Tax Rate Lottery

Here's a plan ventured by blogger, Stephen Gandel, at the Curious Capitalist:

"Let's say that all income below $500K was subject to taxation as it currently is, and that income above that level was subject to a tax rate lottery, held after the income is declared. Some of it gets taxed at, say, 75%, and some is not taxed at all. The goal is to increase revenue from this segment by, say, 10%. Quite a few $B. Maybe the "losers" are exempted from next year's lottery; they'll be taxed at the current rate."

The idea is that higher tax rates make people work less which is bad for tax revenues and, although the author never mentions it, bad for production. So how about we trick the rich into thinking they might not pay any taxes? That way, they keep working which means we could increase tax revenue.

The possibility that they only pay 15% in taxes would encourage them to work more increasing tax revenues! Gotcha Richie Rich!

Not only does this misunderstand the where US tax rates fall on the Laffer Curve, it also misunderstands how people react to uncertainty.

The whole plan is so stupid that I wonder if this isn't some sort of modern Modest Proposal. Allow me to dismantle this idea.

A Hypothetical Example:

Suppose, Richie has as trust fund which pays him $500,000 every year no matter how much or how little he works. Let's also suppose that Richie increases his total yearly earnings by $100 for every hour he works.

If the tax rate is 15% then he gets to keep $85 per hour. Let's say at that rate, he decides to work 50 hours a week for 50 weeks of the year bringing him in a pre-tax earning of $250,000 and $212,500 in after tax earning.

If the tax rate gets hiked to 75%, then Richie gets to keep only $25. This is a 70% reduction in Richie's hourly wage. According to a study done by Emmanuel Saez and Jonathan Gruber (who Gandel quotes in the article), that would reduce the amount Richie would want to work by 28%. That means he'll only work 1,800 hours and earn a pretax amount of $180,000 and keep an after tax amount of $45,000.

Under the first situation, the government gets a tax revenue of $37,500, but under the higher tax situation, the government pulls in $135,000. The numbers in this example are calibrated to be what Saez and Gruber predict people to do. So Gandel is wrong in assuming that increasing taxes will decrease tax revenues. For economists, we are not on the downward sloping portion of the Laffer curve.

So there goes the first part of his argument. If you need more tax revenues, don't do something bizarre like create a lottery. Just raise taxes.

The Lottery:
Suppose the government spins a wheel to determine Richie's tax rate. Half the slots are for a 15% tax rate and half are for a 75% tax rate.

Suppose Richie says, "I stand a good chance of getting a low tax rate so I'll work as if I'm going to face a 15% rate." If he did, he'd work the 2,500 hours and get to keep $212,500 if he lucks out and gets the low rate, but if he doesn't he earn works 2,500 hours to only get $62,500. Compare that to what he would have worked under the 75% tax and you see that he works a 700 hours only to earn $17,500.

It is pretty foolish to assume Richie won't act any differently in a situation where he has a low tax rate and a situation where he could be hit with a high tax rate. Richie will probably split the difference. He might work harder than he would in a high tax world but not as hard as he would in a low tax world.

Here's the kicker. People like two things, they like leisure and they like consumption. To get more consumption, they have to give up leisure. The lottery makes the returns to work uncertain, but doesn't change the certainty of how much you like leisure. The lottery has effectively reduced the incentive to work beyond even what a tax rate of 45% (the average tax rate Richie faces).

Instead of a lottery that on average has a 45% tax rate, we could have simply made taxes 45% and we'd get a higher tax revenue. Not only is a tax on people's earnings a drag on the economy, but the tax lottery actually makes it even more of a drag on the economy without getting anything in return!

The moral of the story is if you want to increase tax revenues then just raise taxes. Creating a tax rate lottery will do more damage to the economy just to raise the same amount of money. Plus the government wouldn't even get more money from the lottery than the old way of taxing.

There are further contradictions in the tax rate lottery which almost don't warrant comment, but here is a list:
1) The author realizes that if Bill Gates gets lucky and only pays a 15% tax rate, then the US government loses ton of money. More money than we can make up by charging a 75% rate on a bunch of people who earn $500,000. But the author also says, if you lose the lottery and get the high rate one year, you'll be exempt the next. This would just encourage people to work little, wait until they lose, then when they're exempt the next year, increase their work thereby avoiding the tax.

2) He claims that people will enjoy talking about how they won the tax rate lottery and they'll similarly enjoy losing the tax rate lottery because they can gripe about it. This is just crazy! If you get caught by the tax, then you'll have given up time with your family for no reason. You think people are going to be cool with that?

3) He claims that the fact that the tax rate lottery makes planning your life harder isn't a real problem for the rich since many of them already deal with uncertainty in their incomes. Many CEO's get 80% of their compensation in variable end of the year bonuses. But how much variation is there? Is it a 50% chance that you get nothing and a 50% chance you get $100 million? Probably not. Whatever variation there is, they probably are fairly certain about what they're getting. Also, it doesn't follow that because they deal with some variation, they should be able to deal with a lot more. That would be like saying, the guy on the tightrope deals with the rope wobbling some, so he won't mind if we start shaking it more.