Increasing Revenue by Lowering Taxes

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Posted in: Tax and Economics

Lawyers and economists know that there are two primary purposes of taxes: one is to raise funds for the government; the other is to discourage activity. If we want less of something, we tax it. For example, if the federal government raised the tax rate on cigarettes or alcohol, it might raise more revenue, but the primary purpose of the tax is to discourage the activity taxed, to change behavior.

If the purpose of the tax is to raise funds for the government, the tax rate must not be too high, or the government will collect less than if it had set the rate lower. Lower tax rates can produce more revenue than higher tax rates for the same reason that Wal-Mart, with its lower prices, makes more money than Tiffany & Co. For example, when the United States has lowered the capital gains rate, it has collected more in capital gains taxes. When it raises the rate, it collects less in taxes.

Consider, for example, what happened since 2003, when Congress lowered the tax rate on capital gains and dividends. The Government revenue from tax payments on capital gains increased by 79 percent and its revenue from dividends increased by 35 percent, even though the taxable rate fell from 39.6 percent to 15 percent. The National Bureau of Economic Research reported in a 2004 Working Paper 2004 (No. 10572), “After a continuous decline in dividend payments over more than two decades, total regular dividends have grown by nearly 20 percent since the beginning of 2003—precisely the point at which the lower tax rate was proposed and subsequently applied retroactively.”

The federal government has now raised the rate on dividends and capital gains to the highest it has been in years. For taxpayers in the 39.6 percent bracket, the tax on qualified dividends (the ones getting the lower rate) will be 23.8 percent (20 percent plus an additional 3.8 percent investment-income surcharge). In a few years, we can examine the statistics and see if this time, it will be any different from how it has been in the past. Will the higher rates increase tax revenues or (as the past indicates) lower revenues and increase incentives to find loopholes?

President Obama has said that the capital gains rate should be higher to be fairer. Yet, if raising tax rates lowers government revenue, the government will have less to spend to fund a safety net for the poor. If this tax on investments leads to fewer jobs (because if we tax capital gains we get less of it, just like we get less of anything when we tax it), the people paying for this greater fairness will be the unemployed.

Recently, the news reported that Pfizer, Inc. wants to buy a British rival, AstraZeneca, PLC for nearly $100 billion. Just by buying that company (and technically transferring 20 percent of its shares to foreign ownership), Pfizer lowers its taxes at $1 billion per year, every year. A few days ago, medical device maker Medtronic Inc. agreed to buy Covidien PLC for $42.9 billion. Medtronic will move its domicile to Ireland, which has a corporate tax rate of only 12.5 percent, while the U.S. tax rate is nearly three times higher. Tax lawyers call these transactions “inversions.” No surprise: they have become increasing popular recently. The corporate tax rate in the U.K. is 21 percent. In contrast, Pfizer now pays 27.4 percent of its income to the U.S. government. Every time Pfizer can lower its tax rate by one percentage point, it raises its net income by $200 million. The tax lawyers for Pfizer must be earning their keep. Senator Ron Wyden (D. Oregon) points out that the U.S. corporate tax rate (35 percent) is not only one of the highest in the world but “a painfully complicated and outdated code.” Many corporations pay next to nothing because of the loopholes, but others pay the full amount. He notes, “the entire system flunks the fairness test.” He proposes cutting the tax to 24 percent and closing the loopholes. That would still not be as low as in the U.K., but it is getting close.

State Taxation Rates Affect State Revenues

The federal government is not the only actor here; states can also set their rates too high. California has some of the highest state taxes in the nation. Along with the high rates, California has seen businesses leave the state, and when they leave, the jobs go with them. In 2006, Nissan moved its headquarters from California to Tennessee. Its CEO, Carlos Ghosn, cited Tennessee’s lower costs of doing business. In 2011, Northrop Grumman moved its headquarters from Century City to Virginia. Last year, Raytheon announced that it was moving the headquarters of two of its four business units from El Segundo, California, to McKinney, Texas. That particular move involved fewer than 200 jobs, but Toyota is also moving its headquarters out of California and taking substantially more jobs with it.

For over a half century, Toyota has had its American headquarters in Torrance, California, a suburb of Los Angeles. Now, it is moving to Plano, Texas, near Dallas, Fort Worth, and taking with it at least 3,000 workers, about 5 percent of the total workforce of Torrance.

Jim Lentz, chief executive of Toyota’s North American operations, said, “The business environment [of California] had nothing to do with the decision to leave California.” Yet some California officials take no solace from that denial; they have other thoughts. A Los Angeles County Supervisor representing the district that includes Torrance says that state officials should have an “exit interview” with Toyota to determine how California can avoid “being a target for every other state.”

