidding!)

We continually hear that "The Rich" got richer thanks to the tax cuts enacted in 2001 George W. Bush's first term. If that’s the case, why is it that in the wake of these lower tax rates (set to expire at the end of this year) the top 1% of income earners now pay roughly 40% of the income taxes collected. As you can see by the chart below from the non-partisan Tax Foundation, that’s double the share they paid back in the early 1980s. (2)

Still convinced the “wealthy” (whatever that means) don’t pay their fair share? It turns out that the U.S. has the most progressive personal income tax rates of any country in the Organization for Economic Cooperation and Development (OECD). According to the Tax Foundation, “the top 10% of U.S. taxpayers pay a larger share of the income tax burden than do their counterparts in any other industrialized country, including traditionally ‘high-tax’ countries such as France, Italy, and Sweden.” (1) Moreover, the Tax Foundation calculates that even if you took as much as half the annual income “from every person making between one and ten million dollars,” you’d only reduce the federal deficit by 1%.

I Double-Dare You to Defend Yourself!

Here's the question: Why- especially in an election year- is raising taxes on top earners so popular? “It’s clearly class envy,” says Tom Giovanetti, president of the Institute for Policy Innovation (IPI), an economic think tank headquartered in Dallas. (It’s no coincidence that Texas is a state with no income tax and far from our nation’s capital.) “There’s a group of voters who are very susceptible to arguments that the rich or corporations should pay more. They’re not interested in thinking it through.”

It may also have to do with the fact that the wealthy aren’t organized. There’s no union for taxpayers who fall in the top two brackets.

It’s All Connected

Here's the problem with raising taxes on business entities: “Any economist will tell you that corporations don’t pay taxes. They’re passed along to consumers in the form of higher prices,” says Giovanetti. “When you’re buying a car from Ford (NYSE:F), you’re paying Ford’s taxes. Business taxes are embedded in the prices of goods and services. They’re counter productive.” In other words, if you want to pay more for your next car, you should be in favor of raising taxes on the automotive industry.

In addition, when you tax “millionaires” you’re taxing a lot of small business owners, who typically hold their companies as “pass-through entities” (sole proprietorship, partnership, LLC) and, thus, pay tax on their business profits at the individual level.

Last fall, Tax Foundation president Scott Hodge pointed out to the House Committee on the Budget that “fully 68% of private business income is earned by taxpayers with AGI [adjusted gross income] above $200,000- the target range of President Obama’s proposed tax rate increases.” Since small businesses are the engine of job creation, reducing the income of the owner means s/he has less incentive to take on the risk of expanding, buying new equipment, or hiring more employees.

Just Do the Math?

Don’t take my word for it. According to Hodge’s testimony, international researchers at the OECD concluded that “the corporate income tax is the most harmful tax for long-term economic growth.” (1) Moreover, while “75 countries have cut their corporate tax rates to make themselves leading industrialized nations at over 39 percent.”(3) Is it any wonder jobs are leaving this country and going overseas?

Think about this on a personal level. If the sales tax in your area was 6% and a neighboring state has no sales tax, wouldn’t it be worth it to drive a little farther to save the money? Especially on a big-ticket item such as a television? Why would the owners of corporations act any differently? All other factors being equal, if you were on the board of a company looking to build a new plant, wouldn’t you vote to locate it in a low-tax country?

If a company can’t or doesn’t choose to re-locate, raising the corporate income tax hurts American employees in the form of lower wages. A national study by an economist at the Federal Reserve Bank in Kansas City, found that “a one percentage point increase in the average corporate tax rate decreases annual gross wages by 0.9 percent.”  The Tax foundation explains that in non-economic speak, “this means that a $10.4 billion increase in corporate tax collections would lower overall wages by $43.5 billion.”(1)

Yet the message we continually get from Democrats is that the way to dig ourselves out of the record-breaking deficit we’ve amassed in the past 4 years of the current administration is to impose ever higher tax rates on businesses and The Rich. “Every time you try to raise taxes you eventually reach a point of diminishing returns,” says Giovanetti. “It drives companies to re-located jobs and employees off-shore and it drives capitalists to move their wealth.”

I’ll Take My Wealth To Go

In other words, the thing that politicians forget is that everyone- even the wealthy- makes choices about how they spend their money. Remember the 10% “luxury tax” passed in the 1990s? It was an additional tax on the purchase of boats and cars above a certain value. Before this tax was repealed, it nearly wiped out the domestic boat industry in this country. Turns out, it doesn't matter how deep pockets go--even "The Rich" will choose to postpone buying a new yacht to avoid the expense of a burdensome tax. “The luxury tax didn’t hurt the wealthy,” says Giovanetti, “It hurt the people that make things for the wealthy.”

Money is one of the most mobile resources corporations and individuals possess. According to Giovanetti, a year after Maryland enacted its so-called ‘millionaire’s tax’ a third of the state’s millionaires disappeared off the tax rolls. “Either they moved or they made changes to their personal finances [in order] to report less income.” There are already anecdotal reports of a similar phenomenon occurring in France, which has just elected a socialist president who ran on a platform of demonizing the wealthy and has promised to sharply raise taxes on top earners. The London newspaper The Guardian reports local realtors are starting to receive inquiries from French citizens looking to re-locate across the Channel.

1. Scott A. Hodge, “Tax Reform: The Key to a Growing Economy and Higher Living Standards for All Americans,” Tax Foundation, Testimony Before the U.S. House of Representatives Committee on the Budget, September 14, 2011. http://www.taxfoundation.org/research/printer/27613.html.

2. William McBride, “Reversal of the Trend: Income Inequality Now Lower than It Was Under Clinton,” Tax Foundation. January 20, 2012.

3. See “Hodge” for an explanation as to why, even considering tax deductions and write-offs, U.S. corporate tax rates are still higher than other developed countries.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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