Optimal Taxation Rates

The Republicans argue for lower taxes, the Democrats for more investment. So who is right? I don't know, but let's start with the correct mathematical basis.

The Republican claim is twofold: that lowering tax rates will increase investment, because there is insufficient incentive for investment, and that by increasing economic activity, lowering taxes will actually increase tax revenue.

Suppose the tax rate were 100%. Clearly, no one would have any incentive to work, because working would not bring any economic reward to the worker. Bringing the tax rate down to 99% would be huge. Suddenly, people would be getting some money for work, and their incentive to work would go up by essentially an infinite ratio. Less absurdly, consider a tax rate of 90%. Dropping from there to 80% effectively doubles the economic reward of income, while government revenue per transaction drops from 0.9 to 0.8, which is only 1/9th of revenues. It's a win-win.

But consider the opposite. At a tax rate of 20%, everyone already has a huge incentive to engage in economic activity. They are getting 80% of their money. The government on the other hand, by dropping the rate from 20% to 10%, is giving up 50% of the revenue from each transaction. It's quite obvious from the basic math that the optimal revenue level is not between 10% and 20%.

I would guess that the optimum is somewhere between 20 and 40 percent, in other words, where it was during the Clinton boom years.

No, dropping tax rates is not always advantageous. At current levels, it's quite harmful. We all need public education, roads, a military, and to finance our operation without debt.

Market Dogma Getting in the way of Reason

I'm in shock after seeing Secretary Paulson bemoaning the fact that he had to take a stake in many banks. He's not nearly so sad to be handing out cash with both hands, but he's offended by government taking a stake in private enterprise.

This is weird to me. I'd think a free market guy would be moaning about having to get involved in the market, but if he's going to do it, then to avoid any moral hazard, by God that company is going to lose equity. This reminds me of something I saw on PBS about the National Institute of Health. Why is it that taxpayer dollars pay for a sizeable fraction of the research in this country, but the government does not get a sizeable fraction of the royalties from the drugs developed from that research? To me, this is the same principle. I have no problem with government sponsored research, particularly in areas where commercialization does not appear imminent, but why government should do the investment and not share in the reward is beyond idiocy.

Why act against economic self-interest?

I've been puzzled for some time now about the appeal that the Republican platform of low taxes has for the lower middle class. The line that "you know how to spend your money better than the government" really resonates.

But there's a disconnect between people who want the streets paved, and lots of services, these are not Libertarians on the whole, and the notion that they aren't getting their money's worth.

Yes, government will always be inefficient. But it will be just as inefficient with less money, it will simply do less for you. The incremental cost of popular government services is cheap for people making $50,000 a year, because more of those costs are borne by people higher up the economic ladder.

I've been particularly impressed by the analysis by Alan S. Blinder in the New York Times about the economics of Republican vs. Democratic administration.
http://www.nytimes.com/2008/08/31/business/31view.html?_r=1&em&oref=slogin

It makes sense to me. When we don't invest in unsexy things like infrastructure, the economy doesn't grow as fast. It's insidious because it's easy to measure taxes, which you pay, and not so easy to estimate the monetary benefits of government programs, which are complex.