If you tax rich people, you get fewer rich people. That’s what the Brits learned when they hiked taxes on their wealthiest citizens. Faced with higher tax rates, the rich (who are a very economically mobile demographic) reacted to the higher taxes by avoiding them.
Britain’s recent experiment with hiking taxes on the rich may have some lessons for the U.S.
To dig itself out of recession, Britain hiked its income-tax rate to 50% for those making more than £150,000 ($240,000). Proponents said the tax was needed to bring fairness to an economy, in which the rich were getting richer and not contributing enough to the cause. Critics said the tax would chase out the job creators.
As it turned out, the real impact was in tax avoidance. According to the Chancellor of the Exchequer’s budget announced today, the income-tax hike caused “massive distortions” that cost the government. A study found that £16 billion of income was deliberately shifted into the previous tax year. As a result, the tax raised only £1 billion – a third of the £3 billion amount forecast.
The big mistake the tax hikers always make is that they assume people will behave the same way at higher tax rates as they do at lower tax rates. As we can see from the example in Britain, this isn’t true. Higher tax rates change people’s behaviors in that they seek ways to avoid the tax. They find loopholes, or they move their wealth to avoid the tax. Or they just stop doing whatever it is that’s causing them to be taxed.
There’s a reason why the chart below from the Heritage Foundation looks the way it does. The 45 year historical average for federal tax receipts here in America is 18% of GDP. While raising taxes and other tax code manipulations can push revenues above that average for short periods of time, behaviors change in reaction to the taxes and the revenues call back down to average.
Put simply, the maximum amount of revenues our government can expect no matter how high they increase taxes is roughly 18% of GDP. Which means government spending shouldn’t be more than 18% of GDP if we expect a balanced budget. Currently, federal spending is roughly 25% of GDP, which is why we’re running annual budget deficits over $1 trillion.
We can’t solve America’s deficit problem by raising taxes.