5. Destruction of Wealth through Taxes

“People do not work, consume, or invest to pay taxes.”

-Arthur B. Laffer

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Government is essential for a well functioning economy and must establish a legal structure. The legal structure helps protect private property rights, enforce contracts, and settle disputes. Furthermore, government also needs to provide public goods. A public good is a good that society needs but the private market has trouble supplying. The reason is the private market cannot restrict access to these goods to paying customers. If no one can be restricted from consuming the good, then free loaders will consume the public good, and not pay for it. Thus, government must step in to provide them. Some public goods are:

• Infrastructure like bridges, highways, streetlights, and flood control projects

• National defense (military) and public safety (police)

• Clean air and water

For some products and services, the private markets can restrict access to paying customers, but may not supply enough of them. Hence, government can step in and help supply these goods, which benefit society. What are some of these goods? Some examples are:

• Education at all levels from elementary, middle, and high schools to colleges and universities.

• Libraries

• Postal service

For government to supply public goods and operate the legal structure, a government has to collect taxes to pay for them. Tax systems are defined as three types, and are the ratio between a household’s taxes and their income. The tax systems are:

1. Progressive tax rate - average tax rate rises with income. For instance, the income taxes for the United States are progressive. Low-income households pay small average tax rates, while high-income households pay higher tax rates. In 2005, the top 5 percent of wage earnings had an average tax rate of 20.8% while the bottom 50 percent has an average tax rate of 3%. Many people believe this tax system is fair because the “rich” get stuck with a larger tax burden. Do not forget, a growing economy causes everyone’s income to rise, and the poor and middle class can creep into higher income tax brackets.

2. Proportional tax rate - the average tax rate stays the same across all income levels. For example, Russian and the Republic of Kazakhstan both have a flat income tax rate of 13% and 20%. Rich or poor Russians or Kazakhs pay the same proportion of their income to government. This tax system has two nice properties. First, taxpayers do not have to remit taxes to government; the person’s employers automatically withhold and remit taxes to government. This tax system only requires paperwork from the employer. Second, future tax payments are predictable. Each dollar a person makes, he knows the exact percentage that goes to government. However, this tax has one problem. Businesses can employ workers illegally. Employers can remit taxes to government for illegal workers by using tax ID’s from legitimate workers. Legitimate workers may never find out because they do not have to verify their income with government.

3. Regressive tax rate - the average tax rate falls with income. As a person’s income increases, his average tax rate declines. For example, a sales tax on food is a regressive tax. For instance, two families each spend $10,000 on food per year. If the sales tax is 7%, then government collects $700 from each family per year. If the first family has an income of $50,000, then their average tax rate on food is 1.4%, while a second family with an income of $20,000 pays 3.5% of their income on the food tax. Clearly, the tax hits poorer families harder. Social security, Medicare, property, excise, and sales taxes are regressive taxes. An excise tax is a tax on a specific good for a specific amount. Governments impose excise taxes on alcohol, tobacco, and gasoline. A sales tax is a percentage applied to a product’s value and applies to many goods.

The United State Tax Code and many state governments have a progressive tax structure, but their tax codes include numerous exemptions and tax credits. A common rumor is the U.S. tax code is so complex members of Congress have to hire accountants to file their tax returns. Ironically, these same imbeciles passed these tax laws! If the people who passed these stupid laws cannot understand them, how can we the people understand them! The current U.S. income tax system has three major shortcomings:

• Taxpayers have a difficult time in determining what their true tax burden is. If a family experiences a significant change in income (or situation), it is very difficult to predict how much taxes they have to pay given all the exceptions and forms.

• Taxpayers may not claim all tax credits that lower their tax burden. For example, some taxpayers may be afraid to apply for tax credits, because they believe too many tax credits will trigger an audit. Further, to claim tax credits, taxpayers have to fill out complicated, confusing forms.

• Politicians help propagate complicated tax codes. It is a universal truth; everyone hates taxes. However, many U.S. politicians are career politicians that favor the expansion of government. Their job is to hand out the most pork possible to their constituents so they can be re-elected. To prevent public protests, politicians tend to pass small taxes on everything and keep inventing new taxes. Further, some clever politicians can make campaign promises to lower one tax, but raise other taxes to make up for the short fall.

