A Thought about Tax Rates and Economic Turmoil

clintl · Feb 7, 2010

Just as refresher, I'm going to link to a graph showing the top marginal income rate in the U.S. since 1913. I don't remember the thread, a link to a graph like this was posted several days ago.

http://en.wikipedia.org/wiki/File:MarginalIncomeTax.svg

I noticed something then, and I've been thinking about it since. The two worst economic downturns of the last century came after a number of years of, by historical standards, a low top marginal tax rate. While those eras of low marginal tax rates were very good economic times for the most part, the end came with a near collapse of the financial system, when investment risk and reckless greed finally caught up with investors. By contrast, nothing of the sort happened when the marginal tax rate was high.

Now, I understand the objections to a high marginal tax rate with respect to fairness and disincentives, but something has occurred to me, and I'd be interested to see if this makes sense to others, too.

Here's my hypothesis - the marginal tax rate on the highest incomes should be fairly high because it reduces the reward that can be gained from reckless greed, which reduces the risk to the overall economy. I don't have any evidence other than that graph and some thinking about this to support it, and maybe it's wrong. But I think it's something worth considering.

And before there are objections to the contrary, I'd like to say that I think it's perfectly fine for people to make lots of money. That's not what this is about. I've always thought the 70-90% range where the top income tax has been for most of the century was way too high, and while I am for a progressive tax rate, I think the 35-40% we've been at for the last 20 years or so is reasonable. But now, I'm thinking maybe there is a good economic reason to put more of a brake on income at the highest levels.

Death Wizard · Feb 7, 2010

It has always felt to me that the only reason not to do this is greed. The wealthiest Americans -- who are predominately middle-age to elderly whites -- want it all. Ronald Reagan would disagree with the greed part, I'm sure.

And by the way, I'm a 52-year-old white guy who makes a rather large salary. So I have something to lose by saying this. But I'm willing to lose a piece of my pie for the good of all colors.

blacbird · Feb 7, 2010

deathwizard said:
Ronald Reagan would disagree with the greed part, I'm sure.

Well . . . not anymore.

caw

Death Wizard · Feb 7, 2010

blacbird said:
Well . . . not anymore.

caw

Ha!

MattW · Feb 7, 2010

It's an interesting hypothesis, but I'm not sure there's a strong correlation between disastrous downturns and the highest tax bracket.

There certainly could be many more factors - I'd personally be interested to see that relationship include factors like deficit spending and CEO salary multiples of median income.

I'm a data nerd - I could play in a spreadsheet like that for days...

rugcat · Feb 7, 2010

I'm not sure there is a causal correlation between the two.

What I am sure of is that the economic theorists who maintain that a low tax rate for the rich is good for the economy and a necessity for economic success, are coincidentally the very people who personally benefit most from such a system.

MattW · Feb 7, 2010

rugcat said:
What I am sure of is that the economic theorists who maintain that a low tax rate for the rich is good for the economy and a necessity for economic success, are coincidentally the very people who personally benefit most from such a system.

You could make the same case for those who espouse high punitive tax rates as well. Trust no one.

MacAllister · Feb 7, 2010

Redistribute the wealth! Don't rest until we're all equally scrabbling for the last loaf of bread in the local cinderblock supply center! From each according to his ability, to each according to...

oops...lost my head for a sec, there. Sorry 'bout that.
Carry on.

clintl · Feb 7, 2010

rugcat said:
I'm not sure there is a causal correlation between the two.

I'm not sure there is, either. But I'm wondering if there is.

Slushie · Feb 7, 2010

clintl said:
Here's my hypothesis - the marginal tax rate on the highest incomes should be fairly high because it reduces the reward that can be gained from reckless greed, which reduces the risk to the overall economy. I don't have any evidence other than that graph and some thinking about this to support it, and maybe it's wrong. But I think it's something worth considering.

And before there are objections to the contrary, I'd like to say that I think it's perfectly fine for people to make lots of money. That's not what this is about. I've always thought the 70-90% range where the top income tax has been for most of the century was way too high, and while I am for a progressive tax rate, I think the 35-40% we've been at for the last 20 years or so is reasonable. But now, I'm thinking maybe there is a good economic reason to put more of a brake on income at the highest levels.

FYI: you're thinking of the "Gipper. . . " thread, and the graphy blacbird linked.

Since we're dealing with hypothesizes here, I'll leave my rants about the IRS, government's inherent fiscal ineptitude, and any type of fairness/morality/idealism tirade at the door.

#

So yeah, I see that correlation between high rates and steadier economics too, but is it causation? There are a bunch of macro-economic variables to be considered.

At the beginning of the 20's, the top rate was dropped from ~70% to ~25%. The theory, then, being Mr. McMoneybags had more capital at his disposal. With the extra cash, he took greater risks on investments; not all these risks turned out in his favor. Add up all the Greedy McMoneybags--more importantly, their capital--and when their collective investments tanked, so did the economy. That's how I understand your premise, clintl. Right?

