February 2011 – Page 2 – Donald Marron

Double Tax Rates, Quadruple the Economic Harm

At last Wednesday’s hearing on tax reform, three witnesses–Rosanne Altshuler, Larry Lindsey, and I–invoked a famous rule of thumb about taxes. We each told the Senate Budget Committee that high tax rates are disproportionately harmful for the economy and that:

If you double tax rates, you quadruple the resulting economic harm.

If a 10% tax rate on some activity does a certain amount of economic damage, for example, then it’s a reasonable guess that doubling the tax rate to 20% would multiply that damage by a factor of four.

It was nice to hear such agreement among the panelists, but judging by the senators’ reaction, this idea is not intuitive. So let me try to explain with a simple example.

Suppose there are five people who might buy a pizza. The first person values a pizza at $14.50, the second at $13.50, the third at $12.50, the fourth at $11.50, and the fifth at $10.50.

If pizzas cost $10, all five people will buy one. The first person gets a net benefit of $4.50, since the pizza was worth $14.50 to her, but she paid only $10. The second person gets a benefit of $3.50, and so on. Add it all up, and the benefit of the pizza market is $12.50 (= $4.50 + $3.50 + $2.50 + $1.50 + $0.50).

Now suppose that the government levies a 10% tax on pizzas; that lifts the price to $11. Now only the four consumers who place the highest value on pizzas will buy them; Mr. $10.50 won’t buy. The four remaining consumers now benefit by $3.50 + $2.50 + $1.50 + $0.50 = $8.00 from buying pizza. The government collects $4.00 in revenue, so the total economic benefit of the pizza market is $12.00, $0.50 less than before. That 50-cent loss falls on the hungry guy who no longer buys a pizza. The $1 loss for each of the four buyers isn’t lost to the economy; instead, it transfers to the government.

Now suppose, instead, that the tax is 20%; pizzas now cost $12 each, and only three consumers will buy. Their total benefit is $4.50 (= $2.50 + $1.50 + $0.50). The government collects $6.00 in revenue, so the total economic benefit is $10.50. That’s $2.00 less than without a tax.

So there you have it. When you double the tax from 10% to 20%, you quadruple the economic harm from $0.50 to $2.00.

Why does this happen? Because doubling the tax doubles the number of consumers who drop out (from 1 to 2) and doubles the average economic value of the pizza sales that never happen (from $0.50 to $1.00). Two times two is four, so the overall effect is to quadruple the economic harm.

Put another way, the value of the second lost pizza ($1.50) is three times larger than the value of the first one ($0.50). So the economic harm of the 20% tax is four times the harm of the 10% tax.

This is a big deal when you design a tax system for the entire economy. To avoid needless economic harm, you should aim for low tax rates and the broadest possible tax base. If you need to raise $6.00 from our mythical food economy, for example, it would be far better to levy a 5% tax on pizzas, tacos, and hamburgers, than a 20% tax on pizzas alone.

I hope that whets your appetite for base-broadening tax reform.

P.S. Did I cook the pizza example to get the increase to be exactly a factor of four? Of course. In the real world, the actual multiple will vary. If the fifth person valued the pizza at only $10.25, for example, the loss from the 10% tax would have been $0.25, and the loss from the 20% tax would have been seven times larger at $1.75. Conversely, if the fourth person valued the pizza at only $11.00, the loss from the 20% tax would have been $1.50, only three times larger than the $0.50 loss from the 10% tax. The double/quadruple rule of thumb assumes an even spread of consumers and their values — a reasonable starting assumption until you have more information.

I Bid $28,000 for Mars

Over at Boing Boing, Lee Billings interviews astrophysicist Greg Laughlin about his formula for valuing planets. Or, more precisely, measuring how much it appears we value those planets based on (a) how much we spend to search for them and (b) planet characteristics like stellar age, stellar mass, light, heat, brightness, etc.

According to the formula, Earth is worth about $5 quadrillion. Which seems about right if you believe my only-partly-joking estimate that the United States alone is worth $1.4 quadrillion.

Mars, however, rings in at a measly $14,000. That seems low to me, so let me make an offer.

Dear Marvin: I would gladly pay you $28,000 for your home, Mars. That’s a 100% mark-up on today’s value. And you and your goons could continue to live there. Thanks, –Donald P.S. Please send Spirit back.

And then there’s Venus. Laughlin ran his equation two ways for the brightest planet in our sky:

Venus is a great example. It does pretty well in the equation, and actually gets a value of about one and a half quadrillion dollars if you tweak its reflectivity a bit to factor in its bright clouds. This echoes what unfolded for Venus in the first half of the 20th century, when astronomers saw these bright clouds and thought they were water clouds, and that it was really humid and warm on the surface. It gave rise to this idea in the 1930s that Venus was a jungle planet. So you put this in the formula, and it has an explosive valuation. Then you’d show up and face the reality of lead melting on the surface beneath sulfuric-acid clouds, and everyone would want their money back!

