FedUpUSA

Efforts to collect more taxes fail because people adjust their behavior accordingly.

Amidst all the “fiscal cliff” talk of raising tax rates, few dare to ask: have tax revenues topped out?

How could tax revenues decline as rates go up? Easy: people modify their behavior in response to whatever incentives and disincentives are present.

Make mortgage interest deductible and people will rack up huge mortgages. Reduce the yield on savings to near-zero (thank you, Federal Reserve) and people will save less.

Raise tax rates and people will lower their income or move to low-tax locales.As the saying has it, “Money goes where it is treated well.”

Supporters of higher rates tout studies that find upper-income taxpayers shrug off higher rates, staying put in high-tax states: Do High Taxes Chase Out The Rich? andSuperrich stay put in high-tax states like California.

On the other side of the ledger is this study from Britain: Two-thirds of millionaires left Britain to avoid 50% tax rate.

Which view is correct? Both, as a result of different dynamics. There are at least four separate dynamics in play.

1. The professional class is often “captured” and cannot move. For tax purposes, households with incomes of $500,000 and up are considered wealthy, i.e. above middle class incomes. Many of these people are self-employed or professional such as doctors and attorneys.

In theory, they could move to lower-tax states or nations, but their practice or enterprise is often local–pulling up stakes would mean sacrificing their high income which is the result of years or decades of networking and building local social capital.

Many of these high-earners are also trapped by their demographics: their kids are relying on their high incomes to pay their college costs, and aging parents may rely on their proximity and income.

Moving away is simply not an option for these high earners. So it’s not that these professionals approve of higher taxes, they just don’t have any practical alternative.

2. What self-employed high earners can do is lower their earnings. If the threshold is $250,000 each, then they will lower their taxable income to $245,000. Those with S corporations, limited liability corporations, etc. have legal ways to lower their taxable income while retaining the benefits of their entity’s income.

For example, maybe the corporation will buy a live/work loft as an office, eliminating the owner’s personal mortgage. The corporation effectively pays the mortgage, meaning their earned income can drop significantly.

Others will choose to work less. Why work so hard just to pay more taxes? Refuse work, cut your hours, enjoy life more.

3. The super-wealthy have the means to transfer income and wealth to lower-tax nations and pursue legal loopholes in the U.S. tax code. Those households making a mere $500,000 rarely have the financial wealth or firepower to justify the costs of hiring big-bucks tax attorneys and moving their assets and operations overseas.

This is the primary difference between high earners and the truly wealthy: the merely well-paid have fewer incentives to establish a legal enterprise overseas and deal with the complexities of the U.S. tax code, which considers all income from all sources to be taxable U.S. income.

For example, a wealthy U.S. citizen may earn $10 million a year, but by buying a villa and establishing a corporation in a low-tax nation, they can legally lower their tax rate on income earned or declared in the low-tax nation. By expensing all sorts of things against their U.S. income, they can effectively pay the U.S. rate on a small portion of their earnings while sheltering 90% overseas in perfectly legitimate ways.

Shifting assets and income streams to shelter income is de rigeur. The wealthy have more opportunities to do so, and so it is unsurprising that they would take those opportunities.

The wealthy and corporations are used to juggling tax code complexities and international assets/declared income; they have to do this to maximize shareholder value. Jacking up rates basically impacts the “captured” professionals and small business owners who have large earned incomes.

At some point many of these people will decide to sell out, retire, or drastically trim their enterprise to avoid working hard just to pay more taxes.

4. These basic avoidance strategies–earning less money and moving income and assets to lower-tax nations–are already common and relatively easy for those with control of their incomes and assets. Tax avoidance is universal, which is why tax increases always raise less money than linear projections anticipate.

If the sales tax or VAT goes up, people buy less retail and buy more on the cash-black market. The wealthy are simply doing the same thing on a larger scale.

Those with an interest in technical analysis may discern a topping pattern in this chart of tax receipts. It looks like the resurgent tax receipts of the QE/stimulus era will top out and roll over as the global recession deepens in 2013, forming a lower high.

We can anticipate a stairstep down pattern as tax receipts decline, new tax increases bump up revenues for a brief time and then people respond with more tax avoidance and tax revenues will resume their decline.

Various studies have found that Federal tax revenues top out just above 20% of total household income, regardless of the era or nominal tax rates. Recall that in many high-tax economies, up to 50% of the economic activity occurs in the informal/black market.

When tax rates are high, people move their consumption and enterprise into the cash informal economy and only pay taxes on half their total income. This is one way that people limit the amount of taxes they pay to around 20%, regardless of the nominal tax rate.

Efforts to collect more taxes fail because people adjust their behavior accordingly. Linear projections of rising tax revenues always fail to account for this easily predictable behavioral response.

Charles Hugh Smith – Of Two Minds

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