Why Henry Blodget is wrong about taxes

April 6, 2010

Henry Blodget says he’s pretty confident taxes are headed higher to deal with the historic rise in federal spending  and agrees with Northern Trust’s Paul Kasriel that higher rates won’t be an economy killer. Blodget quotes Kasriel:

The economy performed pretty well in the eight years ended 2000 even though the top marginal tax rate was higher in these eight years than it was in the prior eight years. The economy did not perform better because of the increase in the top marginal tax rate. Nevertheless, this increase was not sufficient to derail economic progress. In the eight years ended 2008, the economy performed relatively poorly despite the lower top marginal tax rate.  The economy did not under-perform because of the marginal tax rate cut. Nevertheless, the cut in the tax rate was not sufficient to enhance economic performance. The point of all this is that although tax rates matter, they are not all that matters.

Me: I agree that taxes matter but they are not the only thing that matters. But they do matter a lot.  Back when tax rates rose in the 1990′s, the economy was starting from a position of strength, not weakness. There was already  a powerful, self-sustaining recovery in place. Let me point out this 2009 study that examined the affect of higher marginal tax rates on the rich:

Taxes trigger a host of behavioral responses designed to minimize the burden on the individual. … all such responses are sources of inefficiency, whether they take the form of reduced labor supply, increased charitable contributions, increased expenditures for tax professionals, or a different form of business organization, and thus they add to the burden of taxes from society’s perspective.

Following the supply-side debates of the early 1980s, much attention has been focused on the revenue-maximizing tax rate. A top tax rate above X is inefficient because decreasing the tax rate would both increase the utility of the affected taxpayers with income above X and increase government revenue, which can in principle be used to benefit other taxpayers. … Using our previous … the revenue-maximizing tax rate would be 55.6%, not much higher than the combined maximum federal, state, Medicare, and typical sales tax rate in the United States of 2008.

And this is before the 2011 tax increases and the increase in taxes related to healthcare reform. We are probably now on the wrong side of the Laffer Curve.  Greg Mankiw also makes the case that Americans are not undertaxed compared with the rest of the planet’s advanced economies.

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I would also add there were 3 growth drivers during the 1990’s. 1) The initial build-out of the Internet when firms spent billions on fiber, chips, software, webhosting, etc. 2) The Y2K computer conversion increased demand for some of the same equipment plus lots of high-paying software programmers. 3) Now we also found out the Clinton HUD lowered the lending standards for home ownership and set off a housing boom to boot.

The first two aren’t coming back, and who knows about the third.

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