Why raising the tax rate doesn’t raise tax revenue

Posted by Marc Hodak on April 26, 2009 under Unintended consequences | Be the First to Comment

Here’s a simple thought experiment.  There are ten people.  They have an income distribution and a tax bill that look like this:

#       Income    Tax      Effective rate

1 –            50          15              30%

2 –           20            5              25%

3 –             8           1.5             19%

4 –             6           0.8            13%

5 –             5           0.5            10%

6 –             4           0.2              5%

7 –             3            0                0%

8 –             2            0                0%

9 –             1             0               0%

10 –           1             0               0%

Total      100          23              23%

In other words, our little group roughly represents the distribution of income  and income taxes in many developed countries.  Now, let’s say that the government wanted to raise additional income by raising the top marginal rate, which would be felt exclusively by the top earner.  Let’s say the effect of that increase would raise his tax from 15 to 16, or his effective tax rate from 30% to 32%.  That would boost overall tax revenue from 23 to 24, a 4.3% gain.

Now, 4.3% would be considered a huge gain in total income for a government from just a tax rate increase.  Here is why they would not be likely to see it.

Wealthy people are sensitive to their effective tax rates as much as the rest of us, and possibly more (they didn’t get wealthy by being indifferent to money).  The wealthy and their income are highly mobile in every country except the U.S., Libya, and North Korea.  All it would take is a 7% chance of the top earner decamping for, say, Switzerland to make this tax increase lose money for the government on an expected value basis.  When things get too far out of whack, high-tax nations have a lot to worry about on this score.  And that is before counting any effects on marginal productivity.

If a country’s tax rates were at some equilibrium, it would most likely be the equilibrium for maximizing the country’s tax revenues.  I don’t know if any country is exactly at that point, but it’s unlikely that any country is on the strongly upward-sloping part of the Laffer Curve.  All of which probably explains why overall revenue seems relatively insensitive to individual tax rates.