Taxing the rich

In the current debate over whether to extend the Bush tax cuts for those making over $250,000, Democrats have typically advanced the argument that the tax cuts should be raised because the rich simply don't need the money. Sen. Harry Reid has perhaps best captured Democratic sentiment through his class warfare characterization of the debate:

“[Republicans] can pretend we can afford to give billionaires another handout, even though we know we can't.”

Given short shrift by Democrats, however, is the economic impact of a tax increase from 35 percent to 39.6 percent for the top income bracket. While calculating the exact impact is near impossible to predict, it is almost assuredly non-trivial. Let's begin by considering how people react to other types of taxes, such as the 5 cent tax on disposable bags imposed the Washington DC government which took effect on January 1:

The district's fee applies to bags provided by grocery stores, drug stores and liquor stores. In late March, the city produced its first report on the tax's effects: It estimates that stores were providing 22.5 million bags per month before the fee went into effect. In January, estimates indicate retailers only handed out 3 million bags.

City officials aren't sure whether the decline really has been quite that dramatic. They note that retailers aren't used to reporting the number of bags they provide, which could be leading to some early inaccuracies. Still, Charles Allen, chief of staff to D.C. Council member Tommy Wells, who sponsored the fee, says that anecdotally major grocery stores report they're handing out at least 50 percent fewer bags. Some smaller retailers report even bigger drops.

Consumers, in other words, have drastically reduced their usage of disposable bags simply to avoid a 5 cent fee. Assuming that a plastic bag holds $10 worth of groceries, that's a tax rate of 0.5 percent. If someone uses 300 bags per year, that's a tax of only $15, and yet the impact was a reduction in half of bag usage.

Let's also take a look at cigarettes:

Politicians in Annapolis, MD are scratching their heads wondering what happened to all those chain smokers who were supposed to help balance Maryland's budget. Last year the legislature doubled the cigarette tax to $2 a pack to pay for expanded health-care coverage. Eight months later, cigarette sales have plunged 25% and the state is in fiscal distress again.

In other words, an increase of only $1 led to a 25 percent reduction in cigarette purchases. Assuming someone smokes half a pack a day, the tax amounts to about $183 per year and yet still had a significant impact.

Now let's consider someone with a million dollars in annual earnings. Their increase in taxes (assuming for simplicity's sake that they do not itemize) for the $750,000 earned in the top bracket would amount to $34,500. For someone who earns $500,000 per year the extra tax is $11,500.

If people are willing to go to the effort to either bring a bag with them to the grocery store to avoid a 5 cent tax, or either give up smoking or go out of state to purchase cigarettes to avoid a $1 per pack tax, what reason is there to think that a tax increase won't negatively impact the economic behavior of those in the highest income bracket? Remember, free time has its own value, and at some point the extra money generated by increased economic activity will not be worth the commensurate reduction in time spend pursuing non-economic pursuits.

This economy needs more incentives for economic activity not less.