Friday, November 25, 2011

The Laffer Curve & Capital Gains Taxes

Low Corporate Taxes = Excessive CEO Salaries

It doesn't matter what a corporation pays in taxes as compared to GDP, or how it's compared to any other index of measure (to skew the numbers), it's what they actually pay to the U.S. Treasury after loopholes (aka "deductions") that matters most. And for the last 25 years corporations have actually paid historically low taxes.

While today some corporations may have paid the maximum rate of 35% (when it was over 50% in the 1950s), many others paid ZERO, with the average being only 18%.

The same can be said for their CEOs and other high-income earners. While although the top bracket is also almost historically low (at 35%, when it was once over 90%), what they actually pay is nearer to 15% because the majority of their income is earned through capital gains.

And because corporations have been paying a low effective corporate tax rate for decades, that didn't keep them from outsourcing jobs overseas for cheap labor, but rather, it did enable them to pay very excessive CEO salaries...who only mostly pay 15% in federal income taxes on their capital gains.

Two researchers using the Laffer Curve have just calculated a tax rate on the rich that would maximize revenue to the government. If you assume a broad base and no deductions, they peg the revenue maximizing-rate for top earners at 76%. That's for federal income tax only. (In reality, the very top earners today only pay 15% on capital gains.)

The Laffer Curve shows that if both a 0% rate and 100% rate of taxation generate no revenue, it follows from the extreme value theorem that there must exist at least one rate in between where tax revenue would be a maximum. The Laffer Curve is typically represented as a graph which starts at 0% tax, zero revenue, rises to a maximum rate of revenue raised at an intermediate rate of taxation and then falls again to zero revenue at a 100% tax rate.

Economist Paul Pecorino presented a model in 1995 that predicted the peak of the Laffer Curve occurred at tax rates around 65%.

A 1996 study by Dr. Y. Hsing of the United States economy between 1959 and 1991 placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) between 33% and 36%.

A 1981 paper published in the Journal of Political Economy presented a model integrating empirical data that indicated that the point of maximum tax revenue in Sweden in the 1970s would have been 70%.

A recent paper by Trabandt and Uhlig of the National Bureau of Economic Research presented a model that predicted that the U.S. and most European economies are on the left of the Laffer Curve (in other words, that raising taxes would raise further revenue).

The New Palgrave Dictionary of Economics reports that for academic studies, the mid-range for the revenue maximizing rate is around 70%.

A study by Teather and Young of the conservative Adam Smith Institute has suggested that the optimal rate for capital gains tax, as opposed to income tax, may be around 20% (today it's only 15%), but this is at least partly due to savvy taxpayers holding onto assets in anticipation of tax rates being lowered in the future.

A 2007 study by the conservative think tank, the American Enterprise Institute, found that the revenue maximizing rate for corporate taxes in OECD countries, such as the U.S. (Organization for Economic Co-operation and Development) was about 26%, down from about 34% in the 1980s. But even if you agreed with this assessment, for the past 25 years corporations have actually only been paying an "effective" tax rate of 14% to 18%).

In 2005, the Congressional Budget Office (CBO) released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates". In the paper's most generous estimated growth scenario, only 28% of the projected lower tax revenue would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates. The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing. And what have we been forced to do since the Bush tax cuts?

Supply-side economics is a school of macroeconomic thought that argues that overall economic well-being is maximized by lowering the barriers to producing goods and services (the "Supply Side" of the economy). By lowering such "barriers" ( as in: reasonable environmental and financial regulations, fair taxes, and fair wages), consumers are thought to benefit from a greater supply of goods and services at lower prices. (As in goods made in China like iPods and cheap Chinese-made goods sold at Wal-Mart).

Typical supply-side policy would advocate generally lower income tax and capital gains tax rates (to increase the supply of labor and capital), "smaller government" (as in Social Security, Medicare, and unemployment insurance) and a lower regulatory "burden" on enterprises (to lower costs). Although tax policy is often mentioned in relation to supply-side economics, supply-side economists are concerned with all impediments to the supply of goods and services and not just taxation.

Supply-side advocates have argued for lower taxes on the basis of supply-side benefits while citing the Laffer curve as a reason that such cuts would also raise revenue. However, the objective of supply-side theory is to maximize the supply of goods and services, and to achieve this one should, in theory, always lower taxes. In contrast, the Laffer curve would suggest that a tax cut would raise tax revenues only if current tax rates were in the right-hand region of the curve.

The Laffer curve and supply-side economics inspired Reaganomics ("trickle-down") and the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more tax revenue because the United States government's marginal income tax rates prior to the legislation were on the right-hand side of the curve.

David Stockman, Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, was concerned that the administration did not pay enough attention to cutting government spending. Stockman said that "Laffer wasn't wrong, he just didn't go far enough" (in paying attention to government spending).

Some have criticized elements of Reaganomics on the basis of equity. For example, economist John Kenneth Galbraith believed that the Reagan administration actively used the Laffer Curve "to lower taxes on the affluent." Critics also point out that since the Reagan tax cuts, income has not significantly increased for the rest of the population.

Former Labor Secretary and economist Paul Krugman contended that supply-side adherents did not fully believe that the United States income tax rate was on the "backwards-sloping" side of the curve and yet they still advocated lowering taxes.

Political authorities saw that other national governments fared better by having tax collectors claim a medium share of a rapidly growing economy (a low marginal tax) rather than trying to extract a large share of a stagnant economy (a high average tax). Another explanation might be that a higher tax rate also increases the risk of tax evasion towards tax havens, which leads governments to lose revenue. (But even with the Bush tax cuts, people were still moving money to off-shore accounts. They prefer to pay NO taxes.)