Having a large number of small taxes can lead to larger government bureaucracies, because government creates different bureaucracies to collect and enforce all these different small taxes. It would be simpler to have one (or two) tax agency oversee the collection of all taxes. For example, in some states like Texas, a school district, county government, and water utility district each have their own bureaucracies to collect their portion of property taxes.

In some cases, government is double taxing. The government and politicians have stacked taxes upon taxes. Some examples are:

• Some states allow city and county governments to impose multiple sales taxes. Store receipts and utility bills are littered with a variety of taxes and fees.

• Corporations pay income taxes on their profits. If a corporation pays dividends to the stockholders out of corporate profits, then stockholders pay income taxes on their dividends. The same money is taxes twice.

• Many families receive their tax refund check from the U.S. federal government each year. This refund check means these families overpaid their taxes and the government is refunding the difference to the taxpayer. Further, the federal government does not pay interest, even though it will assess interest and penalties for taxpayers who under pay taxes. The problem is many states view this as additional income and tax refund checks.

• Many states have a use tax where taxpayers are supposed to pay taxes on all out of state purchases. The reason is the state did not collect a sales tax. The use tax may be double taxation if a person bought an item in another state and also paid that other state’s sales tax. Of course, many people use the internet to avoid paying taxes. For example, many internet businesses do not charge a sales tax for items sold to customers living in other states.

The 2008 Financial Crisis is adding a new twist to taxes and government imposed fees. Some government agencies are having financial troubles and are forcing either households or businesses to pre-pay taxes. (You would think this would be illegal). In essence, pre-paying taxes is giving government an interest free loan. For example, the State of Michigan has been having budget problems way before the 2008 Financial Crisis. Michigan residents do not only have to pay their property taxes each year, they also have to pay the next five months in advance [1]. Another example is the Federal Deposit Insurance Corporation (FDIC). The FDIC insures bank deposits up to $250,000 per depositor. This insurance is not free. Banks are forced to pay this insurance. However, with the 2008 Financial Crisis, some large banks failed, creating financial hardship on the FDIC. As of November 2009, 120 banks failed and imposed a cost of $28 billion on the FDIC. Here is the kicker, FDIC is requiring banks to pay future insurance three years in advance [2]. This is interesting because banks have already been hit hard by the financial crisis and government is imposing more hardship. What happens if the U.S. economy does not turn around and start growing again? How far in the future is the government going to force its citizens to pay taxes?

Unfortunately, many government officials do not understand how taxes change society’s behavior. Many politicians believe increasing a tax or inventing a new tax will have minimal impact on the economy, but this is not true.

Taxes Change Behavior

The sad truth of the people we elected into office has no understanding of the long-term consequences of their actions. Whenever the legislator dreams up a new tax or increases an old tax, the legislator believes the tax has no impact on human behavior. For example, if there are 100 million red cars out there in the United States, and the legislature passes a new tax on red cars, believing red cars cause more accidents, then the tax base will not remain at 100 million cars. People and businesses will try to avoid this tax. This is a natural phenomenon. If a government has its hand in your pocket, you are going to figure out a way to keep that hand from grabbing too much money. The same would go for red cars. How many people would paint their car a different color in order to avoid this tax? Imagine all the silly lawsuits that people would file, such as which colors constitute red? Is maroon close enough to be considered red?

Tax authorities continuously expand the scope and nature of taxes. In St. Joseph County, Indiana, the government wants to impose a wheel tax. Wheels put wear and tear on roads, and the government wants drivers to pay for it. This tax is ridiculous, because of all the other numerous taxes on vehicles. If you buy a car in Indiana, you have to pay the sales tax. Then every year, you have to pay a tag fee. Granted these fees are not that high. However, a wheel tax can fall heavily on businesses that use semi-trucks. A semi can have anywhere from 4 to 10 wheels without a trailer. If the tax includes a trailer, then add another 4 or more wheels. Hence, this tax can add up and become another cost burden to businesses.