Here's the hole I see. Government revenue has remained relatively flat throughout all these fluctuations of the top, marginal rate. So even though the tax rate is higher, does this automatically mean McMoneybags is paying all his taxes? The Laffer Curve kinda comes in play here, the basic premise being that revenue will go down as the rate climbs above X% of personal income; the top rate wiggles through loopholes, being one of the reasons. There may be only a negligible difference in the personal capital available to McMoneybags when the top rate is 70%, versus 25%. As a result, he could still be willing to make risky investments if his capital is equal through these different rates.

I think, at best, there is only tenuous causation between % GDP change (if that's the economic metric we're using) and the top income rate. There are other variables that more heavily affect our economic success, or lack of.

clintl · Feb 7, 2010

I was thinking more along the lines of economic stability rather than % GDP growth. It's pretty much a basic investment principle that risk and potential reward are linked. What I'm wondering is if the same principle applies to the overall economy, and that a low top marginal tax rate increases the potential reward, but also increases the risk of economic collapse.

You're right that a high marginal tax rate probably encourages more cheating and manipulation, but perhaps there's a side benefit to that. Maybe the effort going into cheating on taxes means less time and resources are available to invent and invest in the kinds of exotic securities products that got us into trouble this time around.

Really, I'm just speculating here. I could be totally wrong, but it's kind of making sense to me.

Slushie · Feb 7, 2010

clintl said:
I was thinking more along the lines of economic stability rather than % GDP growth. It's pretty much a basic investment principle that risk and potential reward are linked. What I'm wondering is if the same principle applies to the overall economy, and that a low top marginal tax rate increases the potential reward, but also increases the risk of economic collapse.

You're right that a high marginal tax rate probably encourages more cheating and manipulation, but perhaps there's a side benefit to that. Maybe the effort going into cheating on taxes means less time and resources are available to invent and invest in the kinds of exotic securities products that got us into trouble this time around.

Really, I'm just speculating here. I could be totally wrong, but it's kind of making sense to me.

I'm not sure how the boldfaced part relates to personal income tax, though. If we're talking corporate taxation, then I can see what you're getting at. But on the flip side it's equally fair to speculate that, with higher taxation digging into corporate profits, the risk associated with those complex securities would be outweighed by the potential return, a return used for compensation of lost profits to taxation.

Another angle is, assuming corporations act like individuals, then they would be looking for ways to evade the increased taxes. They're already doing that, I think. And they probably did it while they were cutting up bundled mortgages. And they'll probably still do it even if the rate were dropped to, like, 25%. I'm not sure increased corporate taxation will divert resources; those resources are already being used in that regard.

Romantic Heretic · Feb 8, 2010

I don't think that the tax rate has anything to do with it. I think regulation does.

The U.S. had a financial collapse about every 15 years up until the Great Depression. At that time the government start regulating financial activity with more vigor than they did before. I believe that's why the U.S. remained fairly stable financially for such a long time.

When the financial regulation was repealed or no longer enforced, the troubles started again.

Coincidentally I believe you'll find that the people favoring less regulation and lower taxation are pretty much the same people. Which would explain why lower tax rates and financial chaos seem to occur at the same time.

clintl · Feb 8, 2010

Those are reasonable points. What I'm suggesting is that they might have a harder time finding buyers for those exotic securities because the benefits to investors would be less.

Don · Feb 8, 2010

I was wondering where all the progressives had gone. Then I spied this thread. :ROFL:

Hey, we really miss you all over here. But it's nice to see you're finding a new cause to replace the old one already.

*runs rapidly from the thread*

robeiae · Feb 8, 2010

Romantic Heretic said:
I don't think that the tax rate has anything to do with it. I think regulation does.

The U.S. had a financial collapse about every 15 years up until the Great Depression. At that time the government start regulating financial activity with more vigor than they did before. I believe that's why the U.S. remained fairly stable financially for such a long time.

I don't think what you've said here is true, at least not the way I'm reading it. Can you explain what you mean? What's a "financial collapse"? Because if you mean a depression/recession of sorts, the numbers don't fit.

Romantic Heretic · Feb 8, 2010

By 'financial collapse' I mean an event in which the finances of the U.S. went into crisis. Money stopped moving, businesses went under and a lot of people suffered.

Let's see.

1792 A minor one.
1796-1797 This one was bad.
1819 A full out depression.
The full list here.

As noted in the list crises and depressions happened much more frequently before regulation was instituted and enforced. The economy expanded rather nicely as well. Although I believe that had much to do with the fact that the U.S. was the only major manufacturing nation undamaged by WWII.

