Diminishing Returns

Apropos of my post about income taxes last Friday, two columns that ran over the weekend dramatically illustrate the downsides of income taxation. First, financial analyst Bill Bonner writing in the Christian Science Monitor explains that millionaires in Maryland are fleeing the state to avoid its 6.25-percent income tax — Missouri’s income tax is barely lower, at 6 percent — causing tax receipts to fall. Bonner attributes this paragraph (perhaps mistakenly) to the Wall Street Journal:

However, there were two things that Maryland politicians didn’t count on (1) a world-wide economic crisis decreasing the number of million dollar earners and (2) millionaires simply leaving (or taking in less income). “By April 2009, one-third of the millionaires have disappeared from Maryland tax rolls. On those missing returns, the government collects 6.25% of nothing. Instead of the state coffers gaining the extra $106 million the politicians predicted, millionaires paid $100 million less in taxes than they did last year – even at higher rates.

Harvard economist and New York Times columnist Greg Mankiw elucidates the micro-level choices that lead high income earners to avoid income taxes or reduce their incomes:

Suppose that some editor offered me $1,000 to write an article. If there were no taxes of any kind, this $1,000 of income would translate into $1,000 in extra saving. If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now, when I pass on, my children would inherit about $10,000. That is simply the miracle of compounding.

Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that $1,000 of pretax income becomes only $523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the $523 in saving grows to $1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that $1,700 enters my estate, my kids will get, at most, $1,000 of it.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

The worst effect of income taxes is probably not actually on the people who pay them. They have the option of consuming more leisure instead of working more and still living very comfortably. The biggest loss is the wealth that is never created because of the system’s disincentives, which hurts consumers across the board.