Tax Cuts

Sept. 18, 2012
Tax increases will have a mixed economic impact.

A likely tax hike on high-income earners is on the minds of many business leaders and high-income individuals (earning more than $250,000/year). One political party maintains that high-income earners are not paying “their fair share” and the other says that lower taxes spur economic growth. There is no two-line graph that we can use to prove that lower taxes help the economy; there are simply too many other factors. A low-tax environment while fighting two wars and muddling through two decades of financial/housing irresponsibility is not the same as a low-tax environment while at peace and with a high-tech boom fueling the economy. 

We talk on the road about the potential end of the so-called Bush Tax Cuts and what the tax hikes are likely to mean. The basic assumption is that taxes will be going up on high-income earners and that the effective tax rate will climb seven to eight percent from where it is today. 

Two salient questions come from the discussion.

One: Do you trust Congress to take the increased revenue from these folks and actually use the money to pay down the debt or reduce the deficit in anything approaching a meaningful way? Do you believe every dollar of increased revenue will decrease the deficit by a dollar? Virtually no one believes that, including me. New programs, increases in existing expenditures, and the natural cost of processing those funds through the Washington system will most likely eradicate anything more than a marginal nudge in the budget deficit. 

Two, will a seven percent hike in taxable income have a meaningful change in the flow-through business or on the high-income individual? Let’s start with a business’ taxable income of $500,000 for the year. A seven percent tax increase means an additional $35,000 in taxes. That is a meaningful sum to many small business owners, and it could impact spending on equipment, training, or employment. A $70,000 hit on a $1,000,000 of income is the cost of a new employee and a significant hit to many firms that operate on a thin margin. An individual earning $300,000 will pay an additional $21,000 in federal taxes. That may be the bathroom renovation, new furniture, a new car, or a reduction in investment. The lack of purchase or investment is in no way tragic on a one-off basis, but, but purchases/investments spur demand for goods and services.

Lower demand means slower job growth and slower economic growth in the aggregate. 

The reality is that a tax increase off today’s very low rates will have a slight negative impact on the economy, but it is likely to have only a marginal positive impact on debt reduction.   

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