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How Raising Taxes Will Not Balance the Budget: More Evidence

In an effort to help fix the deficit, many have advocated increasing taxes on America’s highest earners. The question becomes: is this a good way of increasing the amount of money that the government takes in? According to Professor Antony Davies, when the government raises taxes on top earners, the federal government actually collects less money per person, and when it decreases the government collects more.

There are exceptions to this trend, however. Changes in the marginal tax rate for the average American appear to have no consistent effect on revenues collected. Increases in Social Security and Medicare taxes tend to increase the amount of money collected per person. With the proper use of deductions, exemptions, offsets, and credits, and by delaying or changing the form of one’s compensation, federal income taxes, capital gains taxes, and many other taxes can be at least partially avoided. In contrast, Social Security and Medicare taxes are subject to far fewer loopholes and are much more difficult to avoid.

So how can the government collect more tax revenue? Prof. Davies says that the key is a simplification of America’s notoriously complex tax code. A simpler tax code would make it more difficult for people to avoid taxes and would lead people to spend less time trying to avoid them. Prof. Davies argues, “The less time and money we spend trying to work around a complex tax code, the more time and money we will have available to put to more productive uses.”

Tax Rates vs. Tax Revenues [charts]: Mercatus Charts on tax revenue vs tax rates


Why the payroll tax deal is bad for people with disabilities [article]: A Progressive defense of payroll taxes


How Pols Learned to Stop Worrying and Love the Inpenetrable Tax Code [article]: US News piece on why politicians love tax code complexity


The American Way in Taxation: Internal Revenue, 1862-1963 [book excerpt]: A historical take on the IRS and American taxation


Political cartoon on tax code complexity [cartoon]


In another video, we saw that regardless of tax rates, the federal government’s tax revenue is a constant 18% of GDP.  A possible criticism is that what really matters is the amount of money the government collects. Let’s address this question.

We’ll start with the top marginal income tax rate. This is the income tax rate that applies to the richest Americans. In 1954, the top marginal income tax rate was 91% and the government collected tax revenues of about $2,600 per person.

Now fast forward ten years.  In 1964, the top income tax rate was 77% and the government still collected about $2,600 per person in taxes in today’s dollars.

By 1984, the top income tax rate had fallen to 50% but the government’s tax revenue had risen to $5,700 per person in today’s dollars.  If we fill in all the years from 1954 to 2009, a pattern emerges. There are exceptions but there’s also a clear trend: Higher tax rates result in lower tax revenue.

Now maybe it takes time for changes in tax rates to take effect.  So let’s compare the tax rate in the current year to tax revenues one year later. If we do this, we get the same negative relationship. When the top marginal tax rate is high, one year later, tax revenues are low. When the top marginal income tax rate is low, one year later, tax revenues are high.

If we look at the capital gains tax, a similar pattern emerges. The effect is the same with corporate taxes.

There are two tax rates that don’t follow the patterns we’ve seen so far. Let’s look at these.

The average marginal income tax rate is the federal income tax that applies to the average taxpayer. Over the past 50 years, changes to the average taxpayer’s income tax rate have resulted in neither consistent increases nor consistent decreases in per capita tax revenue. These data suggest that the government neither gains nor loses tax revenue when it raises tax rates on the average American taxpayer.

Other exceptions are Social Security and Medicare tax rates. On average, an increase in these tax rates does increase tax revenue per person. However, there’s no such thing as a free lunch. Increasing Social Security and Medicare tax rates makes it more expensive for firms to hire workers, and so firms hire fewer of them. Over the past 50 years, each one percentage point increase in Social Security and Medicare tax rates has been followed one year later by a tenth of a percent increase in the unemployment rate.

A possible reason why increases in Social Security and Medicare tax rates increase tax revenue is that these taxes are the hardest to avoid. With the proper use of exemptions and deductions and offsets and tax credits and by delaying or changing the form of one’s compensation, federal income tax, capital gains tax, and many other taxes can be at least partially avoided. But when the government raises Social Security and Medicare tax rates, tax revenue rises because Social Security and Medicare tax rates are subject to far fewer loopholes and so are much more difficult to avoid.

What this suggests is that the right discussion is not, “How to raise tax revenue?” but, “How to simplify the tax code?”  The simpler the tax code is, the less able people are to avoid taxes and the less time and money people will spend attempting to avoid them. And the less time and money we spend trying to work around a complex tax code, the more time and money we will have available to put to more productive uses.

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