YOU DECIDE: What are the top tax tradeoffs?

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

Taxes will be a top topic of discussion this year for several reasons. First, it’s an election year, and no matter what the office and what the issues, taxes are at the head of the debate. Second, there’s widespread concern about the national debt, and taxes are one way of dealing with our collective red ink. And last — let’s face it — arguing about taxes, for many, is just plain fun!

So what are our arguments about taxes? Certainly one has to do with tax rates and income. For some taxes, like the federal and North Carolina income taxes, tax rates are higher for higher levels of income.

Supporters like this type of rates — termed progressive — for three reasons. First, richer taxpayers can afford to pay more. Second, if a dollar is worth less to a richer taxpayer than to a poorer taxpayer, then to equalize the contribution, a richer taxpayer has to pay more. And finally, supporters argue that richer taxpayers actually benefit more from the protection, roads, laws and schools provided by government. So if they benefit more, they should pay more.

But not everyone is a fan of progressive tax rates. On a practical level, even if a person agrees with all the points made by supporters — and many people don’t — where are the dividing lines to be drawn for different tax rates? Also, will higher tax rates on richer taxpayers motivate them to work less and thereby stall the economy?

Indeed, this last question is part of another debate over tax rates and economic growth, which has two parts. Part one asks if lower tax rates — because they allow workers to keep more of what they earn — can stimulate work and economic growth. Part two extends this question and asks if the economic boost from lower rates can actually result in more tax revenue than with the higher rates.

The short answer to the two-part question is “yes and maybe.” Economic research shows people may work more in response to the greater take-home pay from lower tax rates, especially from lower income tax rates. But the same research shows that unless the beginning tax rate is very high (such as over 50 percent), lower rates won’t generate more tax revenue than the higher rates.

I should add one footnote to this discussion about tax rates and growth. The research evaluating the impact of tax rates on economic growth must proceed very carefully. For example, both inflation and population growth will cause tax revenue to increase. Isolating any link between tax rates and economic growth must account for these as well as other factors impacting tax revenues.

A tax debate frequently heard in today’s political campaigns involves the tradeoff between tax rates and tax deductions, again, especially for the income tax. Tax deductions (as well as credits and exemptions) reduce the amount of taxable income and therefore require higher tax rates to raise the same amount of revenue. Conversely, if tax deductions are eliminated or reduced, tax rates can also be lowered without reducing tax revenues.

While many promote the idea of fewer tax deductions and lower rates, the proposal becomes stickier when the debate moves from the abstract to specific tax deductions, such as the mortgage interest deduction for homeowners, the child care tax credit, the deduction for charitable contributions and various energy deductions and credits. Every beneficiary of a tax deduction will argue their write-off is special and worthy of keeping. This makes curbing tax deductions very difficult.

The last component of the tax debate is perhaps the trickiest, and it is one we have especially seen debated in North Carolina. It’s really a debate about private versus public. Let me frame the tradeoff this way. Let’s say income tax rates are reduced, and although work effort is stimulated, total tax revenues still drop.

Supporters will point to the additional money in people’s pockets and the increased economic activity and more private sector jobs as a benefit of the tax rate cut, and they would be correct.

But it is also correct to point out offsetting effects of the resulting decline in government spending and government jobs that follow from less money in the tax coffers. Further, it is important to consider what might be the economic impacts of changes in government spending on specific programs. For example, what might be the long-run economic development impacts of less spending on roads or on public school budgets?

So it’s really a question of the relative benefits of private spending versus public spending.

These questions are heavily debated, and my purpose here is not to resolve the competing views but to identify them so the debate can take place in an informed way about the tradeoffs involved.

The debates, discussions and tradeoffs over taxes won’t end this year — and may never end. But if changes to taxes are ever to be made, collectively we’ll have to decide what tradeoffs we’re willing to accept.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/