Why higher taxes reduce the incentive to work more

October 12, 2010 1:05 PM

In July last year Matthew Sinclair co-authored a report with Dr Jonathan Scott on entrepreneurship. They showed that the 50p rate of tax could mean a top combined marginal tax rate of 92 per cent for successful entrepreneurs on income earned, saved, invested in a company and passed on to children. At a time when we desperately need to encourage new businesses to form and grow, this is a massive disincentive for would-be entrepreneurs. When coupled with tighter credit, it’s no surprise that new business registration levels are so low.

With the public finances in such a mess there have been decisions on both sides of the Atlantic to increase taxes on the rich. In America, it’s aimed at those earning over $250,000 a year while the UK’s 50p rate is targeted at those earning £150,000. They can afford it, so why not? But it’s not that simple – as our paper showed higher taxes could mean fewer opportunities for ordinary people. The decisions are purely political, an expedient way to be supposedly “fair”. Studies have shown that the 50p rate will bring in less revenue, so ordinary people will have to pay more – yet the Chancellor feels he cannot scrap it because of the political backlash that he would face. 

A very strong and practical argument against this flawed logic was also made a couple of days ago by Harvard Professor Greg Mankiw. He acknowledges that he is in line to be affected by the tax changes – but then presents a clear and concise case of why it’s such a bad idea. Apologies for the long quote, but it’s worth reading as it shows why higher tax rates provide such a disincentive to work more, and it shows how higher taxes on the rich can affect the interests of ordinary people:

"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?"

Without Obama’s tax changes, he points out that the return would be $2,000 – twice the incentive to take the work on. The services provided by entrepreneurs would be in shorter supply with higher tax rates, meaning that it’s not just the rich who suffer – it’s everyone else who uses, enjoys or needs those services.

In July last year Matthew Sinclair co-authored a report with Dr Jonathan Scott on entrepreneurship. They showed that the 50p rate of tax could mean a top combined marginal tax rate of 92 per cent for successful entrepreneurs on income earned, saved, invested in a company and passed on to children. At a time when we desperately need to encourage new businesses to form and grow, this is a massive disincentive for would-be entrepreneurs. When coupled with tighter credit, it’s no surprise that new business registration levels are so low.

With the public finances in such a mess there have been decisions on both sides of the Atlantic to increase taxes on the rich. In America, it’s aimed at those earning over $250,000 a year while the UK’s 50p rate is targeted at those earning £150,000. They can afford it, so why not? But it’s not that simple – as our paper showed higher taxes could mean fewer opportunities for ordinary people. The decisions are purely political, an expedient way to be supposedly “fair”. Studies have shown that the 50p rate will bring in less revenue, so ordinary people will have to pay more – yet the Chancellor feels he cannot scrap it because of the political backlash that he would face. 

A very strong and practical argument against this flawed logic was also made a couple of days ago by Harvard Professor Greg Mankiw. He acknowledges that he is in line to be affected by the tax changes – but then presents a clear and concise case of why it’s such a bad idea. Apologies for the long quote, but it’s worth reading as it shows why higher tax rates provide such a disincentive to work more, and it shows how higher taxes on the rich can affect the interests of ordinary people:

"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?"

Without Obama’s tax changes, he points out that the return would be $2,000 – twice the incentive to take the work on. The services provided by entrepreneurs would be in shorter supply with higher tax rates, meaning that it’s not just the rich who suffer – it’s everyone else who uses, enjoys or needs those services.

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