Taxes on businesses cause their costs to increase. The business has to pass the cost to its customers, reduce its profits, reduce other costs, like labor, or relocate to another state or country. The worst-case scenario is the business bankrupts with the wheel tax being the final straw that broke the camel's back. Businesses could circumvent the wheel tax by registering its trucks in Mexico and incidentally employ cheaper labor. If the company is not operating in Indiana, the company does not pay a variety of business taxes and also does not employ people there who would have to pay income taxes. Therefore, this stupid tax could cause more unemployment and lower tax revenues for St. Joseph County, and Indiana as a whole. Unfortunately, this line of reasoning with the wheel tax can lead to new taxes. Why not charge a tax for the number of spark plugs a car has. The more spark plugs a car has, the more fuel is combusted, and therefore, the more pollution is released into the air, but why stop there. Taxes have no bounds.

Another problem is taxes cause people to migrate. For example, it is politically popular for politicians to run for office, promise a new program, and the new program is financed from taxing the rich. Many states that were hit hard by the 2008 Financial Crisis, like California, want to increase the tax on the wealthiest Californians. If this tax passes, some millionaires would leave the state, taking their wealth and assets with them. Remember, rich people already pay more taxes than poor ones. Thus, State of California will have to increase other taxes to compensate for the rich Californians who will leave. Remember, California is next door to Nevada, which has no state income tax [3].

Large, excessive taxes can create black markets and lead to smuggling. For example, Michigan imposed the second largest tax on cigarettes in 1994, which increased the tax from $0.25 per pack to $0.75. (Currently the tax is $2.00 per pack [4]). The bad news for Michigan is that the state is north of Indiana and Indiana has one of the lowest taxes on cigarettes. The tax created almost a $0.50 difference per pack in retail price. What do rational consumers do when prices are steep? They search for places where they can find bargains, like heading south to Indiana to buy their cigarettes. This tax is foolish for three reasons:

• People from Michigan will buy fewer cigarettes in Michigan and instead buy them from Indiana [5]. Tax revenue for Michigan may fall, if droves of people purchase their cigarettes outside of Michigan Whether or not Michigan gains more cigarette tax revenues depends on the larger tax per cigarette pack versus the number of cigarettes bought in Michigan.

• Criminal groups can get involved and help smuggle cigarettes. Artificially creating a $0.50 per pack price difference between states can allow smugglers to earn large profits [5]. Michigan does want to create jobs, so this will create some.

• This law will create more violators. Thus, Michigan will spend more money tracking, prosecuting, and incarcerating violators, who smuggle cigarettes into Michigan.

Another problem is complicated, incomprehensible tax codes are favorable to large businesses and corporations. Small businesses may not have the financing to hire tax specialists or consult with attorneys. These specialists can be quite expensive. On the other hand, large businesses can absorb these costs by hiring specialists. For example, many states like Texas, passed sales tax holidays. For three days in August, state and local governments do not collect sales taxes on clothes and school supplies. Imagine a small store owner who has to figure out which items to collect a sales tax on. Large, corporate stores have a specialist that changes programming code in a computer system. That is it. No other burden is placed on store employees and management. Another example is the federal inheritance tax put many small lumber companies out of business. These small companies are proprietorships. When the owner dies, the heirs of the business have to re-organize the business and pay the inheritance tax. Unfortunately, the heirs have to liquidate the business in order to pay these taxes. Thus, the inheritance tax destroys small businesses, when the owners die. Of course, corporations can theoretically live forever and the inheritance tax would have no impact. Finally, many state and local governments wine and dine the large corporations. They grant tax breaks and subsidies to corporations to open branches in their area. Unfortunately, small businesses usually do not get these breaks.

State and local governments know numerous taxes are detrimental to free enterprise. Hence, they use tax abatements to attract new businesses to their areas. New businesses invest in buildings and equipment, and hire workers. Moreover, new businesses can turn blighted cities around and create jobs. However, tax abatements have three problems. First, government is acknowledging that the taxes are too high. Government is temporarily lowering them to create wealth. Second, tax abatements penalize businesses that have been operating there without any tax abatements. Those businesses that remained in their community and paid their taxes are at a disadvantage. New comers can enter their market and have lower costs, because of lower tax burden. Finally, businesses are encouraged to migrate around the country, looking for communities that give the highest tax abatements. Once the tax abatements are over, they can easily migrate to another community, searching for new tax abatements.

