Why The Tax Rate Debate Is Irrelevant

In a 1924 speech before the National Republican Club, President Calvin Coolidge observed "that when the taxation of large incomes is excessive, they tend to disappear." Coolidge found that in 1916, 206 people had incomes of $1,000,000 or more, but once a higher tax rate on million-dollar incomes was passed, the number dwindled--falling all the way to 21 in 1921.

In his book, The View From No. 11, Nigel Lawson, Margaret Thatcher's former chancellor of the exchequer, answered the above riddle with great ease. The Thatcher government inherited nosebleed rates of taxation, but as Lawson quickly found, the "higher rates we inherited were frequently not paid. The well-heeled and well-advised took great pains to avoid liability through the perfectly legal use of tax shelters of one kind or another; and the tax avoidance industry flourished as never before." Translated: When politicians target income for tax purposes, incomes change.

As is frequently the case in Washington, there's a debate going on now between the two major political parties about the proper level of taxation, particularly when it comes to the rich. Both sides have seemingly bought into the notion that the highest earners should be taxed at the highest rate. The debate really comes down to what the rate should be.

What's interesting here is that Democrats and Republicans alike presumably both understand the anecdotal and empirical reality of taxation. Simplified, there are rates of taxation that we're all aware of, but rarely do even the richest in the United States pay the top rate. Despite top tax rates since World War II that have ranged from 28% to 90%, Americans--irrespective of income--have rarely forfeited anywhere near 90% of their income to the government.

More realistically, American workers are among the least taxed in the world, with combined forfeitures to federal, state and local governments averaging out to about 25% of income. In 2008, perennial Forbes 400 member Warren Buffett was very public in his admission that his actual tax rate was nowhere near the top federal rate of 35%, but was actually at 17.7%.

So if we ignore for a moment the incentives and productivity issues that are an essential part of the tax discussion, it can be said upfront that, on a dollar basis, the tax rates that politicians argue about are quite irrelevant. No matter the graduated rates of taxation that most people concentrate on, at first glance they have very little to do with what the various governments take from us.

That being the case, why all the argument about tax rates? Indeed, wouldn't it be better to acknowledge that Americans are only willing to return a certain amount of their wealth to the government each year? And that, therefore, Congress should simply set a flat rate at around that number?

A flat tax rate would of course be a dream, but given the incentives that politicians have, it's a Utopian one. High and ever-changing tax rates are the lifeblood of a political class that clings to power through favors offered through the tax code.

To read more: http://www.forbes.com/2009/03/20/tax-rates-flat-opinions-columnists-john-tamny.html