Taking People's Money

Most people might describe taxation as something other than "taking people's money." Many like to think of taxes as a citizen's "contribution" to governance that makes a civil society possible. But there are some uses of that money to which each of us would not choose to contribute, such as government subsidies for wealthy tobacco or cotton growers, or grants to religious groups with whom we have differences. Also, whether or not we agree with the principle of taxation, we don't like personally paying too much.

Interestingly, the advent of money makes people more willing to give to their leaders or to other people in society by way of government. Consider for a moment if we still had a barter-based economy and every year the tax man showed up to take a large portion of all the things that you owned. That would be more painful for most. Or imagine if you just had to go to work for the government for three or four months each year without pay. Writing a check hides the true nature of taxes to some extent, making it easier to tolerate.

That's as far as this essay will go regarding the political and perhaps moral issues are concerned. I'll leave unanswered questions about how much we owe a government or the society that it represents (although I'll mention that my wife and I are ready to leave if taxes exceed 50% of our income). Im also not going to address the matter of what kinds of expenditures justify taking people's money. These are great topics for another time.

This week I'm going to cover the idea of efficient taxation. The following is an excerpt from my ebook 99 Lies, a part of The Secrets Package.

Lie # 3 - Raising Taxes Raises Revenue

The Reason For The Lie

Raise tax rates, collect more in taxes - it seems logical. It isn't, but rather than educate the populace, politicians play to their ignorance for political purposes. Mostly it is just their ignorance as well. However, there is always some political power to be derived from hurting the wealthy (and often the whole economy) for the pleasure of those non-wealthy voters who are envious or just ignorant.

The Truth

What is lost in all the debate over tax increases versus tax cuts, is science. For example, the Laffer Curve, described by Arthur Laffer, and which shows the relationship between tax rates and tax revenue collected, is probably understood by less than 5% of people. It is the idea that as you raise tax rates, revenue rises only until you reach a certain point. At the top of this curve the actual amount of revenue collected starts to drop as rates climb.

You can understand this at the extremes. If the government took 95% of your income in taxes, would you work much? Do they get any taxes if you don't work? No. More money will actually be collected if they take a lower percentage, right? Of course high taxes will chase businesses and at some point even residents away to other, lower-tax countries too. Add to that the fact that every dollar the government takes can't be invested into new businesses, which would have created more income and therefore more taxes, and you can see that there is a point of diminishing returns.

Where is it? The science isn't that exact yet, but it seems to be somewhere between 15% to 25% as a total tax burden (federal, state and local). What this means is that if tax rates go higher than that (the top of the curve), the government actually collects less money. So even if a person or society wants all sorts of social welfare programs, they have to realize that there is an ideal rate of taxation to get the most money to pay for these programs. Tax more heavily, and you get less, not more.

Of course a government can collect more taxes in the near future with higher rates, but past the top of the curve the long-term collections decline. A simple analogy will make this clear. Imagine a vampire isolated on an island with a few human victims to feed on. He could party it up and drain their blood completely, but then the party would be over and he would have no more blood. He could also take very little and perhaps that isn't enough. Somewhere in between the two extremes is the maximum amount he can suck out each week without hurting the humans and therefore diminishing the future supply of blood.

Replace the vampire with government, and the victims with income producers (all workers, investors and businesses), and you get the point. This maximum rate of extraction is not necessarily what we should aim for as a society, but if we go higher than that we do real damage. We get an anemic economy that can't provide nearly as much blood for our poor vampire, or rather, tax revenue for the government.

Consider a restaurant that's making profit of $60,000 per year. The owner pays $15,000 in taxes, uses $30,000 to live on, and reinvests $15,000 to grow the business. Five years later he has several restaurants. He makes $300,000 per year, and pays $75,000 in taxes. In addition, he has hired dozens more to work in his business, and all of these people pay taxes too. The government is taking in much more money - even at the same tax rates.

Now imagine that before this happened, the government raised the tax rates, and the owner had to pay $30,000 in taxes on his $60,000 profit. Since he needs the other $30,000 to live on, he has nothing left over to invest into the business. It stagnates, and five years later the government is still collecting just $15,000 in taxes from him. They could have been collecting five times as much (and that's not counting the taxes on the new employees). Higher tax rates often mean less revenue, not more.

Politics trumps science, of course. Imagine if the most socialistic politician out there announced to his constituency, "We have scientifically determined the most efficient rate of taxation, and we must lower corporate tax rates and the income tax rates of the rich in order to increase collections." I suspect that no amount of truth here would overcome his constituents desire to both have their social programs and screw the rich. They want the lie, and there will always be a politician to serve it up. I should add that the way many feel about the rich is perhaps understandable, given how often some of the wealthy use government to screw the rest of the citizenry.

Why It Matters

Consider three scenarios. First, if income was taxed at 100%, the economy would be destroyed. Second, if no taxes were collected, no government would be possible, and we would be destroyed by anarchy. In between these two scenarios is the proper rate of taxation, where the government collects enough to provide whatever services are deemed necessary, but doesn't hamper the economy. Tax beyond that rate, and billions in production is destroyed, less tax revenue is collected, and services have to be reduced.

A government can only spend what the producers produce. Collecting taxes as too high of a rate is the proverbial killing of the goose that lays the golden eggs.

A Little More on Taking People's Money

Forbes magazine recently reported on a great example of this principle. Iceland cut it's corporate tax rate step-by-step from 45% in 1991, to 18% in 2001. What happened? Tax revenues went up step-by-step, perfectly demonstrating the Laffer Curve. They tripled by 2001, and tripled again in the next five years. Lower rates meant more tax revenue.

Once you understand this principle, you see that an increase above the most efficient tax rate (15% to 25%?) means less money for education, helping the poor, or anything we might want government to do.I won't want guess the intentions of individuals, but in general if people understand this principle and continue advocating higher taxes, they do so from some motivation other than to raise more revenue for anyone's benefit.

I've side-stepped the whole issuse of whether people have a right to vote away more of my or your income, and for what purposes. We're almost certainly beyond the rate of taxation that yields the maximum revenue in any case, so most who understand this can agree that lower tax rates are a good thing. I like to find common ground when possible, and in this case those who want lower tax rates and those who want government to collect more in taxes for whatever programs can agree that the time is right to look at efficient taxation.

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