Texting, Marginals, and Tax Rates on the Rich

When I was in the fourth grade my teacher said I was marginal. Being confused I immediately took out my ipad and went to Wikipedia. No not really – at that time the wheel had not been invented yet and fire was a new concept. But we did have a huge paper weight in our house that was called a Dickshunary so I asked my mom to help me research marginal. At that time little did I know how much would be riding on something called marginal tax rates. This post explores the importance of marginal tax rates and concludes that little good can come from increasing marginal tax rates on the rich. Raising average tax rates for the rich might be better in economic terms. Unfortunately politics seems to matter more than economics these days.

MY exploration in the dictionary didn’t help much . One definition said that marginal is something found only at the outer limits and therefore is not of central importance. Another definition referred to something on the edge. A third applied the term to apparently less important words written in the margins of a page. Since I had not yet taken on the habit of JD I had little to relieve my marginal headache. I felt even worse when I found the following example of the use of the word marginal – “having reviewed the test, there are two students below the required standard and three more who were marginal.” I wondered who those other students were.  The confusion is that while marginal often refers to things that are not very important – when you have been branded "marginal" like these students – that seems pretty important. It might mean the difference between moving on to the next grade or staying another year with the same mean, ugly, and hateful fourth grade teacher at Coconut Grove Elementary School.

When I took my first economics course at Georgia Tech, Professor Schaffer told me that marginal was critical to understanding decisions. Marginal helps to concentrate the most important factors when making a decision. So let’s suppose we are trying to decide whether or not to walk down the street while texting. On the one hand, there are benefits from this course of action. I can walk down the sidewalk and Tweet to all my friends about how wonderful I feel walking down the street. Let’s call that the marginal benefit of the decision. On the other hand, there are also new costs associated with this decisions. It is quite possible that while I am texting I might walk into a tree or a parked Vespa. Then I would have to go to the hospital. 

Hospitals are costly. Let’s call that the marginal cost of the decision.  I can’t speak for you but let’s say I believe the MB is greater than the MC. Then I make the decision to go ahead and text while walking. Of course if the MC is greater to you than the MB, then you decide not to text while walking. Advanced math explanation:

·         MB > MC then do the action

·         MB< MC then do not do the action

·         MC is an important concept despite the marginal stuff written about it in the dictionary

Last week my post was critical of plans to increase marginal tax rates on the rich. After 396 pages of detailed and insightful analysis, I left out a couple of things. I mentioned that an increase in the marginal tax rate for the upper 2% might not be good for the economy. I suggested it could lead to another recession in the USA as soon as 2013. But I didn’t explain why. So let me carry on that argument.  

Let’s suppose on some planet that resembles Earth that the marginal tax rate for incomes above $200,000 per year was 100%. Let’s call that planet Obiden. The marginal tax rate for incomes equal to or less than $200,000 on Obiden is 35%.  Jim lives on Obiden and runs a manufacturing company that makes Obiden T-shirts. Jim loves to surf on the Han River in his spare time and also enjoys spending time with his family playing checkers and Mass Effect 2.

Jim’s business is doing well and he is thinking of hiring more people and adding a new manufacturing location in a right-to-work state named Michi on Obiden. Michi looks a lot like the outline of my left foot. Anyway, Jim has a crack accountant named Kilt who explains over a couple of Heffe Weitzens that if his income goes above $200,000 he will not get a penny of the increase. With the 100% marginal tax rate on incomes above $200,000 any income he earned above $200,000 would all go to the government for good deeds.  Jim would pay 35% of $200,000 (=$70,000) as his tax. If he made, for example $250,000, he would pay the $70,000 in tax plus another $50,000.Thus his average tax rate would increase to 48%. In this example the government raises revenue, it raises the average tax rate, and it does it by increasing the marginal tax rate.

My liberal friends who are still awake would scream – Larry – no one is proposing a marginal tax rate of 100%. Then they would call me a lot of names and hang up on me. But extremes are often used to make legitimate points. For example, Democrats often depict rich people as selfish and beyond any real empathy for the poor. That extreme view of rich people makes it easier for them to want to punish rich people and confiscate their income and wealth.

But the general point is made. When it comes to the decision to expand Jim’s factory and hire more people on Obiden, it is the marginal tax rate that matters the most.  The definition of marginal is what Prof. Schaffer taught us smelly freshmen – the marginal tax rate is critical for making decisions since it applies to MORE or NEW incomes – not to all our income. When we raise the rate of taxation on wage income, on dividends, or on capital gains on the highest or last income earned – we are directly impacting decisions that involve change.  Changing average tax rates has no such extreme effect.

We don’t know what the critical marginal tax rate is for the USA. Maybe the current rates are already too high for economic expansion. Maybe they are too low. Maybe 39% is too high. No one knows for sure. But you are definitely flirting with danger when you raise these rates at a time when most people are predicting a slowdown in the US economy in the coming months.

When we say rich people we have some idea that these super rich individuals (with incomes over $200,000????) can easily and gleefully absorb the marginal tax increase. And maybe some would or could. But this defies Prof. Schaffer’s lessons. Marginal tax rates impact decisions. Raising MC relative to MB is never a good thing for output and employment. Think of the kinds of decisions that might be made as those with incomes above $200,000 react to the new and higher marginal tax rates:

·         Cut or do not expand output and employment

·         Delay output and employment to a future time when marginal rates might be lowered

·         Work less and take more leisure

·         Move output and employment to another location in Mexico or Canada

·         Consume less as you prefer to not sell stocks or bonds so as to postpone capital gains

·         Consume less as you move from dividend stocks to non-dividend stocks deferring gain to the future

·         Sell your worst stocks at a loss – the benefit of capital losses against taxes is now higher. This reduces your wealth and your desire to spend

These are a few behaviors to note but certainly there are more. The general idea is that raising marginal tax rates reduces the incentives to work, to produce, and to invest. Use the comment section on the blog to tell me what I missed. How else do increases in marginal tax rates cause negative effects?

The main idea should not be lost in the details – raising marginal tax rates create perverse incentives for economic growth. It is possible to raise revenues in such a way that these perverse impacts are minimized. If part of the political solution to current deficit/debt challenges is raising tax revenues on the wealthiest Americans, then more thought should be given as to how to do this. Capping deductions and similar schemes can impact the rich more than others and might have smaller undesirable impacts on economic growth. It goes without saying, however,  the more we restrain unbridled government spending the less has to be done in the way of tax revenues. But that’s another topic and you have shopping to do. So let’s carry this on later.