California's Laffer Curve: Playing with Fire
By David Henderson
It’s not Go Galt: It’s Go to Texas.
As I have noted before, the Laffer Curve–the curve that relates tax revenues to tax rates–must be correct. The relevant question is where we are on the Laffer Curve. Are we on the part of the curve–the “prohibitive region”–where an increase in marginal tax rates will reduce revenues and a decrease in marginal tax rates will increase revenues? For the United States, I think the answer is pretty clearly no.
But what about for California? We are about to have an empirical test. Proposition 30 garnered about 54 percent of the vote earlier this month. One provision is a one-quarter percentage point increase in the sales tax rate.
But the other provision is a substantial increase in marginal tax rates for the highest-income taxpayers. I’ll give the rates for married filing jointly and you can find the others here.
For taxpayers with taxable income between $250K and $300K, the marginal rate rises from 9.3 percent to 10.3 percent.
For taxpayers with taxable income between $300K and $500K, the marginal rate rises from 9.3 percent to 11.3 percent.
For taxpayers with taxable income between $500K and $1,000,000, the marginal rate rises from 9.3 percent to 12.3 percent.
For taxpayers with taxable income over $1,000,000, the marginal rate rises from 10.3 percent to 13.3 percent.
Why would I raise the issue of the Laffer Curve in the context of California’s Prop. 30? For two reasons.
First, the way you’re most likely to get into the prohibitive region is to raise the marginal tax rate on the highest-income people. This is because their marginal tax rate is already high and they generally have the most flexibility in arranging their affairs to reduce their tax.
This flexibility leads to my second reason. When state governments increase tax rates, people in those states have a relevant option that is not relevant to a discussion of increases in federal tax rates. Specifically, they can move to one of the other 49 states. So a simple estimate of the elasticity of taxable income with respect to marginal tax rates will underestimate the actual elasticity. Some of those other states with lower marginal tax rates on high-income–and that includes virtually all the other states–will be attractive substitutes. Texas, for example, has no income tax. Neither do Washington, Florida, and Nevada, to name just 3 others.
Notice one powerful implication of this second reason that makes the analysis quite different from the analysis for federal tax-rate increases. Whereas when the federal government raises tax rates, any loss in revenue is due mainly to people cutting back on their income somewhat, when a state government raises marginal tax rates, people who move to another state cut the income that the state taxes to zero.
A numerical example might help. Take someone making one million dollars annually who lives in California. He now pays approximately $88,000 in state income taxes. With the new higher tax rates, the California State government is planning to collect approximately an extra $19,500 from him, for a total of about $107,500 in tax revenue. But if he moves to another state, it collects a big fat zero. Revenue falls by $88,000. What if one out of every ten people making one million dollars a year leaves California and the rest don’t change their behavior in response to the higher rates? Then the tax rates, which were estimated to extract an extra $195,000 from these people, instead extract $175,500 from the nine who stay ($19,500 * 9) but lose $88,000 from the guy who leaves. Net revenue increase: not the planned $195,000 but, instead, $107,000, or only 55% of the amount the government planned on. And, remember, that’s if the other nine don’t adjust their behavior at all.
Jerry Brown, who pushed hard for this tax increase, and the California voters who voted for this, are playing with fire. They started the fire; I didn’t.