Why Taxing the Rich Does Not Work

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President Obama has said that he wants to "spread the wealth". He proposes to raise taxes on "the rich" to get more money for "stimulus" spending, such as longer unemployment benefits. Let's look at how this "spread the wealth" thing would actually work.

Joe Lunchbox works in a factory owned by Reginald Bigbucks III, a billionaire. Obama stops at the factory during a "Jobs" bus tour through the Midwest. Joe and his coworkers assemble in the lunchroom to hear Obama speak.

"Good news," the president tells the workers. "We are going to be spreading the wealth. We are raising taxes on millionaires and billionaires-like Reginald Bigbucks III-and we are going to spend the money to benefit the middle class, people like you."

Joe raises his hand. "What do you mean?" he asks. "I mean, like, what is actually going to happen?"

Obama explains, "To pay my new taxes, Mr. Bigbucks is handing this factory over to the federal government. We are going to tear it down and sell it for scrap. Then we are going to use the money to extend unemployment benefits for another 99 weeks."

"Oh," Joe sighs. "Well, then, I guess that I'm going to be needing those unemployment benefits."

If the above example strikes you as fanciful, consider the following. To "tax" is to take away something from someone and give it to the government. "The rich" are rich because they own a lot of assets. So, what it means to "tax the rich" is to take assets away from rich people and transfer them to the government.

So, what are the assets that the rich own? The rich don't have money bins full of cash, like Scrooge McDuck. Rather, they own things like factories, office buildings, and oil wells, either directly, or indirectly via stocks and bonds.

In other words, the rich own most of the "nonresidential fixed assets" of the nation. These assets certainly count as "wealth", but what they are physically are the tools that workers use to produce America's GDP.

The government doesn't want factories, office buildings, or oil wells. It wants cash. So, taxing the rich forces them to liquidate assets. This liquidation is accomplished financially, rather than by actually tearing down factories and selling them for scrap.

At the concrete level, what happens is that money that would otherwise have gone to create new nonresidential fixed assets is redirected to buy some of the rich taxpayer's existing assets. The rich person then hands this money over to the government. The end result of this process is that government has more money, and the rich person-and the economy as a whole-has less nonresidential fixed assets.

The relationship between nonresidential fixed assets and GDP has been essentially constant for the past 60 years. One dollar of nonresidential fixed assets yields about $0.50 of GDP. Real GDP per worker has risen over the years as real nonresidential fixed assets per worker have increased. In 2009, according to BEA data, the average job was underpinned by about $200,000 in nonresidential fixed assets.

So, if you tax away $200,000 from "the rich", GDP goes down by about $100,000 per year, federal revenues go down by about $18,000 per year, and total employment goes down by one job. This is how "spreading the wealth" actually works. This may account for why "taxing the rich" is, inexplicably for Progressives, not popular with voters.

Now, $200,000 is more than $18,000, so doesn't "taxing the rich" at least leave the federal government better off? No, it does not. This is because to get the $200,000, the federal government has to give up $18,000 per year in tax revenue from then on. The present value of $18,000 per year is about $620,000. So, when the federal government taxes $200,000 away from "the rich", it makes itself worse off by $420,000, the country as a whole becomes poorer by $3.4 million, and Joe Lunchbox loses his job.

"Wait!" the Progressives might cry. "We don't tax assets, we tax income!"

Well, the death tax, which Progressives love, is a pure tax on assets. It often forces the immediate, direct, and inefficient liquidation of assets to pay the tax. This is why the death tax is so economically destructive, and probably why it is opposed by a vast majority of the public. However, let's look at the income tax, which is the Progressives' favored vehicle for "taxing the rich".

In 2008, John Paulson earned more than a billion dollars. How much of the last (say) $100 million of income did he consume, rather than save and invest? Zero. It is not physically possible for one man to consume what a billion dollars will buy. No matter how rich you are, you can only live in one house at a time, you can only drive one car at a time, and you can't eat any more than a middle class person or you'll get fat.

The richest of the rich save and invest 100% of their incremental income. So, taxing the income of this small group reduces nonresidential fixed assets essentially dollar for dollar. This is the inherent problem with an income tax. When the government taxes away a dollar that would otherwise have been saved and invested, everybody loses. It doesn't matter whether that dollar is taken away from Joe Lunchbox or Reginald Bigbucks III.

On a present value basis, taxing a dollar away from someone who would otherwise save or invest that dollar costs the economy as a whole $17.20, and produces a net loss to the federal treasury of $2.10. Accordingly, taxing away a dollar of income from anyone who saves and invests more than 32% of his earnings on the margin is a net loser, even if all you consider is Federal finances.

Progressives are bewildered that the FairTax, which would replace almost all existing federal taxes with a national sales tax, is so popular with the public. Progressives denounce the FairTax as "regressive".

What voters understand, and Progressives seemingly don't, is that the middle class gets almost all of its income via employment. Both the number of jobs and the wages that those jobs pay depend directly upon the nation's stock of nonresidential fixed assets. Because the FairTax taxes only consumption and has very low compliance costs, the FairTax would maximize savings and investment. This, in turn, would cause nonresidential fixed assets, GDP, employment, and wages to rise at the fastest possible rate. The FairTax would even maximize the present value of federal revenues.

Right now, the middle class needs more jobs and higher wages much more than it needs lower taxes. The federal government needs higher tax revenues, not higher tax rates. This is why "taxing the rich" is an electoral loser and the FairTax is an electoral winner. Let's hope that the Republican presidential hopefuls figure this one out.


Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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