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Thursday, October 07, 2004

A basic economics lesson

Imagine you're working in a society with a high tax rate, with a top marginal tax rate of 100%. Say your income puts you at the border of tax rates, so that your next dollar earned is taxed at 100%. Do you take the opportunity to work a second job, or paid overtime? Of course not. What if the marginal tax rate is 90%? Probably not. Higher tax rates are a disincentive to produce, which means you shouldn't expect a tax rate of 2x to produce twice the tax revenues.

That's the essence of the oft-maligned Laffer Curve.

Another impact of increasing marginal tax rates is its impact on investment decisions. Consider a potential investment of $100,000 with the following returns:
90% lose $100,000
10% gain $900,000
In theory, you would view this investment neutrally, as the expected return is zero: 0.9*-100+0.1*900=0 (In practice, you wouldn't accept a zero return, since you could earn more with safe investments. But for illustrative purposes, let's continue.)

Now consider the impact of taxes. The loss would reduce taxes, and the gain would be subject to taxes. If all this income/loss was taxed at the same rate, then your view of the investment wouldn't change. But say the tax rate on that $100,000 (that you've already earned elsewhere) is 20%, and the tax rate on the gain is 40%. The expected return, after taxes, would be 0.9*-100*.8+0.1*900*.6, or an expected loss of 18,000.


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