Why taxing the rich isn’t a viable strategy

One of the leading candidates in the upcoming gubernatorial election has a simple message for fixing Minnesota’s budget woes: tax the rich more. Specifically, raise the income tax for those with the highest incomes. That’s not exactly the same as taxing the rich, and therein lies the problem.

When I was little, rich people (measured in income, not wealth) tended to get a lot of perks. The corporate car, the corporate golf club membership, three-martini lunches, and so on. Back then, income taxes were very high for the wealthy, so the wealthy avoided high incomes. Why buy your own car when it was much cheaper to convince your employer (who might be yourself) to lend you a car? Once Reaganomics caught on, it became more efficient to give people cash, so incomes rose as perks disappeared. The point is, incomes at the high end are fungible. It’s easy to trade cash for perks, and those who give high salaries have a great deal of incentive to find creative ways to be tax efficient. So if you tax perks, incomes rise, but if you tax incomes, perks rise. Tax rates going up next year? Lower the 401k deduction this year, then raise it next year to compensate.

The second problem with raising income tax as a tax-the-rich strategy is that it only affects the high-income wealthy. People like the aforementioned candidate are wealthy, but it’s all wealth, no income. The money’s already in the bank, so any income tax was long since paid. Only if that money makes more money is it taxable, and then it’s even more fungible. Interest and dividends are taxable as regular income, but capital gains (increase in stock price) only become income when the stock is sold. So you sell stocks only when the tax rates are particularly favorable or when you really need the cash. It’s a cat-and-mouse game that the government can never win, in part because the super-wealthy can save money by spending big bucks to avoid taxes, and in part because the super-wealthy are themselves voters who can save money by making campaign donations to create loopholes.

One of the big problems in the financial meltdown was that home prices dropped dramatically, and the revenue for most municipalities is based in property taxes. When you tie the government’s income to one part of the economy, a crash in that sector leaves the government empty handed, which causes government layoffs as well as fewer government services when people need them the most. That’s why most economists favor a value added tax (VAT), like in the EU: it taxes nearly every financial transaction, so government coffers rely on no single part of the economy. Relying on a tax-the-rich strategy is perhaps the worst of all: not only isn’t it economically diverse, it relies on an absence of loopholes for those best suited to create and exploit loopholes.

On Tuesday I’ll be voting for Tom Horner, whose strategy is neither to tax the rich (exclusively) nor to decimate governmental services. Rather he plans to lower the sales tax rate but broaden the number of goods taxed, making it ever so slightly more like a VAT. It’s a pragmatic, rather than a feel-good strategy.