The 2008 Financial Crisis is adding a new twist to tax abatements. With the staggering jobs losses that occurred in 2009 and a national unemployment rate around 10%, politicians are afraid of further jobs losses. Some businesses are demanding more tax breaks, or they will close down and relocate to another community.

Are heavily taxes states detrimental to their economies? The five states with the highest and lowest tax burdens are shown in Table 5.1. The definitions of the terms in the table are:

• Tax Burden: The tax burden is the percentage of income that goes to the state and local government. Federal income taxes were not included, because high-income states, like Massachusetts, pay more federal income taxes as oppose to other states. The average tax burden for state and local governments in 2008 is 9.7%. The five states with the highest and lowest tax burdens are shown in Table 5.1.

• State Real Gross Domestic Product (GDP): GDP is the total amount of goods and services produced within the state for one year. Real means inflation has been removed, and per capita is GDP per person. Thus, any growth in GDP means the state’s economy is larger and has been adjusted for a state’s population. The average state GDP in 2008 is $37,899 per capita. All states that have both a high and low tax burdens have GDPs that exceed the average GDP except for Florida.

• State Real GDP Growth Rate: Growth in GDP indicates the size of the state’s economy is increasing. The average state real GDP growth rate in 2008 is 0.7%. Out of the high tax burdened states, Maryland and New York have higher GDP growth rates while Hawaii is average. Out of the low tax burden states, Alaska, Florida, and Nevada have lower GDP growth rates. Of course, Florida and Nevada have been hit hard by the 2008 Financial Crisis and falling real estate prices.

• Unemployment Rate: The unemployment rate is defined as the percentage of workers who are unemployed and actively searching for work. The average unemployment rate in 2008 is 5.8%. All states, except Alaska, Florida, and Nevada, have lower unemployment rates. Be careful, high tax states may not be creating jobs. Instead, unemployed workers may be migrating to other states. In addition, if an unemployed person gives up looking for a job, then he is no longer considered unemployed and taken out of the statistic.

Table 5.1. States with the Highest and Lowest Tax Burdens in 2008

Sources: Bureau of Economic Analysis, U.S. Department of Commerce; Bureau of Labor Statistics, U.S. Department of Labor; and The Tax Foundation

It is hard to draw conclusions, because the average burden of the U.S. government was 21.7% in 2007, which is much higher than the states’ tax burden. The data is not conclusive until we examine states that do not have income taxes. However, the lower unemployment may be the labor migration from high taxed states to low taxed ones. States like California and Michigan are seeing some of their citizens migrate to other states [6]. Of course, if people are leaving, then less people mean government should supply less government services. However, taxes and government budgets rarely decrease.

The Laffer Curve

The Laffer Curve is the relationship between tax rates and tax revenues, and imbeds the behavior of consumers and producers. When government increases the tax rate, two opposing effects occur. First, government collects more taxes from each item that is taxed. Second, a tax always causes a higher price. Consequently, consumers always decrease their consumption of more expensive goods. Further, consumers could evade the tax or change their circumstances to reduce the impact of a tax. Consequently, a tax increase always causes the tax base to decrease [7].

When government increases a tax, a tax increase has one of these impacts:

1. When tax rates are low, a higher tax causes government tax revenue to increase. The government collects more revenue from a higher tax rate than the amount of revenues lost from the lower tax base.

2. When tax rates are high, a higher tax causes government tax revenue to decrease. The tax base drops more, wiping out the gains from the higher tax.

No one knows the true shape of the Laffer Curve and it is more of a teaching tool for economics courses. Only two points are known on the Laffer Curve:

• If the tax rate is 0%, then the government collects zero tax revenue.

• If the tax rate is 100%, then the tax revenue is still zero. Who in their right mind would work if all your earnings went to government?

A Laffer Curve is an upside down U-shape and only a particular tax rate maximizes government revenue. An example of a Laffer Curve is shown in Figure 5.1 and a tax rate of 40% would maximize tax revenues in this case. Unfortunately, many bureaucrats and political leaders ignore the Laffer Curve. As government expands, political leaders always increase a tax or fee, because they ignore the fact that taxes destroys a market economy and the underlining tax base. If politicians see tax revenues fall after a tax increase, then they always believe people are evading taxes and cheating the government out its money. Then these same politicians expand their tax authorities, searching for these tax evaders.

