Why Do Higher Tax Rates Often Lead to Lower Tax Revenues?

It’s really counter-intuitive.  But, raising tax rates, leads to lower tax revenues for the government and lower economic growth for the economy.  Well-known economist Arthur Laffer reminds readers of this fact in an article in The Wall Street Journal this week.  The article includes lots of data for the skeptics too.  If you get a chance, you might want to read the article.  So, why do higher tax rates lead to lower economic growth?  Let’s talk about it now.

The first reason is very simple.  Taking money from the highly productive private sector of the economy means less capital formation (that is, less money from savers and investors that is pooled together to invest in new business).  Obviously, with less capital formation and diminished new economic activity, economic growth drops and tax revenues decline as well.

A second reason is more subtle and many within government seem to ignore it.  People don’t want to pay higher taxes and they will take action to cut their tax bill.  For example, a family might move from a State with an income tax that’s going up to a different State that has zero income taxes.  Or, if the tax rates are high enough, one member in a two-income household might quit work and just stay home.  This is especially true in higher income households that might feel the burden of higher and higher marginal tax rates.

Ironically, the very people who call for cutting deficits with higher taxes, don’t seem to realize that those higher marginal taxes will not only raise unemployment and cut economic growth, they will actually tend to raise deficits as well.

Back to Arthur Laffer’s article for an example.  Between 1968 and 1981, under Presidents Johnson, Nixon, Ford and Carter, tax rates went up.  What happened to tax revenues from the top 1% of taxpayers?  It dropped from 1.9% of GDP to 1.5% of GDP.  So, higher tax rates led to lower tax revenues as a percentage of GDP.

If we want to boost tax revenues, we better start cutting taxes.  Plus, if we want to try to avoid a double-dip recession in 2011, then we ought to cut taxes on economic growth now – by cutting taxes on income, savings, and investment.

Citizen Economics Blog – News, Analysis, Insight, Practical Knowledge by Gerard Francis Lameiro, Ph.D.

Bookmark and Share
This entry was posted in Double-Dip Recession, Economic Growth, Economy, Jobs, Taxes, Unemployment. Bookmark the permalink. Comments are closed, but you can leave a trackback: Trackback URL.