In my first Thoughts on taxes post, I listed reasons why I prefer a simple and broad tax system.
In this post, I will elaborate on the first reason I listed for preferring a simple tax code:
- No matter the complexity of the income tax system, government collects about the same percent of the overall economy’s income (GDP) in taxes.
Since World War II, our country has had a fairly wide variation in complexity and rates in its income tax code. Yet, the chart on this page shows individual income taxes collections have stayed in a relatively narrow range between 8% and 10% of GDP.
Politicians often say they want to raise tax rates to increase tax collections. This chart suggests that rates — at least for the various tax codes since about 1950 — don’t have significant effects on government’s take of the economy as a percent of GDP.
So, making moderate changes to get more (or less) revenue doesn’t seem to work.
This doesn’t seem to be widely known and is rarely brought up when discussing tax rate proposals.
It also doesn’t seem intuitive. It’s fair to ask, how could it be that tax rate changes don’t seem to have much effect on the total percent of income collected in taxes?
Great question. I’m not sure I know the full answer, but a key part of it is that the complexity of the tax code itself.
Different types and amounts of income are taxed at different rates and we all have choices that allow us at least some flexibility on how much taxes we pay. We’ll tend to favor the types and amount of income that we feel are a good deal on an after-tax basis.
If the tax rate for dividend income, for example, is lower than the tax rate on capital gains (both are investment income) — then it’s worth our while to favor dividends over capital gains. Investment advisers will encourage us to switch investment strategies to invest in companies that pay dividends to help us minimize our tax bill. Management teams will respond by distributing more money back to owners through dividends than share repurchases.
Consider the recent example where Great Britain raised the tax rate to 50% on those making more than a million pounds. The number of folks reporting more than a million pounds dropped in one year from 16,000 to 6,000 and taxes collected from this group declined from 13.4 billion to 6.5 billion pounds.
The article states:
It is thought that many of the highest earners moved abroad or reduced their taxable incomes to avoid paying the new levy.
So, while the tax rate went up, the amount of income exposed to this tax rate when down meaning the weighted average tax rate in England probably didn’t change that much.
There are other decisions we can make that change our tax rates. How much you donate to charity, how big of a mortgage you decide to get, deciding not to sell a stock because you won’t make enough after taxes on the gain, how much you decide to save in tax deferred retirement accounts and how much you decide to contribute to your HSA or cafeteria plan are some of the more common decisions that have clear tax implications.
Raise tax rates on folks like Warren Buffett, a vocal tax increase advocate, and he’ll just donate more to charity to lower his tax rate.
