Sammy on Taxes – And a Response by Cactus

Sammy sent me the following post

The most common explanation for supply-side economics is that cutting tax rates results in higher tax collections via increased economic growth. But could there be another, microeconomic, mechanism as well?

Here is Arthur B Laffer in WSJ “Tax Threat to Prosperity”:

Over the past 30 years, the U.S. has seen large changes in income tax rates as well as other tax rates. And, as would be expected, the budgetary implications of these tax changes have once again become a hotly debated partisan issue.

But missing from the discussion are the huge differences in how the top 1% of income earners respond to changes in tax rates versus, say, the bottom 75% or 80% of taxpayers — the so-called middle class and lowest income groups. The “rich” quite simply are not like the rest of us. (italics mine).
…the very highest income earners are and have always been able to vary their reported income and thus control the amount of taxes they pay. Whether through tax shelters, deferrals, gifts, write-offs, cross income mobility or any of a number of other measures, the effective average tax rate barely budges. But this group’s total tax payments are incredibly volatile.

In other words, lowering marginal tax rates at the upper end results in higher tax collections by reducing incentives for tax avoidance. When evaluating tax shelters a major variable is “Marginal Tax Rate.” The lower that number is the more likely they are to ship the money to the government.

If there is anything worse for economic growth than high taxes, it is shifting resources to non-economic tax shelters.

(There is a PhD dissertation waiting to be written on the effect of taxation (ie. 1031 exchange) on the real estate bubble).

This was by Sammy.

Here’s my response, fwiw. Regular readers know I worked for a year at what is now one of the Big 4 accounting firms – it was my first job after grad school and I really didn’t like it at all. But I learned a lot about how the world works. And once I figured out what the company really did, I really wasn’t able to do my job very well.

Let me tell you a purely hypothetical story. The partner to whom I indirectly reported was what was known in the firm’s parlance as a POGI – a Partner of Great Importance – to be distinguished from a PONI – a Partner of No Importance. One day, he gave a presentation to all of us who reported to him (plus a lot of people that didn’t). In the meeting, he told us about a, well, I’ll call it a plan, enacted for a Major Hypothetical Client. Major Hypothetical Client was and continues to be a household name in pretty much any country in the world other than North Korea, and if I had to guess, one of the ten or so most recognizable brands in the world. Major Client makes products that, from what I can tell, are no better or worse than the products made by its competitors, but when the Major Hypothetical Client’s name and logo are slapped on these products, they increase in value five-fold. Sometimes more. At least that seems to be the premium customers are willing to pay for that name and logo.

Anyway, the plan, and I repeat that this story is purely hypothetical, was more or less the following – part ownership of the logo was transferred to Major Hypothetical Company of Bermuda (or the Bahamas or some tax shelter in the Caribbean) through some convoluted scheme that involved payments being made back and forth between the parent company and the sub, but in such a way that the net of those payments equaled zero. But… because in the tax shelter taxes were essentially zero (and why not – the subsidiary was nothing more than a post office box so any income received by the tax shelter country was free), Major Hypothetical Client was now able to make a substantial part of its income subject to an infinitesimal tax. Total cost cost: whatever fees they paid their accounting firm.

The group that serviced High Net Worth individuals was down the hall, and I heard they did similar things for their clients. Which means… say you’re the heir to a large fortune. You have a trust fund that generates $20 million a year. You have two options:

1. Pay one of the big accounting firms a fee (say, $100,000 a year) and see your income essentially exempt from taxes
2. Don’t use these tax avoidance schemes and pay taxes like anyone else

If you’re the sort of person who is willing to use these tax avoidance schemes – and I would hazard to guess that not that many people in that situation are not – how low do tax rates have to be in order that you do not engage in those schemes? The answer: half a percent. Guess how low tax rates would have to be for someone making $200 million a year not to use the same schemes.

So… if the approach is to count on the goodwill of people who would otherwise employ those who can use what I like to think of as legalized fraud, Laffer is essentially arguing not only for a regressive tax system, but a very, very regressive tax system.

A better approach – end all these loopholes. All of them.