A hundred years ago, when I was in college, one of my economics professors used to say, “If you punish a behavior you get less of it and if you reward a behavior you get more of it.”
He was referring to taxes. Taxes are essentially penalizing a behavior. It is only natural that the activity you are taxing will go down and hence the revenue the government receives will not be what it expects.
More recently, this was made clearer by Arthur Laffer, with a graphic illustration aptly named the Laffer Curve. The bottom line is that there are two tax rates that produce zero revenue for the government.
The first is a zero rate of tax, which of course will produce zero revenue. No big surprise there! The second rate that will produce zero revenue is a 100 percent tax rate.
If everything you produce is confiscated in taxes, what is your motivation for producing anything? If your net personal result is the same if you work or if you don’t work, why work?
Now the logical conclusion is that there is an optimal rate of taxes that generates the most revenue for the taxing authority and yet still motivates the producers to produce. There are several factors that go into this calculation and they are constantly changing with the times.
According to Laffer, revenue responses to a tax rate change will
depend upon the tax system in place, the time period being considered, the ease of moving into underground activities and the prevalence of legal loopholes.
This makes it a little more difficult than just saying lowering tax rates will increase revenue. This statement will hold generally but not absolutely.
The point I want to make with this information is how governments operate when thinkingabout taxes and what the reality ends up being.
Let’s take Ohio’s cigarette tax, which was increased several years ago. What the people in Columbus do is they look at how many packs of cigarettes are sold in a year and then decide how much revenue they want based on that quantity.
For example, let’s say that 1 million packs of cigarettes are sold each day in Ohio. It makes some sense that if you add one dollar of tax to a pack of cigarettes that this tax will generate $365 million new dollars in revenue each year.
The reality is quite different, however. Penalizing the purchase of cigarettes means
people will purchase fewer, thereby changing their behavior or finding
alternatives. The actual revenue received by the state will be considerably less than planned.
This works the same for gasoline, sugary drinks, bullets, salty snacks, alcohol, gambling or any other product or behavior the state deems worthy.
All this is well and good except the state spends the $365 million upfront and then is baffled when the revenue isn’t there. It’s even worse if the state plans on this revenue and goes out and borrows money based on these new future revenues.
It baffles my mind since I know that the state is aware of this phenomenon. Otherwise, why would it give tax incentives in order to encourage the behavior it wants; tax credits for
buying green cars, property tax abatements for building new buildings, deductions for providing health insurance to employees and many more.
As we go into this election, remember the Laffer Curve and listen to the words of the candidates when it comes to taxing (penalizing) a behavior to lower the deficit and create jobs.
Look past the rhetoric and look at the economics. Both parties are guilty of this because the behavior of politicians is always about power and not about sound economics. One more reason to celebrate John Galt Day on Aug. 13 — go on strike for the day.
Gary L. Rathbun is the president and CEO of Private Wealth Consultants, Ltd.
