Several smoke and mirrors tricks are buried within the arguments for the complete extension of the Bush tax cuts (the contested portion over 250k). These are (1) the consumption fallacy, (2) the tax-cuts-on-someone-else fallacy, and (3) the fallacy of the complete misunderstanding of how taxable income is figured. The first two fallacies must be understood because they are repeatedly used by both the left and the right to justify intellectually bankrupt arguments and ideas -- such as the idea that paying someone not to work creates wealth or that some rich guy who feeds his five dogs expensive steak is somehow good for me. They are also part of my 10 Principles of Economics from September 14.
(1) The consumption fallacy:
As opposed to the fallacy, the reality is that your contribution to society is what you produce, not what you consume. Multiple arguments in favor of extending the contentious part of the Bush tax cuts go something along the lines of “but the rich people are responsible for most of the consumption that drives the economy." Tea Party darling Marco Rubio said that the top 2% of the US accounts for 30% of the consumption. This argument is utter nonsense. It reminds me of Peter Schiff’s story where some Asians and an American crash on a desert island and the American is assigned the job of eating while the Asians are assigned tasks essential to survival. Schiff says a modern day economist would say the American is the key to the entire island’s economy. Milton Friedman said repeatedly that one’s contribution to the economy is what he produces, not what he consumes. Those on the right should realize that this is the exact argument used by those on the left to justify extending unemployment benefits (the apparent horse to be traded in this deal).
(2) The cuts-on-someone-else fallacy:
As opposed to the fallacy, a tax cut on another man helps you when compared to no tax cuts for anyone; however, when compared to a tax cut for yourself, the choice is clear which is better for you. If you and I are on Peter Schiff’s desert island, and someone drops $100 on me, it clearly helps you. (Let’s pretend we can buy stuff from the outside world with the $100 even though we can’t leave the island.) But were that $100 to fall on you instead, it would help you more. If there’s room in the budget to cut taxes for those making over 250k, there’s room in the budget to cut taxes for those making under 250k, and there are convincing arguments to go that route. For starters, someone making $67,000/year already pays a higher total federal tax rate than someone making $380,000/year. This is possible because the Social Security tax is so highly regressive. [See footnote.] Furthermore, the sub-250k sector of our economy includes the portion that is actually hurting. Contrary to laughable claims saying otherwise, those making over 250k/year simply are not feeling the pain felt by so much of the rest of the country. Adam Smith supported a progressive income tax: "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion." Smith justified this position with his statement on what the purpose of government is: "Civil government, so far as it is instituted for the security of property, is in reality instituted for the defence of the rich against the poor, or of those who have some property against those who have none at all."
(3) How taxable income is figured:
Let's look at the Subchapter S argument that so much of the 250k+ income is from small business owners. What is taxable income? It is net income. Net income=gross revenue-expenses. Expenses=employee salaries, rent, inventory, advertising, and equipment. Net income (after taxes)=the owner’s 3rd car, 2nd home, or trip to the islands in the winter. The easiest way for a business owner to reduce his tax liability is to reinvest what is leftover in growing his business, rather than growing his lifestyle. There is, of course, the excess burden of taxation that needs to be compensated for. The best way to compensate for this would be to cut the payroll tax by an amount equal to the increased revenue from the top marginal adjustment. This would lower the cost of employing an additional worker, shifting the point where marginal cost equals marginal benefit outward, thereby increasing employment.
Finally, to clarify: The problem that the US faces is too much spending. Shortage of taxes is not the problem. Research repeatedly has pointed to an ideal level of total government spending somewhere near 10% of GDP. Milton Friedman advocated this level for years. I share this view as well and therefore don’t think taxes should be raised on anyone. My main point, however, is that given the reality of budgetary and political constraints, if there’s $70 billion dollars/year of room for tax cuts, they should not be directed solely at the top 2% of the population. With unemployment hovering at 10% with no end in sight, better tax cuts would be tax cuts that reduce the cost of labor.
This includes total federal income tax and total payroll tax to include the employer contributed portion. An average worker with $380,000 of taxable income would pay 23.27% federal income tax, 2.9% Medicare tax, and 3.4% Social Security tax for a total federal tax rate of 29.57%, An average worker with $67,000 of taxable income would pay 15.68% federal income tax, 2.9% Medicare tax, and 12.4% Social Security tax for a total federal tax rate of 30.98%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.