Supply Side Economics: Will it Damage or Help Your 401k?

Supply side economics (the Laffer Curve) claims that cutting taxes can increase revenue because it rewards people for working. However most academic economists claim the theory is wrong.  My opinion is that the theory, in certain conditions, is correct.

The problem with examining historical tax rates and assuming that taxpayers’ behavior is not affected by high tax rates is that in the past there were so many loopholes that past tax rates are not comparable in a linear way with current tax rates.

During the era from the 1930’s until 1974 the tax law was very loose about loopholes. A wealthy business owner could organize a tax deductible employer paid Defined Benefit retirement program with gigantic tax deductions for the owner and only tiny contributions for employees. In one case a person who earned $700,000 was able to get a $600,000 deduction for a pension contribution expense. Then in 1974 Congress restricted that.

In 1986 the TEFRA tax act closed more loopholes. Before 1986 you could buy a tax shelter with 3 to 1 leverage at the end of the year so as to negate the earned income from a W-2 job or self employment. Also there was special tax treatment for annuities, rental real estate, etc. that is no longer allowed. So the allegation that high income people’s behavior was unaffected by high taxes before 1986 is untrue because of the blatant loopholes.

During the 1990’s tax attorney’s and CPA firms began offering extremely aggressive complicated tax shelters that were legitimatized by including an opinion letter from a tax attorney in the file. Then in 2001 President Bush instituted an aggressive program to stop that by requiring tax advisors to issue a Circular 230 notice to clients. No longer could an attorney’s letter be used to help people construct a tax shelter with a flimsy letter of an attorney’s opinions. Thus another loophole was closed. The amount of income that was forced to be classified as taxable instead of sheltered has steadily increased despite nominal tax rate cuts.

In addition AMT tax which started in 1969 has never been fairly adjusted for inflation. It was intended to catch people who made more than $400,000 in today’s dollars but now catches some who make only roughly $50,000. The annual $3,000 limit for capital losses has not been adjusted for inflation. The IRA annual contribution limit of $2,000 was not adjusted for inflation from 1972 to 2001 during which time it should have been raised to $12,000 to adjust for inflation. (It is now about $6,000). So simply looking at tax rates and assuming that rich people will report to work during an era of draconian confiscatory rates is not correct.

The type of people who make $500,000 earned income are the leadership class. Tax them excessively and they may drop out of the labor force, take early retirement, or move to offshore. What will happen if huge tax increases are imposed on high income people is that talented high achievers who enjoy working and who have funded their retirement programs will take early retirement. Younger highly paid workers could emigrate to other countries to obtain low tax rates. (Even though U.S. citizens are required to pay taxes worldwide, income from a “C” corporation overseas is not taxable until a dividend or wage is paid out, so having a corporation for a self-employed American overseas could result in tax savings). This will result in a brain drain as the most experienced, talented people leave the work force. The reduction of after-tax income will mean less will be spent by affluent consumers which will make the recession worse and thus reduce tax revenue and also increase the cost of welfare programs.

The result of tax increases will be more stagnation, decay and a lower standard of living as well as a worse fiscal position for the government.

About the author

Don Martin, CFP®

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