taxes

The tug of war on taxes

Role of taxes in our lives
Arnon Hadar

Few things cause more angst -- or generate more controversy -- than the role of taxes in our lives. Some people believe taxes are too high, while others say they are too low.

The one thing we can agree on is that everybody appears to disagree about the impact tax changes would have on America's prospects for economic growth.

Arnon Hadar has his own take on the subject. The professor of economics at Dominican University of California in San Rafael, Calif., offers his own thoughts on the following.

Taxes and its risks
Taxes and its risks

From an economic perspective, how do you view the tug of war between raising taxes to cut the deficit on one side and the risk that higher taxes will jeopardize the economic recovery on the other side?

A very important point regarding the "tug of war" is to distinguish between an economy in recession and a growing economy. In the former, it is true that, at a given level of expenditures, imposing higher taxes will jeopardize the economic recovery. But, in a growing economy, tax revenue increases without (the) imposition of higher rates … might ameliorate, though not necessarily solve, the debt problem.

If additional tax revenue is then needed, it is far better to increase tax rates during a period of economic growth than during stagnation.

In recession or early recovery, increasing tax rates will make the macroeconomic performance worse. It is important to note that the prospect in this case is even worse than it appears -- namely, increasing taxes by $1 will NOT reduce the deficit by $1, but by less. This is due to the associated negative effect on (gross domestic product) growth and, therefore, on tax collection.

There is a second distinction relevant to the question -- namely, the impact on economic growth of a tax imposed on low-earning individuals and on very high-income earners. Whereas a $1 additional tax on low-wage people reduces effective demand by more than 80 cents, on the average, a $1 tax on very high-income earners does not have a noticeable negative effect on aggregate demand and economic activity.

In this latter case, the "tug of war" does NOT really exist -- imposing an additional tax can help alleviate the deficit problem without negatively affecting economic growth.

Federal income tax breakdown
Federal income tax breakdown

How do you solve the tax dilemma of "the rich need to pay more" in taxes while nearly half of US households pay no federal income taxes?

I leave aside the question whether "dilemma" is the best term to express the issue at hand. Let's look at those 46 percent of the households not paying federal income tax. We should first note that those same households do pay some taxes, such as federal payroll and excise taxes as well as state and local income, sales, and property taxes.

Of (the 46 percent) not paying federal income tax, about half (23 percent) do not pay because they are poor, not because of any tax breaks. They had no taxable income. Of the rest (the other 23 percent), almost half (around 44 percent) are senior citizens benefiting from pertinent provisions, and another 30 percent (of the other 23 percent) is low-income working families with children. Thus, almost all those who do not pay federal income tax simply cannot afford it, legitimately.

Furthermore, among the rich that pay federal income tax, many take advantage of various loopholes, often paying a lower tax rate than their secretaries.

Flat tax structure
Flat tax structure

Is there a merit to a flat tax?

Again, a necessary question that needs to be answered first is: Merit for whom? Clearly, any realistic flat tax will benefit some while making others worse off.

I think the most frequently mentioned benefit of such (a) tax is simplification -- an easily understood rule and a straightforward way to determine one's tax. It is true that (the) U.S. tax system -- corporate and personal income tax -- is very complicated, but it is not because it is proportional or progressive. It is because of the arduous journey that needs to be undertaken in order to determine one's taxable income, irrespective of whether it is proportional/progressive or not.

Once the amount of taxable income is determined, to calculate the tax that needs to be paid is easy, whether the tax structure is proportional or flat. It is all the deductions and exemptions that make things complex.

In reality, rather than in pure theory, it is inconceivable that with congressmen representing different constituencies and all the thousands of corporate lobbyists, a true simplification -- a sustainable one -- can be achieved. And the pressures that lawmakers would be under if a move to a flat-tax structure were considered would be enormous.

Finally, it should be noted that … a flat-tax structure -- assuming, theoretically, deductions or exemptions only for the very poorest, who cannot afford it, or only for a truly very limited group -- is bound to benefit the high-income earners, and the losers would be sections of the middle class.

Effects of cutting corporate taxes
Effects of cutting corporate taxes

Would cutting corporate taxes boost employment and the economy?

This question is more complicated because it depends not only on which taxes are reduced, but also on too many other variables, of which the most relevant now is the state of the economy.

While, in general, reduced taxes on corporate income will tend to increase the rate of return on investment, which in turn should be expected to positively affect investment, some of the empirical research I looked at provides quite inconclusive answers. There are too many variables to consider.

But, assuming that some taxes on corporations have a negative effect on investment -- i.e., their reduction should result in a positive impact on the economy -- the relevant question now is whether a reduction in such taxes now will have a significant effect on GDP and employment.

At the current state of high (unemployment) and underemployment with a significant shortfall of aggregate demand, with small businesses having very limited access to credit and large firms enjoying very high profits, a reduction in corporate taxes will not have a significant effect on the economy.

Furthermore, large investment projects require a few years before having their full impact on employment -- another aspect that needs to be taken into consideration. Perhaps, rather than reduce taxes on corporations in general, some targeted incentives to specific industries with relatively strong impact on employment and future returns should be considered.

It is interesting to note that the effective corporate tax rate has been going down significantly over the last 50-plus years, and corporate income tax as a share of GDP has also gone down quite significantly.

We would like to thank Arnon Hadar, professor of economics at Dominican University in California, for his insights. Questions for this interview were contributed by Greg McBride, CFA, senior financial analyst for Bankrate.com.

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