A Taxing Situation

To me, few things are more unpleasant than taxes. Meaning, I may have a few problems in 2010. Stimulus and bailouts are taking their toll on the federal deficit's girth, so the White House and Congress are taking a hard look at taxes for fiscal solutions. But imposing new or higher taxes can backfire—and encumber the nascent economic recovery.

Each year brings a slew of tax legislation and proposals. Not all become laws. This year, the added pressures of reducing the large deficit and paying for the administration's busy legislative agenda (though health care now appears DOA) could mean tax talks get more serious. So far, proposals to impose or raise taxes have touched on (to name a few): sales, income, bonuses, retirement contributions, health care, banks, hedge funds, money managers, financial transactions, Medicare, offshore profits, and even wine—under all sorts of monikers: Cadillac plans, Millionaire's tax, etc.

Raising taxes is an easy go-to, but politicians should be wary. When you tax something, you get less of it. The Laffer Curve—named after economist Arthur Laffer and shaped like a sideways "U"—theorized the tax rate translates directly into incentive to earn taxable income, impacting government revenue. At a 0% tax rate, the incentive to earn income is at its greatest, though the government earns no revenue. At a 100% tax rate, it's surmised the government also earns no revenue since the incentive to earn income is completely taken away. Somewhere between these points is the theoretical sweet-spot—a tax rate that balances taxes and incentives to generate the optimum amount of government revenue.

Of course, "theoretical" means we have no way of deriving an actual ideal tax rate, but the message behind the theory is clear: Higher taxes don't always mean higher revenue. Quite the reverse—taxes that cross a certain threshold create disincentive to earn (why put effort towards something that gets taken away?). In today's highly mobile global economy, this means businesses and individuals can move to more tax-friendly environs, leaving revenue-hungry governments empty-handed.

Moreover, raising taxes to reduce the federal deficit is misguided. Some taxes are good—even necessary. A lot of non-profit social and conservatory programs wouldn't exist without federal support. National parks, highway maintenance, defense, and public education are a few areas that offer societal value (though some people can quibble about the degrees of that value) but aren't overflowing with capitalists. But the worry over deficits—and attempts to tame it—could impact the economy negatively, not positively.

Historically, high budget deficits don't spell doom for the economy or for markets. In fact, markets have performed better following budget deficit peaks than following budget surplus highs. Intuitively, this isn't baseless: High budget deficits usually result from heavy government spending, which generally winds its way through the economy, lifting business activity and economic and market outlooks. It's also not surprising to see deficits grow during or following recessions, but as business activity picks up and generates extra government revenue, the levels tend to naturally decline to more normal levels.

Taxes can dampen this process. Taxes on individuals mean there is less to spend. Taxes on businesses tend to be passed on to employees, shareholders, and customers—and are hardly an incentive for businesses to grow. The UK's brilliant move to tax bank bonuses—to be paid by the banks—is pushing one large bank to consider cutting employee compensation. These moves likely won't help economic activity. And the fact financial firms are politicians' favorite moving targets these days could put a greater damper on recovery. Banks plowing profits into paying taxes mean there's less for lending—and our economies lean on lending and credit to expand.

Taxes may be unpleasant for me (and perhaps you, too?), but they can be downright poisonous to a politician's career. In an election year (in the US and UK)—and one where almost everyone's pockets are a little tighter—politicians should use restraint and caution when thinking about new and/or higher taxes.