Tax Hikes and the 2011 Economic Collapse

By Arthur Laffer

June 7 (WSJ) —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.

It shouldn’t 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 and Warren Buffett—hold the bulk of their wealth in the nontaxed form of unrealized capital gains? The composition of wealth also responds to incentives. And it’s 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 1992—over $15 billion—in 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 $8,000 tax credit ended? It isn’t rocket surgery, as the Ivy League professor said.

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush’s tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate 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 there’s 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 Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s 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 don’t work until they take effect. Mr. Obama’s 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 what’s 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 ain’t seen nothing yet.

Yes, those are very strong forces, especially for the second half.

They will also cause tax collections to go up this year, reducing non gov net financial assets which means we go into next year’s slow down that much weaker financially.

The thing that can reverse it is an acceleration of borrowing to spend in the domestic private sectors. That’s usually from housing, cars, maybe cap ex, commercial construction, etc. But those traditional areas of credit growth aren’t showing any signs of being able to take up the slack, at least yet. while the employment picture is modestly improving (see Karim’s work on total hours worked) seems to me it has a long way to go before it generates robust credit growth.

And, of course, the external risks remain.

11 Responses

  1. Laffer’s usually out to lunch, but in this case he’s (sadly) right. It’a case of the stopped clock that’s right twice a day.

  2. Laffer: “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.”

    Hah hah! Ye Olde Bait and Switch. Get the stimulus from the threat of tax increases next year, and then, repeal them next year! 😉 (And then give a payroll tax holiday, as well. :))

    I actually think something like that will happen, regardless of the election results.

  3. Yes, unfortunately our politians in Washington are doing everything in their power to hamstring banks from lending, i.e., card act, draconian capital rules, etc.

  4. Taxing the rich will not collapse the economy. The rich do not put their money in productive uses but in speculative ones. Not taxing the rich actually has collapsed the economy. But supply-siders will never admit to as much.

  5. Ho-hum. Wake me when Art says something new and interesting. How many years has he been touting this line now? How come the Bush tax cuts didn’t solve all our problems like they were supposed to, but instead resulted in unprecedented collapse? Obviously, some of the incentives were wrong. Now Laffer wants the country to adopt the same old failed policies. Gimme a break.

    1. Toms Hickey:

      I know you are mentally, emotionally, and spiritually incapabale of processing this, but bush tax cuts did help.

      i thinks obama will let them expire in 2011, otherwise he will be agreeing that bush actually did something right.

      1. Tax Cuts for the rich led to speculation of the rich’s money. It did not foster long term wealth. Those jobs that it created were real estate related. Those were bubble jobs. So in the end it did not help. But hindered the economy.

      2. Thanks you Adam for explaining how tax cut for rich led to bank giving itinerant strawberry picker $750,000 for house. And you are correct, private sector would be in better shape if it was even *deeper* in debt!

        I am sure you and Toms Hickey can get together and discuss whether mechanism was “dollar hegemony” or “historical dialectic” while parroting to each other favorite passages from Chomsky and laughing at idiot hicks from kansas.

      3. Zanon, once again the rudest guy on this site. Once again misusing Chomsky as he abhors communism (the fruit of the dialectical hegemony) and is a social anarchist. Details …details…whatever works for Zanon…

  6. Zanon, Former Presidential Candidate – Senator McCain said you were not willing to go out and pick strawberries, for any price. Not even for 100 dollars per hour. I think this fits well with many of Warren’s ideas. You have a class of people that are not willing to do hard labor for any amount of dollars. Some people will sit all day on blogs and debate monetary policy for no pay at all, like all of you here do. But me, I pick strawberries. So you should be happy that I will pick strawberries that you eat for a mere simple california home and free up your time so you can make jokes about me on here. I am amazed at you and the others that keep coming here for FREE and expect no pay for all the time and effort and thought you contribute here, but get mad that I expect a house for working hard out in the sun fighting snakes and skin cancer to get your fruit.

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