Taxing The Rich: A Fiscal Castle of Sand

Martin O'Malley's Big Tax DisasterThe Wall Street Journal looks at the severe falloff in tax revenues from millionaires in Maryland after the state socked them with a new, higher tax rate for the purpose of closing a budget gap, a move hailed at the time by supposedly big-thinking liberals. Somehow, Maryland liberals were surprised that this didn’t work out:

One-third of the millionaires have disappeared from Maryland tax rolls. In 2008 roughly 3,000 million-dollar income tax returns were filed by the end of April. This year there were 2,000, which the state comptroller’s office concedes is a “substantial decline.” On those missing returns, the government collects 6.25% of nothing. Instead of the state coffers gaining the extra $106 million the politicians predicted, millionaires paid $100 million less in taxes than they did last year — even at higher rates.

The easy partisan divide on this issue is over how much of the decline in revenues is attributable to millionaires leaving the state or voluntarily reducing their taxable income (by working less or hiding money in tax shelters) as opposed to the effects of the recession, which the WSJ notes as an obvious contributing factor. But that’s only one problem with sharply progressive tax rates; the Journal notes a structural problem that is at least equally serious in times of recession, as New York and California in particular are discovering to their grief. Specifically, the surplus annual income and investment returns of the wealthy tend to be much more volatile year-to-year than the great mass of incomes earned by average citizens.

Let’s consider an illustration: in a boom year, the stock market rises 20%, and housing prices rise 30%. Lots of people (proportionately to the number of millionaires) make big gushing spigots of money from this, not just capital gains from sales but commissions, year-end bonuses, the whole gamut of ways people profit in eye-popping amounts from a boom. The average guy sees some extra money too, but he’s less likely to see a dramatic percentage increase in compensation. Despite some variations across different boom era, by and large, this has always been true.

When booms turn to busts, though, the high-end incomes are the hardest hit in percentage terms. We think of down times as being harder on the average worker because in human terms they are: it’s a lot worse to lose your job than to go from making $10 million a year to $800,000. But when unemployment goes from 5% to 10%, the dropoff in the tax rolls isn’t that dramatic, especially given that a lot of those lost jobs were people paying little or no income or capital gains taxes to start with, and so the state budget literally does not feel their pain. Whereas collections from high-end incomes can and do drop off far more than 5% in a year, as the Maryland example illustrates. Here in New York, investment banker bonuses that were once the core of the state and city tax bases evaporated overnight. Put simply, taxing the rich is the least recession-proof revenue-raising strategy you could design.

This would be problematic enough if the federal and state governments were trying to sustain a stable income and socking away the extra money for a rainy day (Gov. Palin in Alaska did something like this with the revenue from oil boom years, but Alaska too is subject to the laws of political gravity). Instead, Congress and the states tend to create new permanent claims on temporary income in the best of times, creating long-term self-perpetuating entitlement and spending programs and hiring more unionized workers. (The Obama ‘stimulus’ bill combined the worst of both worlds, giving states temporary revenues while demanding that they use them to permanently increase funding obligations, and doing so during a recession). This tax-on-the-boom, spend-through-the-bust philosophy is designed for certain failure; it’s not possible it could ever succeed.

Yet, that’s exactly how all tax-the-rich systems are designed. And no amount of failure will ever teach their proponents anything.