WASHINGTON, September 2, 2015 − Currently popular Republican presidential candidate Donald Trump has issued a few specifics about what he would do with his tax policy were he to win the election. “I think the rich should pay more,” he says.
President Obama agrees, often contending that “the rich should pay their fair share,” although never actually specifying what a “fair share” is. In reality, raising taxes on the rich hurts all of us.
President Obama has already raised marginal income tax rates on the wealthy by 10 percent. He also raised capital gains taxes on the wealthy by more than 50 percent. He says this is needed to reduce income inequality and to pay for health insurance, welfare and food stamps for the lowest income earners.
Donald Trump says that wealthy hedge fund managers don’t pay their fair share due to a loophole that allows their income to be taxed at a lower rate. Besides, he contends, the financial wizards aren’t building buildings. All they are doing is moving paper around, he says, perhaps not fully understanding the real value of raising billions of dollars for companies like Google or Facebook or even Trump properties. According to Trump, bankers, investment bankers, hedge fund managers and the like earn such large incomes that they should be taxed at a higher rate.
Both Trump and Obama agree that by raising taxes on the wealthy, the middle class will get a tax break and therefore pay less. The problem is that while the middle class could pay a lower rate, there will likely be fewer people paying income taxes, while those that do pay will be earning less income.
If we remove the instinctive emotional reaction many of us have when we learn of people earning what seems like a ridiculously large income − often exceeding $100 million annually − and just look for a fair and optimum tax policy, we can arrive at a more reasonable conclusion.
Our goal should be to implement a tax policy that encourages economic growth − growth that will continually raise the standard of living for all Americans while meeting the goals of raising sufficient revenue, achieving equity, creating no market distortions and being easy to administer.
Following Obama’s and Trump’s notion of over-taxing the wealthy would lead to slower growth and less equity, actually worsening income inequality and lessening economic opportunity for all Americans.
The reasons are simple.
There are three things that people do with their income. They pay taxes, spend it or save (invest) it. For income earners, taxes are paid first; then the remaining level of spending is set. What is left over after taxes and spending goes to saving and investments. Raising taxes on the wealthy effectively leaves their level of spending the same, making less available for them to save and invest. That, in turn, reduces capital available to the economy. It is the highest income earners who provide the majority of new capital for our economy.
There are two basic inputs into the economy: capital and labor. How productive these inputs are when producing output (product) depends on a number of factors, including technology, entrepreneurship, natural resources and human capital (education).
In today’s economy, the labor force is disproportionately small since less than 63 percent of the adult population is currently working or willing or able to work. This figure should be in the 67 percent range as it generally was before the Great Recession.
Raising taxes on the wealthy reduces capital formation. Couple that with the current low labor participation rate, add in the burdensome government regulations that stifle entrepreneurship and we have only technology remaining to drive economic growth.
With less growth there is less demand for labor. This lack of demand for labor keeps wages low and the number of jobs available (opportunities) low as well, hurting the vast majority of American workers who were supposed to benefit when the government hiked taxes on the wealthy.
There is a much better solution to the current problem that reaches all of the popular goals but may prove to be politically impossible.
Remember: an individual doesn’t pay in terms of percentage points. A person pays in dollars. The better solution to our taxation dilemma is this:
A single rate tax of 15 percent on all income above a livable minimum (twice the poverty rate) with no deductions for anything. All income is treated the same whether earned by wages, salaries, rent, interest, profits, dividends or capital gains. The corporate tax rate would also be 15 percent.
This simple, understandable policy would raise more tax revenue, significantly add to economic growth, quickly reduce unemployment and increase wages, revive the great American entrepreneurial spirit, provide opportunities for all and be (arguably) fair. By fairness we mean that, above a livable minimum wage, all income from all Americans would be treated exactly the same.
While this plan would be economically optimal, it may be politically difficult to sell to the electorate. The alternative is to set a higher rate, perhaps 25 percent, on marginal income of the very highest income earners. This will have negative economic effects but may be the right “second best” solution.
While taxing the rich may sound good on the political trail, the reality is that taxing the rich hurts the poor.