Taxes on the "rich": Common sense versus Economic analysis

Below are some additional thoughts regarding the ongoing debate on whether the "rich" should pay higher taxes in order to provide for the well-being of the "poor". I previously touched on the subject here.

(I put "rich" and "poor" in the quotation marks, since in the modern developed countries most of those who qualify for tax purposes as rich/poor are really the members of the middle class.)  

The common sense point of view is based on the concept of "social justice" - some people are more fortunate and should share with those who happened to be less lucky. This point can be perhaps made stronger by noting that the "rich" and their furtunes benefit from the protection of the state that they live in and therefore the state may demand from them to contribute a higher share.

Of course, the opposite argument can be made, based on the concept of "individual freedom": very often  wealth is a result of hard work put into earning and maintaining this wealth, so why should anyone share the results of his/her hard labor with others?

Of course, both of these points are philosophical and can hardly be convincing for the opponents of either. In addition, the debate nowadays is really not about whether the "rich" should help the "poor", but to which extent they should help: the tax-based government assistance ranges rom providing food and shelter to those who are truly poor to funding university scholarships and house-mortgages, which are really the benefits enjoyed by the middle class (although someone truly poor may call them "luxuries")

There are however some economic arguments which make clear that the "tax the rich" debate is not merely a matter of moral attitudes (as could be concluded from the political debates, where each side often blames the opponents for denying "social justice" or "personal freedom" .)

Here are two points to consider:

1. Tax incidence Who pays the tax? Most of the modern "rich" are owners of businesses who benefit from using other people's labor and selling the produce of their enterprize. The businesses minimize the reduction of their profits due to taxation by raising the prices, and lowering the wages or reducing the number of their employees. Thus, a part of the tax levied on the "rich" really falls on consumers and workers. How big is that part is apparently still debated by the economists. Yet, one should be aware that the "tax on rich" may really be more of a burden the "poor"

2. Laffer curve Raising the tax rates does not necessarily increase he revenue that the government receives from the taxes. This is exemplified by so-called "Laffer curve", which is based on a very simple logical argument:

Laffer curve

"The curve is constructed by thought experiment. First, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist at least one rate in between where tax revenue would be a maximum." [Emphasis mine]

If the tax rates are on the downward slope of the curve, then the way to increase the tax revenue is by reducing the rates rather than by increasing them! This observation led to what has become known as the "supply side economics", which was the basis for the tax policies of Ronald Reagan. The policies did not succeed, since every group of the society responds to tax insensitives differently: as the result of the Reagan's policies the revenues did not increase, but decreased. With the government spending on the same level as before this lead to the growing national deficite. 

Yet, Laffer curve may work, if the lower tax rates are applied to certain groups of society that respond to tax insensitives, and such a group of the society turns out to be... the "rich". Here is what Greg Mankiw's economics textbook says on the subject:

"Yet Laffer’s argument is not completely without merit. Although an overall cut in tax rates normally reduces revenue, some taxpayers at some times may be on the wrong side of the Laffer curve. In the 1980s, tax revenue collected from the richest Americans, who face the highest tax rates, did rise when their taxes were cut. The idea that cutting taxes can raise revenue may be correct if applied to those taxpayers facing the highest tax rates. In addition, Laffer’s argument may be more plausible when applied to other countries, where tax rates are much higher than in the United States. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more tax revenue if it had lowered its tax rates." [Emphasis mine]

Thus, astonishingly, the tax cuts aimed specifically at the "rich" may raise tax revenue to the greater benefit of the "poor"!

In conclusion, I would like to reiterate my main point: the question of whether the rich should pay higher taxes is more than a philosophical discussion of "social justice" versus "individual freedom". Deeper economic arguments can be made to support the point of view that lower taxes on the wealthier members of the society can be beneficial to the poorer ones. In fact, we have to separate the question into two: i) whether the "rich" should be responsible for the well-being of the "poor", and, ii) if "yes", whether the greater benefit to the "rich" (i.e. lower tax rates on high-income earners) and the greater benefit to the poor (more government services due to the higher tax revenue) are mutually exclusive.