Current popular presidential candidate Donald Trump has issued a few specifics about what he would do with his tax policy. “I think the rich should pay more” he says. President Obama agrees, often saying the “The rich should pay their fair share,” although never actually specifying what a “fair share” is. In reality raising taxes on the rich, hurts all of us.
President Obama has already raised marginal income tax rates on the wealthy by 10%. He also raised capital gain taxes on the wealthy by more than 50%. He says this is needed to reduce income inequality and to pay for health insurance, welfare and food stamps for the lowest income earners.
Donald Trump says that wealthy hedge fund managers don’t pay their fair share because of a loophole that allows their income to be taxed at a lower rate. Besides, he says, the financial guys aren’t building buildings. All they are doing is moving paper around. (Perhaps he doesn’t fully understand the value of raising billions of dollars for companies like Google or Facebook or even Trump properties.) Since they earn such large incomes, they should be taxed at a higher rate.
Both Trump and Obama agree that by raising taxes on the wealthy, the middle class will get a tax break and therefore pay less taxes. The problem is that while the middle class could pay a lower rate, there will likely be less people paying income taxes and those that do pay will be earning less income.
If we remove the emotional reaction to people earning what seems like a ridiculously large income, often exceeding $100 million annually, and just look for a fair and optimum tax policy, we can make a more reasonable conclusion.
The goal should be to implement a tax policy that encourages economic growth to continually raise the standard of living of Americans and that meets the goals of raising sufficient revenue, achieving equity, creating no market distortions and is easy to administer.
Following Obama and Trump’s suggestion of over-taxing the wealthy would lead to slower growth, less equity by worsening income inequality and less opportunity for Americans. The reason is simple.
There are three things that people do with their income. They pay taxes, spend it or save (invest) it. For income earners, the taxes are paid first, then the level of spending is set. What is left over goes to saving and investments. By raising taxes on the wealthy, and with their level of spending staying the same, there is less available for them to save and invest which reduces capital available to the economy. It is the highest income earners who provide the majority of new capital to the economy.
There are two basic inputs into the economy: capital and labor. How productive the inputs are when producing output depends on a number of factors like technology, entrepreneurship, natural resources and human capital (education).
In today’s economy, the labor force is disproportionately small since less than 63% of the adult population is working or willing to work. This figure should be in the 67% range as it was before the great recession.
Raising taxes on the wealthy reduces capital formation. Couple that with the low labor participation rate and add in the burdensome regulations that stifle entrepreneurship and we having just technology and energy to drive economic growth.
With less growth there is less demand for labor which keeps wages low and the number of jobs available (opportunity) also low, hurting the vast majority of American workers who were supposed to benefit by taxing the wealthy.