Figure 5.1. An example of a Laffer Curve

A clear example of the Laffer Curve at work is the federal excise taxes on petroleum fuels. The tax rates are shown in Table 5.2. The effective date is when the tax came into effect. President Roosevelt is the first President to impose taxes on gasoline and used the tax revenue to finance construction of the U.S. highway system. This was one of the ways he helped to create jobs during the Great Depression. Table 5.2 has two clear patterns. First, tax rate increases occur more frequently towards the present time. Second, the tax hikes become larger over time. This result is interesting because some people are calling for higher taxes on fossil fuels to maintain the highway system and replace dilapidated, falling apart bridges. However, Americans were able to construct our highway system when taxes were as low as one cent per gallon of gasoline. Also, this table does not include the state excise tax which averages about 6 cents per gallon.

Table 5.2. Federal Excise Taxes on Gasoline and Diesel Fuel

Source: Federal Highway Administration 1999 [8].

The Laffer Curve was the basis of Reaganomics. President Reagan’s economic plan was to lower taxes. With lower tax rates during the 1980s, the U.S. economy grew furiously. Although the average tax rates for the ‘rich” decreased, the top 1% of income earners paid a whopping 43.9% more in taxes. With a rapidly growing economy, a larger, growing economy always causes tax revenues to increase which help offsets the lower tax rates [7]. Many blame Reagan for the huge government deficits during the 1980s and increasing the U.S. public debt. However, during the 1980s, the U.S. economy had plenty of good-paying jobs with benefits.

Instability of State Government Finance

The state and local governments are fueling the tax nightmare. Similar to the federal government, they instituted complicated tax codes with numerous exemptions and credits. Further, all state and local governments (except one state) have balance budget amendments, which could make public finance more unstable!

Common sense would make it seem that a balance budget law would make public finance more stable. Where does this instability come from? Politicians are continually expanding government spending, but to meet this spending, more tax revenue has to flow to government. Here is where the instability comes into play.

• Growing economy – a growing economy lowers unemployment and raises incomes. More people are employed and higher incomes always lead to higher tax revenues. What does government do with higher tax revenues? Politicians always spend this extra revenue. They spread the money around, greasing the wheels for their constituents. Thus, politicians are always increasing the size of government.

• Recessions – a contracting economy increases unemployment and lowers incomes. More people are out of work and falling incomes lead to lower tax revenues. However, politicians rarely decrease government spending or contract government programs. Further, state and local governments are not allowed to operate budget deficits. Thus, politicians have to raise taxes to maintain government spending. Here is the source of instability. State and local governments always have a financial crisis during downturns in the economy. Then they raise taxes on a faltering economy.

Do you need some recent examples? The 2008 Financial Crisis put New York State into a financial crisis. The state rapidly increased government spending when taxes from Wall Street were pouring money into the state coffers. However, the 2008 Financial Crisis slowed down the financial markets, caused several large bankruptcies of financial firms, and the layoffs of thousands of workers. It is rumored that New York State got 25% of its tax revenue from Wall Street. It is no surprise that New York State is looking at a $14 billion budget deficit for 2009-2010, and the state wants to tax everything and anything.

During 2001 and 2007, the U.S. real estate market was red hot. Property values were quickly climbing. What else was going on? As property values went up, property taxes also went up, because property taxes in all states are tied directly to a property’s value. Local governments were awash with tax money and the politicians increased the size of local governments, like expanding jails and hiring more police. The states that had the largest increase in property values were Arizona, California, Florida, and Nevada. With the collapse of the housing bubble in 2007, does it come as no surprise that these same states are having the most severe financial problems in the nation?

Many more examples illustrate the instability of state and local government finance. For instance, many states started to collect income taxes during the 1970s. Several cities like New York City were teetering on bankruptcy. What happened during the 1970s? The Organization of Petroleum Exporting Countries (OPEC) cut back on the production of petroleum, causing petroleum prices to spike. The problem is petroleum is used in almost everything like gasoline, diesel fuel, jet fuel, plastics, fertilizers, and much more. Higher petroleum prices cause all prices in the economy to increase, causing a supply shock and a recession. Almost everyone in the economy was hurt by the high petroleum prices, including government. States do that they do best and created income taxes to overcome falling tax revenues.

