Sunday, August 24, 2008

Will Higher Tax Rates Create More Tax Revenue?

My expectation is that federal income taxes will increase, no matter who is elected, since it is unlikely Congress will extend the Bush tax cuts. Of course, I expect that the Democrats will significantly hike taxes if they should win the Presidential elections, since a win may cause Democrats to believe there is a mandate for higher tax rates.

However, higher tax rates does not necessarily mean higher tax revenues.

An article in The Wall Street Journal titled You Can't Soak the Rich shares a concept called Hauser's law. Ken Hauser is an economist who published an interesting analysis of the U.S. tax system comparing tax collections, normalized to GDP, and top marginal tax rates. The article concludes that, "The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP." The reason is that higher tax rates cause more people to shield income from taxes.

I believe Hauser's law because it is based on actual data from 1950 through 2007. During that time, the highest tax rate declined from 91% to the present 35%. Yet, during that same time frame, tax revenues collected was a relatively stable 19.5% of GDP. Since GDP has been going up since 1950 , total tax revenue has also been increasing, even as the top tax rates were declining.

If we want to increase tax revenue, we need to increase GDP. The Wall Street Journal article further states, "Economists ... accept that a tax rate hike will reduce GDP," meaning higher tax rates will likely reduce tax revenue, if one believes Hauser's law.

It seems those advocating tax rate increases do not believe in Hauser's law. The next four years will prove whether Hauser is or the proponents of a tax rate increase are correct.

For more on New Beginnings, check back every Sunday for a new segment.

This is not financial advice. Please consult a professional advisor.

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