Dollar's Demise Traces Roots to U.S. Tax Trap

The dollar has tanked this year, though the drop has been fairly steady and orderly. That may be about to change.

The history of financial markets suggests that crashes are painfully common. Steady bad news very often leads to a rout. Sadly, the scenario that turns the dollar's bear market into a crash is beginning to look like a sure thing.

If a dollar crash were to occur, it might happen because foreign investors decide that the U.S. has fallen into a so-called tax trap. A tax trap occurs when a nation finds itself unable to increase revenue by lifting tax rates. Such a circumstance, if paired with mounting deficits, can lead to wholesale flight from a nation's assets. The Chinese will only lend money if they think we will pay it back. If doubt about the latter deepens, all bets are off.

The dollar will be dead, and the tax trap will have killed it.

Why might the U.S. be in a tax trap? The problem is that the U.S. income tax, a primary source of federal revenue, is very progressive, and has high rates. When rates are already high, it becomes harder and harder to raise money by lifting them more. This is, of course, the observation that made economist Arthur Laffer famous, and for the U.S. it is a real concern.

Corporate Taxes

First, our corporate tax rate is the world's second highest, and a number of recent studies have found that such rates don't lead to more revenue. This version of the Laffer curve is now fairly widely acknowledged.

But what is less commonly understood is that our graduated income tax also probably has reached the point where higher rates raise little new revenue, at least given the political landscape. President Barack Obama has pledged to only increase taxes on those with incomes higher than $250,000. But lifting only that top marginal rate can have perverse revenue effects.

Here is why. When tax rates go up, wealthy individuals have many options to reduce their tax bill. They can work a little less, they can purchase municipal bonds that pay tax-free interest, and they can take a vast number of other similar steps.

More of Less

If we start with a tax rate of 35 percent, then for every dollar of income reduction, the government loses 35 cents. After the adjustment occurs, the government collects revenue via the higher rate applied to what is left. If you lift the marginal rate from 35 percent to 45 percent--assuming taxpayers adjust their incomes lower--then you lose 35 cents for every dollar of income reduction, while getting back 10 cents on every dollar that is left in the top bracket. The revenue effect depends on how much income adjusts, and how much income is left in the top bracket after that adjustment.

If you only change the top rate, then it gets surprisingly hard to generate revenue, even when income adjustments are small.

Let's take the tax changes the Democrats have planned for next year. They want to let the top marginal rate go from 35 percent to 39.6 percent, and to reduce the value of itemized deductions in a way that adds a little more than a percent to the marginal tax rate, making the total 40.8 percent.

Making Adjustments

The top income tax rate kicks in for a married couple at $372,951. Everyone with an income above that will face the higher rate, and some adjust their taxable income down accordingly.

How big will that adjustment be? A study by Emmanuel Saez, an economist at the University of California-Berkeley, suggests that these taxpayers would reduce their income by about 5.2 percent.

If incomes do decline in that amount, then the tax increases will raise very little revenue. Indeed, the breakeven point for the government is surprisingly high. For every individual who has income below about $613,000, the government will actually lose money because of the tax hike. The 35 cents lost for every dollar of income reduction isn't offset by the roughly 6 cents gained on the income that remains.

The numbers are even worse if we analyze the 5.4 percent millionaire surtax that just passed the House as part of the health-care bill. Within the top tax bracket, the lower the income, the more people there are with that income. You have to collect a lot more money from the richest taxpayers in the bracket to offset the revenue losses from those at the bottom of the bracket as they make moves to avoid the tax by lowering their income. As a result the net revenue raised by these tax changes is likely to be tiny.

A Wash

That means that the tax increases that the Democrats plan to pay for their expensive programs are unlikely to raise much revenue.

The government deficit already looks like it will approach $1 trillion a year over the next decade. But in fact, the higher tax rates, especially those that are, as in the health-care bill, paired with higher spending, are going to make it worse.

When foreign investors see that higher taxes deliver little new revenue while spending soars, they will head for the exits.

The dollar will be dead, and the tax trap will have killed it.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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