Tax Rascal

Tax Cuts Killed the Three-Martini Lunch

Categories: Tax Policy
Tax Cuts Killed the Three-Martini Lunch

Do income tax rates really matter? The intuitive answer is that they must — a higher income tax discourages people from working as hard as they might, but also provides extra funds to the government. Oddly enough, neither of these points are quite true: according to economist Kurt Hauser, government revenue is always about 19.5% of GDP, whether top tax rates are 91% or 28%. Meanwhile, a glance through the list of countries in order of top tax rate shows that there isn’t a strong relationship there, either: economic basketcase Zimbabwe is right next to Australia.

It’s easy to take this information as evidence that tax rates are completely meaningless the long run. But that’s a little hasty. A better thing to consider is the notion that there may be a ‘natural’ tax rate people are primed to pay, to the point that if Federal tax rates are higher, they’ll find ways around them, and if they’re lower, the states will make up the difference.

The 1920’s and 1950’s are a great example of this. During both time periods, taxes were fairly high, but wealthy people could still keep a large fraction of their income. The trick was to use deductions carefully — expense accounts, company cars, and company apartments could all get around specific tax laws (and illegally omitting perks from one’s tax filings was harder to catch than simply fudging the income numbers). This also explains another phenomenon: when income taxes were high and business deductions were lavish, going to a nice restaurant for lunch and drinks was a pretty cost-effective way to do business. With lower personal tax rates and stricter rules, that’s not the case — and the social stigma against drinking during work hours has certainly increased.

Another way people get around high taxes is to push for special tax breaks. The oil and cattle industries were especially adept at this — for a while, it was possible to get rich selling crude oil or cattle at under cost, thanks to the extensive tax benefits and subsidies. It’s hard for a politician to talk about the importance of tax cuts when that kind of thing is happening — which is probably why major tax cuts are made more politically palatable by closing loopholes. This is one of the reasons that those giant tax reductions (from 90% to 70%, 70% to 50%, and 50% to 28%) aren’t accompanied by major drops in revenue: tax policy shifts from soaking some of the rich to gently dampening a lot more of them.

It’s clear from this overview that tax laws affect people’s actions and expectations in strange, unpredictable ways. Over the next few blog entries, I’d like to discuss some more of these, while explaining the implications for individual taxpayers. For most of us, taxes are something we spend most of the year ignoring and a month or two dreading, but a little research shows that, dreadful though they may be, taxes are absolutely fascinating.

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