A new report Peter Diamond and Emmanuel Saez calculated the tax rate on the rich that would maximize revenue to the government as 76%. Paul Krugman summarizes:

"In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners—full stop. Why? Because if you're trying to maximize any sort of aggregate welfare measure, it's clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount—not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn't imply a 100% tax rate, because there are going to be behavioral responses—high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%."

Today the highest income bracket's tax rate is only half that, at 35%; but that rate doesn't kick in until one earns a "wage" of $379,000 a year; but even doctors are rarely paid this much (members of congress earn $174,000).

It's usually the CEO's of large banks, major defense contractors, oil barons, hedge-fund mangers, lobbyists, and corporate executives who fall into this higher income range. But the bulk of their earnings are usually not in the form of paid wages.

Those people (the top 1%) earn most of their money with capital gains earned through stock incentives and bonuses that are only taxed at 15%, not the upper marginal income tax rate of 35% (Regular working people earning over $35,000 a year pay 25%)

Rather than change the tax rates, just eliminate loopholes for corporations to collect the "full effective rate" of 35%, and tax capital gains as "regular income" and then tax them according to the current income tax bracket. If CEOs earn $5 million in stock options, rather than tax them at 15% for capital gains, tax them at 35% for regular income.

It would be half as less than the proposed 70% rate (as suggested by the new data), and it would also bring in a lot more revenue for the U.S. Treasury.

Because corporations have been paying a low effective corporate tax rate for decades, that didn't keep them from outsourcing jobs overseas for cheap labor, but rather, it did enable them to pay very excessive CEO salaries...who only pay 15% in federal incomes for capital gains.

But Republicans, bankers, the Tea Party, and corporate CEOs are still crying about high taxes!

Ronald Reagan

Ronald Reagan's first tax bill was enacted in August 1981. It included a sweeping cut in marginal income tax rates, lowering the top rate from 70% to 50% (a whopping 20 percentage points) - and lowered the lowest rate to 11% from 14% (only a stingy 3 percentage points).

The House vote was 238 to 195, with 48 Democrats on the winning side and only one Republican with the losers. The Senate vote was 89 to 11, with 37 Democrats voting aye and only one Republican voting nay. Reaganomics had officially begun.

Wisconsin Republican Rep. Bill Steiger and Wyoming Republican Sen. Clifford Hansen, were two main sponsors of an important capital gains tax cut in 1978. 

The highest tax rate on "unearned" (i.e., non-wage or capital gains and dividends) income dropped from 70% to 28%. The corporate tax rate also fell to 34% from 46%. And tax brackets were pushed out, so that taxpayers wouldn't cross the threshold until their incomes were far higher ($379,000).

The Wall Street Journal claimed that the highest 1% of income earners paid more in taxes as a share of GDP in 1988 at lower tax rates than they had in 1980 at higher tax rates.

To Ronald Reagan, what's been called the Laffer Curve was pure common sense. (There was no increase in the minimum wage over his full eight years in office).

Reagan also repealed the excess profits tax on oil companies (Windfall Profits Tax) who are today earning record profits, and like ExxonMobil, are dodging taxes as well.

The negotiations for what would become the North American Free Trade Agreement began in Reagan's second term, but it was President Clinton who pushed the agreement through Congress in 1993 over the objections of the unions and many in his own party. (New data now reports that 56,000 factories closed and 8.2 million jobs were lost from 2000 to 2010 due to outsourcing.)

President Clinton also signed into law a capital gains tax cut with the Taxpayer Relief Act of 1997 which lowered the top capital gains rate further, from 28% to 20%.

Conservatives claim that nothing other than Reaganomics created over 21 million jobs during Reagan's 8-year- term as President. The stock market went through the roof (as though "bubbles" were a good thing), and that low capital gains taxes drove the economy.

But little is said about starving the government of necessary revenues are needed to fund Social Security, Medicare, and infrastructure. Only defense spending is considered a priority by the Republicans and corporate America, because profits "defense" generates profits.

Then we had the Bush tax cuts which lowered capital gains taxes further still, to an historically low 15% (the lowest since they were first not taxed as regular income in 1921.

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  1. Today in the New York Times:

    "In the eight decades before the recent recession, there was never a period when as much as 9 percent of American gross domestic product went to companies in the form of after-tax profits. Now the figure is over 10 percent. For companies, these are boom times. For workers, the opposite is true."

  2. If the Bush tax cuts are allowed to expire, the top tax bracket of 35% would go up to 39.6% (for income over $379,000 a year), and tax on capital gains (like CEO stock options) would go from 15% to 20% - - but this is what needs changed. Capital gains and dividends should be taxed as regular income. That's how the ultra-wealthy make most their income (instead of paying taxes in the higher income bracket, they pay the lower capital gains rate), and that's how Warren Buffett's secretary pays a higher effective tax rate for income taxes than her boss.

  3. CEOs only “earn” bonuses when their company “performs.” One measure of that performance: “earnings per share,” or company income divided by outstanding shares of stock. Execs have figured out they don't have to boost earnings to hit their per-share targets. They simply reduce the number of company shares — by having their companies “buy back” shares of their own stock off the open market. U.S. corporations overall have so far this year authorized $445 billion worth of buybacks.

  4. Almost 70% of all capital gains taxes are paid by the top 1%

    A week after hinting he may raise the capital gains tax, Jon Huntsman proposed eliminating it altogether.