At any rate it's my belief that regulation helps ameliorate the greed and fear that drives the financial sector. They don't call them 'Panics' because they sound cool.

clintl · Feb 8, 2010

I think it's pretty clear from US economic history that a regulated economy has worked better at reducing the frequency and severity of economic downturns and panics than an unregulated one.

robeiae · Feb 8, 2010

Romantic Heretic said:
By 'financial collapse' I mean an event in which the finances of the U.S. went into crisis. Money stopped moving, businesses went under and a lot of people suffered.

Let's see.

1792 A minor one.
1796-1797 This one was bad.
1819 A full out depression.
The full list here.

As noted in the list crises and depressions happened much more frequently before regulation was instituted and enforced. The economy expanded rather nicely as well. Although I believe that had much to do with the fact that the U.S. was the only major manufacturing nation undamaged by WWII.

At any rate it's my belief that regulation helps ameliorate the greed and fear that drives the financial sector. They don't call them 'Panics' because they sound cool.

That's not a "financial collapse" every fifteen years, though. And some of the ones you would cite can be partly--but directly--attributed to events outside of the US, outside of the US governments control, no matter what regulations it might or might not have had.

Beyond that, your "regulation" meme is too simplistic. Financial markets--all markets, really--have changed over time. You can't very well argue for regulations that would have prevented exotic mortgage derivatives in the 1800's as a means of staving off those "collapses."

Prozyan · Feb 8, 2010

Romantic Heretic said:
I don't think that the tax rate has anything to do with it. I think regulation does.

I think this is a pretty good point, as far as it goes.

History shows that one of the causes of the Great Depression was allowing the so-called "common man" to enter into the stock market, where they were preyed upon. This led to the big money people to suffer heavy but recoverable losses when the crash came, but the "common man" was bankrupted.

It is generally agreed upon that this current economic crisis exploded with the housing bubble (though it can be argued it can be traced back to the dot-com bubble bursting and the housing bubble was artificially created to support the economy following this) which, I believe, originated when it was decided that every American had a right to own a home and the Fed took steps to ensure this was possible.

The resultant ARM loans and general predatory behavior of some lenders again led to financial disaster.

So, just thinking off the top of my head, I don't see a correlation between tax rates, but rather decisions being made that the "common man" has some right, such as home ownership, combined with insufficient protections for said common man.

robeiae · Feb 8, 2010

clintl said:
I think it's pretty clear from US economic history that a regulated economy has worked better at reducing the frequency and severity of economic downturns and panics than an unregulated one.

The term "regulated" is too broad, in my view. The regulations in place now--and in 2001, and throughout the '90s--are monumental, compared to the ones in place in any period you might choose from the past.

I think you, too, are looking for a simplistic description for something that just isn't simple.

Gregg · Feb 8, 2010

I would think that the capital gains tax rate, which has changed considerably over the last century, has something to do with risk taking.

If, indeed, higher risk leads to higher reward, then lower tax rates could lead to less risk taking. People wouldn't have to take on higher risk to make the same amount of money.
If I'm allowed to keep 75% of my money, I don't need to take on additional risk as when I can keep only 60% of my money.

robeiae · Feb 8, 2010

That's a fair way to look at it, to a degree. I mean, if you're doing great by keeping 60% of your money, you could just as easily decide that if you get to keep 15% more, you'll go ahead and risk that money, or maybe just blow it all on hookers...or hats.

Bottom line, it's all about the incentives that are created.

Sometimes, the government can--through specific action--create desired incentives. But imo, most of the time unpredicted and/or unwanted incentives are created.

Slushie · Feb 8, 2010

clintl said:
Those are reasonable points. What I'm suggesting is that they might have a harder time finding buyers for those exotic securities because the benefits to investors would be less.

So, to be more specific, we're talking more about capital gains than the catch-all income tax?

Capital gains is fairly new tax scheme (or, extortion scheme as Don would say) and has remained relatively stable for both long-term and short-term rates. Yet, since it was introduced in. . . 1986, I think--we've seen several expansions and contractions of the market. There's not even a correlation between capital gains taxation and market stability.

I think the problem with the hypothesis is, nothing about economics exists in a vacuum. For any idea to withstand scrutiny, several other variables need to be weighed, but right now we're treating these variables as constants, or non-existent; that's not realistic and skews the ideas being putting forward.

Side note: a big variable we're ignoring is the FR. I think their effect on the flow of capital through our markets dwarf that of any changes in the top rate.

Another side note: we might get to see this theory in action next year. The current long and short rates expire at the end of this year; we're probably going to see an across-the-board hike in capital gains. Then we'll see how much of an effect--if any--this will have on the market.

Slushie · Feb 8, 2010

Gregg is right. Capital gains is older than I thought. I was looking at this chart, but they only tracked the rates after the tax reform in the 80's.

Slushie learns again. I can has cookie?

A Thought about Tax Rates and Economic Turmoil

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