To support the Supervisor’s concern, we only have to turn to Mr. Lentz, who also acknowledged that Plano’s lower cost of cost of living was a factor. And, then he cited Texas’s business-friendly climate, as well as the absence of any personal income tax in that state. Lower Texas taxes on Toyota’s employees will translate into higher after-tax salaries for them. For many workers, it will mean more than a million dollars over their lifetime. Consider a single 30-year-old Californian who rents and earns only $75,000 annually. Assuming her gross income remains the same, she will gain an additional $14,909 each year, in discretionary income simply by moving to Texas. If she saves the difference and invests it, she will have over $1.5 million saved over her lifetime. If she spends it instead, it still would give her nearly $15,000 extra per year, a substantial percentage of her $75,000 base annual salary. That extra $15,000 will not cost Toyota a penny.

Every time the rich leave, California gets a little poorer. The upper one percent (150,000 out of 1.5 million tax returns) of Californians paid over 40 percent of California state income taxes in 2011 and over 50 percent of state income taxes in 2012. (By the way, on the federal level, the top one percent of taxpayers pays more in federal income taxes than the bottom 90 percent.). Professional golfer Tiger Woods admitted that he left California for Florida (which has no state income tax) for tax reasons.

The upper five percent of Californians paid 70 percent of the state income tax. One gets to be in the top five percent by earning over $206,000 per year—a tidy sum but one that many Toyota management personnel will reach. Not only will the state lose substantial income tax revenue from Toyota’s exit, but the City of Torrance will also lose substantial property tax revenue. Torrance collected $1.2 million annually in taxes and fees from Toyota.

Yes, Texas and Florida have mosquitos and Southern California’s weather is so much better, even with the mudslides, forest fires, and earthquakes. Still, taxes do seem to affect employment. About eight percent of people living in the Los Angeles metropolitan area are unemployed, while the unemployment rate in the Nashville metropolitan area is 5.4 percent; in Dallas, it is a mere 5.3 percent.

In December of last year, the Los Angeles 2020 Commission published its report, “A Time for Truth.” This Commission came into being because Los Angeles City Council President Herb Wesson asked Mickey Kantor to establish an independent, private commission to study and report on fiscal stability and job growth in Los Angeles. Then-Mayor Antonio Villaraigosa endorsed the establishment of this Commission. The Commission’s Report is sobering. From 1980 to 2010, the City of Angels added one million new residents but lost more than 165,000 jobs—that means more people but fewer of them paying taxes. Los Angeles is the only one of the seven largest U.S. cities where the number of jobs has actually declined since 1990.

Lowering Taxes as One Solution to Raise Revenue

California should think of lowering its taxes to raise more revenue. During the 1980s during the Reagan tax cuts, the federal government lowered the top marginal rates from 70 percent to 33 percent. As rates got lower, the total share of federal income taxes paid by the most affluent 5 percent of all Americans jumped from 35.4 percent in 1981 to 44 percent in 1990. The truly well off found that there was less reason (and less opportunity) to shelter their earnings from Uncle Sam. When President Bill Clinton proposed substantial increases in the marginal tax rates, he became what one panelist on “Wall Street Week” called “our greatest salesman for tax-free municipal bonds.”

Prior to Reagan, the previous president who supported lowering the tax rate was JFK. Kennedy reduced the lowest bracket by 6 percentage points, from 20 percent to 14 percent, and reduced the highest bracket 21-percentage points, from 91 percent to 70 percent. The richest people saw their marginal rate reduced substantially more than did the poorest. Yet in 1965, the first year for which the new rates applied, high-income taxpayers declared more taxable income and paid more taxes than they would have paid under the old law. Those earning more than $500,000 annually, for example, paid $701 million in federal taxes before the JFK tax cuts, and $1.02 billion after the tax cuts. This trend was true at every level.

Reagan followed in JFK’s footprints. Between 1981 and 1986, President Ronald Reagan reduced marginal tax rates across the board. The full reduction in the 1981 Act did not take place until 1984. The tax reforms of the 1986 Act further reduced the top rate from 50 percent to 28 percent. As the marginal rates became lower, the percentage of taxes collected from the poor dropped, while the percentage collected from the rich rose substantially.

IRS data show that the share of total individual income taxes paid by the top one percent of adjusted gross income was only 17.9 percent in 1981 (before Reagan reduced marginal tax rates), but it rose to 21.8 percent in 1984 and to 25.6 percent in 1990 (after all of the reductions in the marginal rate). Again, these statistics are similar for every income level. Moreover, the bottom 50 percent reduced its payment from 7.4 percent in 1981 to 5.7 percent in 1990.

