Monday, March 19, 2007

Tax Cut 4: Tax Competition Among US States, the Laffer Curve

There is a very interesting news below -- a movement towards abolition of income tax, retention of consumption taxes to finance a smaller government, among a number of US states. If this trend will continue, Washington DC, the capital of the federal government, will be seen by many US states as a parasite: while many states are engaged in tax competition like abolition of income tax, the White House and its coterie of legislators are busy enacting new taxes (like taxing US citizens even if they are working and living abroad!) because they are busy making wars elsewhere, or promising endless foreign aid, or government to government transfer of taxpayers' money.

The free market movement in the world will become stronger if the free marketers in the US and Europe will succeed in shrinking their governments, in reducing the taxes and interventionist powers of their governments. A bloated US (and European) government is among the most convenient excuse given by politicians, bureaucrats and consultants in poorer countries, why taxes and government presence in many facets of the citizens' lives, should remain high. For instance, big foreign aid will require big local counterpart funding.
Rich States, Poor States
January 25, 2007

If you're searching for the next big thing in American politics, it's wise to keep an eye on the states. Here's one possibility: the abolition of state income taxes.

In Georgia, Missouri and South Carolina, Governors and state legislatures are drafting serious proposals to repeal their income taxes to promote economic development. St. Louis, one of America's most distressed cities, may overturn its wage/income tax as a way to spur urban revival.

And in Michigan, the legislature is in the last stages of phasing out its hated business income tax -- the most onerous in the land. "States are now in a ferocious competition to attract jobs and businesses," says economist Arthur Laffer, who is advising several Governors and legislators on the issue, "and one of the best ways to win this race is to abolish the state income tax."

...But the biggest target is the income tax. Newly re-elected South Carolina Governor Mark Sanford is talking of reviving his plan to phase out the income tax over 18 years. Mr. Sanford ran into opposition from the legislature in his first term, but he tells us that "I still consider this one of my top priorities and if the legislature wants to do it, I would be ecstatic."

Georgia may beat Mr. Sanford to the punch. House Republicans in Atlanta have announced that one of their top priorities is to use the half-billion-dollar budget surplus as a downpayment to "dismantle the current tax code."

House Republican Majority Leader Jerry Keen tells us the debate in Atlanta is between a flat-rate income tax and a plan that would "do away with the personal income tax but broaden the sales tax by eliminating 107 exemptions. We're committed to a pro-growth tax plan that announces to the country that Georgia is open for business."

...The idea of financing state services without an income tax is hardly radical. Nine states today -- Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming -- manage well Without one. With a few exceptions, the non-income tax states are America's Most prosperous. Meanwhile, the high income tax states, which tend to be congregated in the Northeast, keep surrendering jobs, people, and voters to the South and West...

On the Laffer Curve and Optimal Tax Rate

The Laffer curve is a graph showing an optimal level of tax rate where government revenues reach maximum level. If the tax rate further increases, say from 30% to 40%, revenues go down as people would rather reduce work and have more sleep and leisure since more income means more taxes to be surrendered to the government. Or people would rather misdeclare their income to evade paying more taxes, or bribe tax collectors, resulting in lower revenues than projected.

The concept was developed by an American economist, Prof. ArthurLaffer. He further argued that lower taxes result in lower prices, higher demand, leading to higher production and hence, bigger economic pie and higher taxable base. We can add that lower taxes or tax cuts are tantamount to pay hike to everyone whose monthly and yearly income are automatically deducted with government withholding taxes. Thus, pay hike means more pockets for the people, more spending power, more demand and consumption, and so on.

Taxes are always distortionary. You remove 1/3 to ½ of a productive person's monthly income and savings, purportedly for whatever welfarist and missionary functions by the state, you immediately alterthe working, spending and savings attitude of that person. For instance, instead of bringing his family to dream vacations in thePhilippines (Boracay, Coron-Palawan, Puerto Galera, Baguio, etc.) twice a year – that creates jobs to many people living and working there – they only go there once every 2 years. Because the equivalentvalue of his expenses for such holiday was confiscated by the government. And government, once it holds the money, can decide whether to improve the justice system that will benefit everyone, or improve the chances for re-election of the incumbent politicians through endless pork barrel or charter-change campaigns.

So, since taxes are distortionary because they are forced collections, taxes should be few and small. That is, the distortions should be few and small.

In a way, you can have 2 (or more) Laffer curves, depending on yourpurpose. For instance:

Laffer curve 1 – a level of tax rate that will finance the current and projected levelof government expenditures. For statist and interventionist politicians, plus their coterie of equally statist consultants, staff and bureaucrats, retain the current government expenditures of 50-60%of GDP (the current level in many western & northern European countries), then devise a tax rate that will somehow give you a tax & "non-tax" (but still compulsory payment to government, like driver's license fee, passport fee…) revenues of 50-60% of GDP.

Laffer curve 2 – a level of tax rate to really unburden taxpayers and finance a government that is just focused on a few, limited, andimportant function – protect lives, properties, and individual liberties of the citizens. Because the more functions and welfarism that a government intends to do, the more taxes, fees and penalties itwill collect and confiscate from the citizens.

The Laffer curve concept is a beautiful guide to remind governments when they should stop confiscating a big portion of the income and savings of their citizens. It is also a good reminder to socialists, welfarists, and other advocates of wanton confiscation of income andsavings of productive people, that there is a limit to such philosophy based on forced equality, if not envy.

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