If Venus is valued using its actual surface temperature, it’s like 10^-12 of a single cent. @home.com was valued on the order of a billion dollars for its market cap, and the stock is now literally worth zero. Venus is unfortunately the @home.com of planets.

In short, Venus might be worth as much as the United States or nothing. If the astrophysicist thing doesn’t work out, Laughlin could clearly find work as an economist.

Seven Ideas to Guide Tax Reform

This morning I appeared at a Senate Budget Committee hearing, “Tax Reform: A Necessary Component for Restoring Fiscal Sustainability.” My full testimony, “Cutting Tax Preferences Is Key to Tax Reform and Deficit Reduction,” is available here.

Here’s my opening statement:

America’s tax system is broken. It’s needlessly complex, economically harmful, and often unfair. It fails at its most basic task, raising enough money to pay our government’s bills. And it’s increasingly unpredictable, with large, temporary tax cuts not only in the individual income tax, but also in corporate, payroll, and estate taxes.

For all those reasons, our tax system cries out for reform. Such reform could follow many paths. Some analysts recommend the introduction of new taxes—such as a value-added tax, national retail sales tax, or pollution taxes—to supplement or replace our current system. Those ideas are worth serious discussion, but in today’s testimony I would like to focus on a more traditional approach to reform: redesigning our income tax.

I would like to make seven main points:

1. Tax preferences pervade the tax code. These preferences total more than $1 trillion annually, almost as much as what we collected from individual and corporate income taxes combined. These preferences narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates higher than they would otherwise be, and are often unfair.

2. The first step in any income tax reform should be to broaden the tax base by reducing or eliminating tax preferences. Doing so would help level the playing field among different economic activities, reduce the degree to which taxes distort economic behavior, and make taxes simpler to file and administer.

3. Policymakers can use the resulting revenue – potentially hundreds of billions of dollars each year – to lower tax rates, reduce future deficits, or both. Lowering tax rates would further reduce the economic distortions created by the tax system and would encourage economic growth. Reducing future deficits would help tame our federal debt, which threatens to grow to unsustainable levels in coming years and thus poses a significant risk to our economy.

4. Many tax preferences are effectively spending programs run through the tax code; that poses a challenge for how we talk about tax reform and the size of government. Any cuts to these spending-like preferences will increase federal revenues, but will reduce government’s influence over economic activity. Advocates of smaller government are often skeptical of proposals that would increase federal revenues. When it comes to paring back spending-like tax preferences, however, an increase in revenues may actually mean that government’s role in getting smaller.

5. Other tax preferences, however, are not spending programs in disguise. More and more observers have embraced the idea that tax preferences resemble spending through the tax code. That’s a promising development. Unfortunately, that enthusiasm has sometimes led to the misconception that all items identified as tax preferences are akin to spending. That’s understandable given that these items are often called “tax expenditures.” But it is not correct. Preferential tax rates on long-term capital gains and qualified dividends, for example, are (imperfect) efforts to limit the double taxation that can occur when investment income is subject to both personal and corporate taxes. Such provisions should be viewed and evaluated as tax measures, not as hidden spending programs.

6. Many tax preferences provide benefits to millions of taxpayers; they aren’t just “tax breaks for special interests.” For example, the three largest tax preferences are the exclusion for employer-provided health insurance, preferences for retirement saving, and the mortgage interest deduction. Americans should understand that to get the benefits of tax reform – lower rates, simpler taxes, and a more vibrant economy – they will need to give up some popular tax breaks.

7. Policymakers should re-evaluate the design of any tax preferences that they decide to keep. Some preferences are needlessly complex and could be simplified; that’s true, for example, of the preferences aimed at low-income workers and families. Other preferences might operate more efficiently as credits rather than as deductions or exclusions. Credits can provide more uniform incentives to particular activities – e.g., homeownership – than deductions or exclusions whose value depends on whether a taxpayer itemizes and what tax bracket they are in.

Bottom line: By reducing, eliminating, or redesigning many tax preferences, policymakers can:

Make the tax system simpler, fairer, and more conducive to America’s future prosperity;
Raise revenues to finance both across-the-board tax cuts and much-needed deficit reduction; and
Improve the efficiency and fairness of any remaining preferences.

P.S. The other witnesses included two other Tax Policy Center folks — former director Rosanne Altshuler and co-founder Gene Steuerle — and Larry Lindsey. All our testimonies are available here.