Do you need more examples? How many states passed a lottery to help finance education? The politicians said the lottery would fix funding for education. Sure, the funding helped until the next downturn in the economy. Then state government invents new tax sources. Government is too stingy to make cuts or impose financial restraints on itself. Moreover, state governments also have some financial instability on their expenditure side. The federal and state governments finance a variety of social programs to help the elderly, poor, disabled, unemployed, and students. The source of the instability is:

• Growing economy – jobs are more plentiful and easier to find. Hence, states spend less on social programs, because households collect less unemployment, food stamps, welfare, and state health insurance. Attendance at colleges and universities tend to fall, thus government pays less for student aid and state scholarships. Unfortunately, politicians never save this money. They may decrease the requirements for state aid or expand other programs.

• Recessions – jobs are scarce and hard to find. Therefore, states spend more on social programs. People collect more unemployment, food stamps, welfare, and other aid. A recession can bust budgets and the politicians usually tighten the requirements for these programs. Moreover, attendance at colleges and universities tend to rise.

The federal and state government have good intentions in creating these programs. However, social programs have the following problems.

• The government is freely handing out money. Some people will purposely change their circumstance or lie to get government aid. For example, a person lies about a back problem to get disability pay. A mother on welfare avoids marriage or obtains a divorce in order to collect a welfare check. Despite any government crackdown, free loaders who do not need the aid will always take advantage of free help. Always! (Is it not shocking that so many young people that look healthy are collecting disability pay?)

• The government provides the wrong incentives. For instance, state welfare programs give more money to single mothers with more children. Consequently, single mothers have more children in order to collect larger welfare checks. Unfortunately, the children see their mother getting this free money, which encourages some of them to do poorly in school and not acquire any skills. They know they can get welfare too, once they are 18 and have children. Thus, government programs encourage single-parent households and continue a cycle of dependence on the next generation.

• Government programs create dependence on aid. Many people on aid are not upgrading their skills or looking for a job. Why would they? If you receive $15,000 a year from government to do nothing, what would your salary threshold be to start working? Would you start working for $30,000 per year? The problem is now you are working, and you have to pay taxes out of that salary. That salary threshold could be quite high for most people. Thus, recipients have a strong incentive to collect the government help for as long as possible without working.

• Government programs detract funding away from charity organizations. People contribute less to charities, because they know some of their taxes support social programs.

There is nothing wrong with social programs. Government needs a smarter approach and social programs need two characteristics. First, the aid has to be temporary. Second, a program needs to wean the recipients off the aid. The only exception is social security. Many countries give their senior citizens a form of social security. This could be viewed as a reward to the elderly for being a taxpayer for most of their lives. Of course, the elderly tend to be a strong voting group that career politicians have to pay attention to.

Property Taxes versus Income Taxes

Different taxes have different impacts on society.  For instance, many people and organizations argue for the elimination of state income taxes.  Their argument hinges on seven states that do not currently have an income tax.  They cite that states will grow faster and create more jobs.  The federal government collects economic data on states and we can check if states without income taxes are better than the U.S. average.  The states are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.  Are these states economic powerhouses?  The four statistics that were defined earlier in this chapter are shown in Table 5.3:

Table 5.3. Tax Burden for State’s without an Income Tax versus State’s Economic Level in 2008

Sources: Bureau of Economic Analysis, U.S. Department of Commerce; Bureau of Labor Statistics, U.S. Department of Labor; and The Tax Foundation.

• Tax Burden: The average tax burden in 2008 is 9.7%. All states have lower tax burdens.

• State Real Gross Domestic Product (GDP): The average state GDP in 2008 is $37,899 per capita. The states, Alaska, Nevada, Texas, Washington, and Wyoming have higher GDP’s than average.

• State Real GDP Growth Rate: The average state real GDP growth rate in 2008 is 0.7%. South Dakota, Texas, Washington, and Wyoming have growth rates higher than the U.S. average.

• Unemployment Rate: The average unemployment rate in 2008 is 5.8%. South Dakota, Texas, Washington, and Wyoming have lower unemployment rates than the nation. Again, people could be migrating from high tax states to low tax ones.

