Common Sense Economics: What Everyone Needs to Know about Wealth and Prosperity
When high tax rates take a large share of income, the incentive to work and use resources productively declines. The marginal tax rate is particularly important. This is the share of additional income that is taxed away at any given income level. For example, in the United States in 2015, if a taxpayer with $60,000 in taxable income earned an extra $100, he or she had to pay $25 of that $100 in federal income tax. Therefore, the taxpayer faced a marginal tax rate of 25%.
As marginal tax rates increase, the share of additional earnings that people get to keep decline. For example, at the 25 percent marginal tax rate, individuals are permitted to keep $75 if they earn an additional $100. But, if the marginal tax rate rose to 40 percent, then the taxpayer would only get to keep $60 out of a $100 increase in earnings.
There are three reasons why high marginal tax rates will reduce output and income. First, high marginal tax rates discourage work effort and reduce the productivity of labor. …
Second, high marginal tax rates will reduce both the level and efficiency of capital formation. …
Third, high marginal tax rates encourage individuals to consume tax-deductible goods in place of nondeductible goods, even though the nondeductible goods may be more desirable. When purchases are tax deductible, individuals who purchase them do not bear their full cost, because the expenditure reduces the taxes they would otherwise pay. When marginal tax rates are high, tax-deductible expenditures become relatively cheap.
The sales of the British-made luxury car Rolls-Royce in the 1970s provides a vivid illustration of this point. During this era, the marginal income tax rates in the United Kingdom were as high as 98 percent on large incomes. A business owner paying that tax rate could buy a car as a tax-deductible business expense, so why not buy an exotic, more expensive car? The purchase would reduce the owner’s profit by the car’s price—say £100,000, but the owner would have received only £2,000 of his or her profit anyway, because the 98 percent marginal tax rate would have reduced the £100,000 to £2,000. In effect, the government was paying 98% of the car’s costs (through lost tax revenue). When the UK cut the top marginal tax rate to 70 percent, the sales of Rolls Royce vehicles plummeted. After the rate reduction, the £100,000 car now cost the business owner not £2,000 but £30,000. The lower marginal rates made it much more expensive for wealthy Brits to purchase Rolls Royces, and they responded by reducing their purchases.
- If you had a choice of buying something that was a “business expense” instead of paying taxes, would you prefer expensive food? Fancy clothes? Expensive cars or cell phones?
- In effect, this makes people consume things, instead of investing or saving or even donating to charity (where there are limits on how much you can deduct), instead of paying taxes. Lowering the tax rates, encourages more productive use of funds – unless you are a producer of fancy luxury goods. What do you think happens to the producers of champagne, expensive cars, and yachts when tax rates go down?
This reading is an excerpt from Certell’s Common Sense Economics eBook. Certell offers curriculum materials and eBooks free of charge for students and teachers. Click here to download the Common Sense Economics
27, Sept. 2018, Fraser Yachts. Project Brage [Digital photograph]. Retrieved from <www.fraseryachts.com>.