Discouraging Earning / Incentivizing Poverty

Two recent news items couldn’t have been more timely as my microeconomics class is studying tax systems.  Both actor Gerard Depardieu and golfer Phil Mickelson are starting to feel burdened by high marginal tax rates. Mickelson is flirting with moving away from California to avoid a 62% tax rate. Depardieu actually moved from France to Russia to avoid a proposed 75% rate for those making more than a million euros a year.

Both Depardieu and Mickelson illustrate the downside of a progressive tax system where the more you earn, the higher your tax rate. At a certain point, otherwise productive people are discouraged from earning more (or are encouraged to relocate to a more favorable tax environment).  Now, no one’s crying for multi-millionaire actors and athletes who don’t want to pay their “fair share,” but raising tax rates on the very wealthy can be counter productive.  France and California’s (deadweight) loss may be Russia and Florida’s gain.  In a world where wealthy people can freely move from one tax bracket to another, lower rates may raise more revenue than higher ones.

No one in my class  (myself included) is willing to support a regressive tax system where the more you earn the lower your tax rate.  How could someone possibly justify the poor paying a higher percentage than the rich?  Even a strictly proportional system is a hard pill to swallow since the poor bear a heavier burden. But the other side of that coin is worth examining.  A progressive tax system can distort incentives for the wealthy. It can also distort incentives for the poor.

In “The Dead Zone: The Implicit Marginal Tax Rate” (spoiler alert: this article would make the tea-party blush) Clifford F. Thies points out that a family of three in Virginia earning anywhere from $0 to $40,000 a year was eligible for benefits roughly totaling $40,000 a year.  That means that any raise in pay would be balanced out by a loss of benefits until a person breaks through the $40,000 ceiling.  In fact, when taking the loss of subsidies into account, a family moving from a $20,000 per year income to$30,000 is essentially facing marginal tax rates exceeding 100%. Not much of an incentive to move up the pay scale.

The assignment for my students (and our government) is to develop a tax system that is equitable while still encouraging people to work.  Not an easy task.

P.S. On a related note, in his excellent article, “Mickelson has a point on taxes,” Edward J. McCaffery compare’s Mickelson’s taxes to Mitt Romney’s to illustrate the paradox of the the U.S. tax system — we tax work, but not wealth:

“The Mitt-Lefty paradox has a simple explanation: In America, we tax work. And highly. We do not tax capital or wealth much at all. Indeed, if you have wealth already, taxes are essentially optional under what I call tax Planning 101, the simple advice to buy/borrow/die.

In step one, you buy assets that rise in value without producing cash, such as growth stocks or real estate. In step two, you borrow to finance your lifestyle. In step three, you die, and your heirs get your assets, tax free, and with a “stepped up” basis that eliminates all capital gains. That’s it.

Romney, with a personal fortune estimated at $250 million (his five kids have another $100 million) has figured this out. When he pays taxes, at all, he does so at the low capital gains rate.”

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