During the year of the 2008 Financial Crisis, states without income taxes appear to be in much better shape than the other states.  These states have lower tax burdens, and their economies seem to be doing better.  This leads to one premise.  The more taxes a government imposes, that government has a higher financial exposure during downturns in the economy.  For example, you have two state governments.  One has a couple of small taxes while the other has many taxes at various levels.  When the economy enters a recession, the lower economic activity harms the state government more with the many taxes than the state government with fewer taxes.   

One, of course, has to be careful of the definition of an income tax.  For example, the State of Texas has a franchise tax.  The franchise tax is a tax on business income and all businesses in Texas have to file, even if a business has no income and does not have to pay the tax.  This was a way for Texas to impose an income tax on businesses without calling it an income tax.  The State of Texas shortchanged its citizens, because voters have to amend the state constitution that would allow the state to collect income taxes.  Texans already pay high property taxes and are not likely to approve any new taxes.

Although states with no income taxes are in better financial shape, they have to rely on fees and property taxes to support their government agencies.  Fees and property taxes are regressive taxes and impact the poor and the elderly more.  For example, the State of New Jersey is one of the most heavily taxed states and it has some the highest property taxes in the nation.  Property taxes average approximately $8,000 per year on a house [9].  This is only one tax!  Someone on a fixed income will have to come up with at least $666 per month just to pay his property taxes.  This is insane!

A property tax is an inherently unfair tax. Property taxes are based on housing market values. Market values are determined by one or two homes selling on the block. Then the tax authority uses formulas to apply this market value to all other homes in the neighborhood. The problem is houses are unique and are not identical. Further, some homes may be new, re-modeled, or left to deteriorate. Thus, one or two homes selling in the neighborhood establishes the market value for everybody else in the neighborhood. Of course, it would be interesting to see how the 2007 housing bubble bust will play out. Currently all housing markets in 2009 are declining. Thus, ideally, property taxes should also be falling, which means local governments should be losing tax revenue. However, local governments will probably do one or more to prevent property taxes from become lower:

• Homeowners have to go through a process to dispute the value of their homes with the tax authorities. Local government may make the process more difficult. Unfortunately, some homeowners may not go through the appeal process to get lower appraised values. Of course, the end of an appeal process is a court. County courts are financed through county governments that rely heavily on property taxes.

• Local governments could raise the tax rates on property values. For local governments that are at their maximum constitutional tax rates, they could invent new taxes and fees.

• Of course, what if homes are not selling in your neighborhood? How do you establish a property’s value? Remember, the burden of proof is on the homeowner. He has to concretely prove his home’s value if his property’s value is lower than the government’s assessed value.

• Ø  This one should not be a surprised.  Some local governments are ignoring the selling price of a house that was sold as a foreclosure.  With foreclosed homes being discounted by 30% or more, local governments are ignoring these sales as special cases.

Some states like California, Idaho, Massachusetts, and Washington use the home’s last selling price to determine a house’s value. This could be a good system, especially for the elderly who bought their homes 30 years ago. However, homeowners who purchased a home at the height of the housing bubble are locked into high property values. The only way to lower these homeowner’s property taxes is they buy a new house for a lower value [4].

The severe problem of property taxes is their negative impact on industrial properties. Not only the land and buildings are taxed, but also all the machines and equipment. How do you place a market value on a 20-year old, 10-ton press? Further, property taxes are tied to a property’s value and not a company’s profits. For companies that are earning losses, they still have to pay property taxes. At least with an income tax, a company earning losses can have a lower tax burden. Thus, property taxes may put the industrial complex at a severe disadvantage; no breaks from the taxman when times are tough!

Conclusion

When a country has a capitalistic system with strong private property rights and minimal interference from government, that society becomes richer over time. As an economy becomes richer, the tax base continually expands, causing the government to become awash with more money. As government spends the tax revenue, government tends to create new bureaucracies or to expand old ones. A strong economy and expanding government can create a large number of good paying jobs. However, overtime, government keeps expanding regulations and increasing taxes. Eventually too many regulations and taxes become detrimental to the economy, causing incomes and business activity to fall. The problem is government does not decrease the size of its government, even if population is falling or people are leaving. Then government gets into this cycle of increasing taxes to make up for lower tax collections and less population.

