By Arthur Laffer
On or about Jan. 1 2011 federal state & local tax rates are scheduled to rise quite sharply. President George W. Bushs tax cuts expire on that date meaning that the highest federal personal income tax rate will go 39.6 from 35.
It shouldnt surprise anyone that the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates. People and businesses change the location of income based on incentives.
Likewise who is gobsmacked when they are told that the two wealthiest Americans Bill Gates & Warren Buffett hold the bulk of their wealth in the non-taxed form of unrealized capital gains?
People can change the volume the location and the composition of their income and they can do so in response to changes in government policies.
The composition of wealth also responds to incentives. And its also simple enough for most people to understand that if the government taxes people who work and pays people not to work fewer people will work. Incentives matter.
People can also change the timing of when they earn and receive their income in response to government policies.
According to a 2004 U.S. Treasury report high income taxpayers accelerated the receipt of wages and year-end bonuses from 1993 to 1992over $15 billionin order to avoid the effects of the anticipated increase in the top rate from 31 to 39.6. At the end of 1993 taxpayers shifted wages and bonuses yet again to avoid the increase in Medicare taxes that went into effect beginning 1994.
Just remember what happened to auto sales when the cash for clunkers program ended. Or how about new housing sales when the $8000 tax credit ended? It
isnt rocket surgery as the Ivy League professor said.
On or about Jan. 1 2011 the highest federal dividend tax rate also pops up to 39.6 from 15 the capital gains tax rate to 20 from 15 and the estate tax rate to 55 from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.
Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And theres always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere.
Now if people know tax rates will be higher next year than they are this year what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result income this year has already been inflated above where it otherwise should be and next year 2011 income will be lower than it otherwise should be.
Also the prospect of rising prices higher interest rates and more regulations next year will further entice demand and supply to be shifted from 2011 into 2010. In my view this shift of income and demand is a major reason that the economy in 2010 has appeared as strong as it has. When we pass the tax
boundary of Jan. 1 2011 my best guess is that the train goes off the tracks and we get our worst nightmare of a severe double dip recession.
In 1981 Ronald Reaganwith bipartisan supportbegan the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA) whereby the bulk of the tax cuts didnt take effect until Jan. 1 1983. Reagans delayed tax cuts were the mirror image of President Barack Obamas delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e. no growth) and the unemployment rate rose to well over 10.
But at the tax boundary of Jan. 1 1983 the economy took off like a rocket with average real growth reaching 7.5 in 1983 and 5.5 in 1984. It has always amazed me how tax cuts dont work until they take effect. Mr. Obamas experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011.
Consider corporate profits as a share of GDP. Today corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011.
These profits will tumble in 2011 preceded most likely by the stock market.
In 2010 without any prepayment penalties people can cash in their Individual Retirement Accounts (IRAs) Keough deferred income accounts and 401(k) deferred income accounts. After paying their taxes these deferred income accounts can be rolled into Roth IRAs that provide after-tax income to their owners into the future. Given whats going to happen to tax rates this conversion seems like a no-brainer.
The result will be a crash in tax receipts once the surge is past.
If you thought deficits and unemployment have been bad lately you aint seen nothing yet.
Mr. Laffer is the chairman of Laffer Associates and co-author of Return to Prosperity: How America Can Regain Its Economic Superpower Status (Threshold 2010).
