Raising taxes can backfire by squelching entrepreneurial efforts

Charles Rangel, congressman from New York, has proposed a sweeping tax reform bill. He argues that the bill represents "fair taxation" because it dramatically raises the tax rates for high-income taxpayers.

My first reaction is a question based on my understanding that 20 percent of taxpayers pay 80 percent of all income taxes — even though they earn only 50 percent of all income — while the bottom 50 percent of all taxpayers pay less than 4 percent of income taxes. What would the ratios have to be before they are "fair"?

To understand how taxes impact the economy, we need to ask what changes a tax will create in the overall economy.

The first analysis indicates that taxpayers who are taxed more have less money and will buy fewer goods and services. A too-simple analysis would indicate that this would cause less employment in those industries in which taxpayers buy less.

However, the tax dollars have to go somewhere. If the government simply transfers the money to other people, the other people will increase purchases of goods and services. That will cause employment to go up in those industries. So if a taxpayer would have bought a car, but the recipient of the taxes buys health care, then employment would shift from the automobile industry to the health-care industry. The economy might not be significantly affected.

But even this is too simple. Taking taxes from some people and giving the money to others requires more government workers to assess and enforce the tax and others to oversee the paying of benefits. That means that there will be fewer people employed producing goods and services and more people employed simply administering the tax. In total, there will be fewer goods and services available since fewer people will be producing them.

Another impact is that taxpayers start to hire accountants and lawyers to keep the records needed to calculate taxes and also to figure out ways to pay less in taxes. As a result, more people are employed keeping track of taxes, and fewer people will be employed producing primary goods and services.

The incentive to cheat on taxes increases as tax rates increase. Higher tax rates might cause some workers to retire earlier. Also, high-income taxpayers might choose to buy art or yachts that produce no income rather than invest in businesses that produce income (and goods and services) that is taxed.

Another potential problem is that high-income people who pay the taxes invest more of their income than the low income recipients who receive benefits from those taxes. Higher taxes mean that there will be less investment in plants and equipment and less employment because there are fewer plants and less equipment that requires workers to operate.

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