Consulting by RPM || Free Advice Blog

Laffer on Why This Is the Calm Before the Storm

I have actually been surprised by how well the economy has held up so far. Obviously the economy is in terrible shape, by just about anyone’s reckoning, but if this is really going to be the Second Great Depression (as I’ve been saying for more than a year), it doesn’t seem too bad yet, does it?

Arthur Laffer had a WSJ article back in early June, when I was at the Rothbard Graduate Seminar, that I never got a chance to read. Tonight I went back to it, and Laffer hits on a crucial point that a lot of Austrian analysts don’t incorporate into their views:

People can…change the timing of when they earn and receive their income in response to government policies. According to a 2004 U.S. Treasury report, “high income taxpayers accelerated the receipt of wages and year-end bonuses from 1993 to 1992—over $15 billion—in order to avoid the effects of the anticipated increase in the top rate from 31% to 39.6%. At the end of 1993, taxpayers shifted wages and bonuses yet again to avoid the increase in Medicare taxes that went into effect beginning 1994.”

Just remember what happened to auto sales when the cash for clunkers program ended. Or how about new housing sales when the $8,000 tax credit ended?…

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush’s tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.

Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And there’s always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere.

Now, if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be.

Also, the prospect of rising prices, higher interest rates and more regulations next year will further entice demand and supply to be shifted from 2011 into 2010. In my view, this shift of income and demand is a major reason that the economy in 2010 has appeared as strong as it has. When we pass the tax boundary of Jan. 1, 2011, my best guess is that the train goes off the tracks and we get our worst nightmare of a severe “double dip” recession.
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Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011, preceded most likely by the stock market.

In 2010, without any prepayment penalties, people can cash in their Individual Retirement Accounts (IRAs), Keough deferred income accounts and 401(k) deferred income accounts. After paying their taxes, these deferred income accounts can be rolled into Roth IRAs that provide after-tax income to their owners into the future. Given what’s going to happen to tax rates, this conversion seems like a no-brainer.

The result will be a crash in tax receipts once the surge is past. If you thought deficits and unemployment have been bad lately, you ain’t seen nothing yet.

One of the things I learned while working for Laffer was that the quantitative effect of tax rate changes is larger than most people, even free-market economists, recognize. Part of the problem comes from not thinking on the margin.

For example, someone in the top income bracket right now gets a $1,000 corporate dividend and owes 15% on it. So that means after taxes the individual gets $850.

Next year, that dividend will be taxed at the normal income tax rate, which will be 39.6% for the top bracket. So that same $1,000 pre-tax corporate profit dividend payment will be $604 that the individual actually pockets.

Thus, the individual’s after-tax earnings on that $1,000 of corporate profit go from $850 to $604, a drop of 29%. That’s a pretty big margin, so shareholders are going to take great pains to accelerate their operations as much as they can to earn income this year at the expense of future years.

(Things are amplified the higher you get. For example, hiking the tax rate from 90% to 95% cuts the after-tax return in half, even though it seems like it’s a piddling increase.)

Even going from a regular income tax rate of 35% to 39.6% means that the after-tax return on $1,000 in income goes from $650 down to $604, a drop of 7 percent.

So as bad as the economy is right now, keep in mind that the pending tax hikes actually make it better this year than it otherwise would be. And as Laffer points out, next year will be that much worse, simply because of the rational shifting of income generation activities, on top of everything else.