Empires go through this whole cycle. For example, at the beginning of an empire, taxes are low. The empire grows giving government more tax revenue. Towards the end of the empire, taxes become high and that society stagnates. Then government continually increases taxes on a stagnant economy until the empire crumbles [7].

This cycle happened to two southern states, Louisiana and Oklahoma. During the early 1980’s, OPEC caused the petroleum price to increase significantly. As non-petroleum producing states were hurting, the petroleum producing states were thriving, such as Louisiana and Oklahoma. The petroleum industry were creating jobs and causing a large amount of tax revenue to flow to the state governments. These state governments rapidly increased the size of their governments. These states expanded their education system, expanded state government, and built massive prison systems. When the oil price went bust in late 1980’s, these states did not reduce the size of their governments. Instead, they relied on a variety of tax increases to sustain their high levels of government that remain in effect today. I am not sure how Texas escaped this fate, especially when the oil bust put the state in a severe recession. It may be because Texas before the 1990’s had a very pro-business environment, no income tax, and low property taxes. Thus, the state was able to attract many new employers to relocate there.

This cycle may have occurred to the U.S. economy on a wider scale. Have you noticed in our lifetime that the U.S. economy shifted from an industrial society to a service-oriented one? Then we listen to our politicians. Our tax systems are antiquated and obsolete. Our tax systems need to be updated, because they are based on a manufacturing economy and not a service oriented one. Their reasoning is many types of services are exempt from taxes. What about this idea; maybe the U.S. manufacturing sector left the United States because of all the taxes (and regulations), while the service-oriented sector prospered under low taxes. A manufacturing company is subjected to all these taxes:

• Income taxes: A business may have to pay federal, state, county, and city income taxes. These taxes vary by state.

• Social Security and Medicare taxes: Employees pay approximately 8% to Social Security and approximately 1% to Medicare. These are matching taxes because employers have to match the amount paid by employees.

• Property taxes, which include all the machines, equipment, and buildings: High-tech and capital-intensive industries could be heavily taxed through property taxes.

• Workers’ disability compensation: States determine the insurance rates. This is a tax because this insurance is administered by the state and not voluntary.

• Unemployment insurance: States determine the rates. Again, the state forces employers to pay this insurance and administers this program.

• Mandated benefits: Businesses are required to provide benefits like medical insurance and pensions to full-time employees. Thus, many service-oriented businesses rely on part-time labor to avoid paying these benefits.

Just by picking up a factory and moving it to China, a company can avoid these taxes or pay much lower taxes. Then you add the cheap labor and lax regulations. No wonder why Wal-Mart is one the largest corporations in America and competes with everyone in price with its cheap Chinese products.

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References

[1] McHugh, Jack and Steve Stanek. November 1, 2004. “'Shift-and-Shaft' Tax Proposal Ekes out Win in Michigan.” Budget and Tax News. Available at www.heartland.org (access date: 01/04/2010).

[2] Gordon, Marcy. November 13, 2009. “Banks will have to prepay insurance fees.” The South Bend Tribune.

[3] Chamberlain, Andrew. June 12, 2006. “Is California's Tax Base Preparing to Flee?” Tax Foundation.

[4] Christie, Les. October 14, 2008. “Home prices may plummet, but taxes won't.” CNN. Available at www.cnnmoney.com (access date: 10/15/08).

[5] Mumford, Lou. February 13, 2004. “Michigan stores fear smokers will head south.” South Bend Tribune.

[6] Cox, Wendell. January 6, 2009. “ Moving to Flyover Country.” News Geography. Available at http://www.newgeography.com (access date 01/08/09).

[7] Laffer, Arthur B. June 1, 2004. "The Laffer Curve: Past, Present, and Future." The Heritage Foundation. Available at www.heritage.org (access date: 3/23/07).

[8] Federal Highway Administration. September 1999. Federal Tax Rates on Motor Fuels and Lubricating Oils. Washington, DC: U.S. Department of Transportation, Table FE-101A. Available at http://www.fhwa.dot.gov/ohim/hs98/tables/fe101a.pdf (access date: 8/14/06).

[9] Summers, Pat. June 5, 2008. “Homeowners Demand Tax Reassessments As Market Values Plummet.” eFinanceDirectory.