Economics 101: the Difference Between Tax Rates and Tax Revenues

by Paul Mladjenovic.
Coyright 2010. Paul Mladjenovic. All rights reserved.

www.RavingCapitalist.com


The other day I heard a politician say that taxes must go up so that the federal government’s deficit can go down. It didn’t occur to him that the primary reason that the deficit is high is directly due to spending.

Too many people confuse the terms “tax rates” and “tax revenues”. They are frequently used interchangeably but they are distinctly different things. In addition, many politicians have the erroneous idea that increasing tax rates will increase tax revenue. Let’s clear this up (especially in this election season).

TAX RATES ARE (FORCED) PRICES.

TAX REVENUES ARE WHAT ARE RECEIVED WHEN THOSE PRICES ARE PAID.

Very crucial difference! It is a similar difference in the rest of the economy. When a company that sells, say…food, that product will have a price. Say that it is $1.00 for a can of beans. If they sell 5,000 cans of beans that month then we say that they had gross revenues from this particular product of $5,000 (5,000 cans times $1.00). So far so good? By the way, just to keep it simple everything else in this example is immaterial (the quality of the beans are the same and so forth).

Let’s say that the market for the can of beans is competitive (many other companies sell beans too) but the company decided to raise the price of their can of beans to $1.50. Presume that the economy is slow and that their competitors decide to “hold the line” and keep their can of beans to only $1.00. Now what do you think will happen?

Unless you are an economics professor in college, you probably got that one right…

The company with the $1.50 can of beans will see shrinking sales in that competitive environment. Say that their sales fall to 3,000 cans. Now what? Their new gross revenues fall to $4,500 (3000 cans x $1.50 per can).
This is an example of prices going up but the ending result (gross revenues) going down. Of course, keep in mind that in a free market, the prices are voluntary…consumers don’t have to accept those prices. They can go certainly elsewhere. This is the main reason why in a bad economy, companies tend to cut prices so that they can maintain (or possibly increase) their revenues.

Many economists (unfortunately) forget this very simple, real-world dynamic. An economy is made up of consumers and producers and their transactions are voluntary. In a competitive, free market, businesses (producers) can’t force consumers to pay their prices. In taxes, however, the whole point is FORCE.

Many politicians, bureaucrats and media pundits think that if you increase tax rates, you can increase tax revenues because the government can FORCE people to pay those tax rates. Again, economists forget that those tax rates are not paid by “machines”…they are paid by people. People can change their behavior (and usually do) when given certain incentives and dis-incentives.

When you raise TAX RATES, you ultimately encourage people to find creative ways to not pay those tax rates. Some ways may not be legitimate (such as tax evasion), but many ways are perfectly legal. Tax avoidance is legitimate and most people will seek every possible legal way to avoid paying taxes.

Here are some examples:

1. People will work less to lower their taxable revenue to lower tax brackets
2. People will seek tax-free income to minimize income taxes
3. People will delay the sale of assets to avoid capital gains taxes
4. People move to lower-tax jurisdictions (either states or countries)
5. Fill in the blank (you may know your own example).

Then there are the “unintended consequences” which lower tax revenues:

1. A struggling business is hit with a higher tax bill. To stay in business, they lay off some employees. These employees stop paying income taxes because they are out of work. The end result for government is that tax revenues plummet.

2. the entrepreneur that avoids business expansion because that would increase costs (higher business taxes and payroll taxes). Jobs that would have been created ultimately do not. Tax revenues from newly-paid employees never materialize.

3. The affluent person that would have sought a profit by investing in a business enterprise is discouraged by the costs and risk associated with higher taxes. They seek the relative tax-free safety of municipal bonds and forego investments that could have yielded higher tax revenues for the government.

4. Again, fill in the blank. You can think of other examples too.

Now take the above examples (and many others not mentioned) and multiply them by millions of people (and businesses). Now do you get the picture?

Economies are not “simple, static machines” that neatly and predictably respond to the government’s coercive efforts (be it tax policy or otherwise). Economies are complex, organic and dynamic. The players in them are thinking, acting human beings that will respond to incentives and disincentives (again, taxes or otherwise).

Understanding this then makes other events seem very plausible. Understanding this and studying the history of taxation bears a very loud truth:

All things being equal, higher tax rates generally yield less tax revenues.

All things being equal, lower tax rates generally yield higher tax revenues.

Feel free to pass this along to your favorite politician. In the coming issues of the Prosperity Alert, we will cover ways to cut your taxes and keep more of your money (more details about the Prosperity Alert are at www.RavingCapitalist.com).

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Paul Mladjenovic is the author of "Stock Investing for Dummies" and a national educator on investing, taxes and home business strategies. His newest publication on saving big on taxes will be available by October 2010. The full details will be in his newsletter, the Prosperity Alert. Get it free at...
www.RavingCapitalist.com

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