As taxes flattened during the 1980s, the rich paid more and the poor paid less. Yet, a flatter (nominally less progressive) tax rate was actually more progressive when implemented. The flatter the tax system became, the more progressive it really was. That’s because higher rates encourage tax shelters and discourage work. A high, progressive rate structure helps tax accountants, tax lawyers, and tax lobbyists, but it does not help poor people, the middle class, the economy, and fairness.

Posted in: Tax and Economics

Tags: Legal, Tax

  • After reading the article, I double-checked for the world “greed”. Not there. Mr. Rotunda shows a lack of understanding of the real problem of the super-rich people he is defending. Their problem is that they do not have enough money. At least that’s how they see it, but unfortunately, it is NOT a solvable problem. No matter how much money he has, such a person will not believe that he finally has enough. Or to frame it in tax terms, no matter how low his taxes, such a person will never want to pay any taxes.

    What America has now is a sick and twisted system. Most businesspeople are fine and upstanding people, and they don’t even mind paying their taxes. As long as everyone pays fairly, then there’s no competitive disadvantage. It’s a little more difficult to prove how they feel about progressive taxation, but if you look at it from the bottom of the period, the large mass of small and mid-sized businesses, I’m sure they would agree that the biggest and most successful businesses should pay at least as much as they do but could probably afford to pay a bit more.

    Too bad they don’t control the game, eh? The rules of the American business game are written by the most cheaply bribed politicians working for the least ethical and greediest businessmen. The rules of the game of American business now demand cancerous growth uber alles. Unfortunately, the problem with cancer as a growth model is that the cancer always kills its host.

    Freedom is about meaningful and unconstrained choice. When any company becomes too large and successful, it necessarily reduces the freedom. The obvious solution is tax incentives that encourage the extreme winners to divide into competing pieces. Not a penalty for success, but an incentive to reproduce and evolve the good business models. Not cancer, but an amoeba as a growth model.

  • Ian Quinn

    This is Prof. Rotunda’s argument: A decrease on tax rates leads to an increase in tax revenue – especially when the tax rate being lowered is the capital gains tax or the highest earner’s income tax. He argues this is true at both the state and federal levels. I will concede the state-level argument – when state’s have differing tax rates, rich people and even entire businesses will be tempted to leave the high tax states for the low tax ones. The logic is – I think – unassailable and the examples cited underscore the argument – but only at the state level.
    Lower taxes on capital gains and/or the highest earners will not necessarily result in increased tax revenues at the federal level. Let’s look at the capital gains tax separately from the highest earners tax. Changes in the effective capital gains tax rate do not correlate much at all with changes in GDP (see graph) When the capital gains tax was lowered in 2003, revenue increased – however that increase in revenue had more to do with wall street rebounding from the tech bubble burst and the Sept. 11 bear markets and the beginnings of the housing bubble than in anything else – people will invest if it they expect a pay off and so long as that pay off is taxed at a rate less than 100%, they will make investments in pursuit of those payoffs (capital gains).
    Now so far as the tax rates on the highest earners is concerned – Rotunda gives one example from 1965 when the tax rate on the very highest earners was lowered from 91% to 70% – the total tax revenue generated from those making above $500,000/yr jumped from $701 million to $1.02 billion after the tax cut. So the total number of people making more then $500,000/yr almost doubled in one year. In Rotunda’s first paragraph, two possible purposes for taxes are mentioned – one is to raise revenue for the gov’t, and the other is to discourage certain activities (sin taxes such as those for alcohol and tobacco). The 91% tax rate on incomes over $500K/yr is in keeping with what Piketty describes as the uniquely American practice of confiscatory progressive taxation of incomes. The 91% tax rate was not so much about revenue as it was about confiscating excessive income – income that was presumed to have been earned unfairly. The compensation paid to CEOs and corporate executives was once upon a time (1950s) comparatively modest. Part of this was because there was little incentive to negotiate for higher pay when they would only get to keep 9 cents of each additional dollar. Lowering the top tax rates from their confiscatory levels has resulted not in any increase in productivity or general prosperity – it has only increased the incentive for executives to take advantage of asymmetrical bargaining positions to demand ever larger salaries and bonuses.

  • jrconner

    Believe this argument and you’ll believe anything.

  • Chess Hack

    Professor Rotunda – The 1980’s called. They’d like you to return their tired, shopworn, and discredited supply-side thesis. http://www.americanprogress.org/issues/economy/news/2012/08/01/11998/the-failure-of-supply-side-economics/