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October 29, 2002, 9:00 a.m. Life at the Margins Even moderate tax rates discourage economic activity.

ver since the implementation of an income tax in 1913, federal and state governments have relied, to a growing extent, on income taxes as a major source of funding for government spending. As the demand for resources increased, governments increased income taxes.

When John F. Kennedy became president in 1960, he inherited an income-tax system where the maximum personal income tax rate was 92%! During his short tenure as president he proposed a sharp reduction in personal income-tax rates, recognizing that high marginal-tax rates impeded economic growth. His successor, Lyndon B. Johnson, convinced Congress to approve across-the-board reductions in income taxes. Unfortunately, under Richard M. Nixon, marginal tax rates rose again and the maximum rate in the late '60s was as high as 77%, including a 10% surtax.

Beginning in 1980, President Reagan, a Republican, espousing many of the economic principles of President Kennedy, a Democrat, proposed a substantial reduction in personal income taxes, and with the help of many Democrats, he lowered the maximum personal income-tax rate to 28% in 1986. (One moral of this story is that both Republicans and Democrats can agree on good economic policy.)

The volatility in tax rates over the past thirty years belies the true drawback of high personal income-tax rates — they discourage economic activity, the lifeblood of a growing and prosperous economy. During the '90s, politicians from all persuasions took economic growth for granted but when the new millennium recession hit, state governments found themselves saddled with declining revenues and the necessity to curtail spending.

While the federal government could finance deficits for as long as necessary, state governments weren't as lucky — they couldn't print money and they had to adhere to a budget. As a result, many politicians today are pushing for policies that encourage economic growth. Unfortunately, there is also a growing movement to increase taxes as a solution to short-term budget shortfalls.

Traditional income-tax analysis implies that taxes affect only "me." In other words, when I receive a paycheck or receive a specific payment of money for work performed, I pay the taxes and spend or save what is left over. For many people in, let's say, the 28% tax bracket, keeping 72% isn't all that bad. This analysis leads some politicians to think that current tax rates are too low and that they should be raised. What effect does increasing tax rates really have on economic activity?

One way to find out is to take another look at how income taxes affect simple business transactions. Rather than looking at income taxes as a one-event phenomenon, let's look at them from the following perspective: How much do I have to earn to get my house painter, for example, who is working for me, $1 of after-tax income? Or, looked at in another way, to what extent is the government discouraging this transaction by imposing high personal income taxes?

I created this table to calculate how much money I must earn, given different marginal tax rates, to provide the painter with $1 of after tax income. The table reflects the transactional effect of high marginal tax rates in the following way:

Select a marginal tax rate from Column A and my painter's marginal tax rate in Row B. The intersection of these two points is that amount of money that must be earned to produce $1 of after-tax income. For example, if my marginal tax rate is 50% and my painter's marginal tax rate is 50%, then I would have to earn $4 to get him $1 of after-tax income.

For that one transaction, the government is cutting itself in on 75% of what I have to earn. Yikes! Notice, at lower tax rates, the government's cut becomes bearable. If both the painter and I are in the 15% marginal tax bracket, then I only have to earn $1.38 to get the painter a dollar of after-tax income. Obviously, as personal income-tax rates rise, economic growth is discouraged.

Let's go back to the Nixon era when marginal tax rates were 77%. When you realize that it took $18.90 of earnings to generate $1 in after-tax income (in this analysis), you can understand why economic activity in those days consisted of high inflation and no growth. If I were to calculate the impact of maximum tax rates before President Kennedy, I would have had to earn over $156 to generate just $1 of after-tax earnings. I'd rather stay in bed. For all you math types, calculate what I would have had to earn in Great Britain before Margaret Thatcher when marginal tax rates were 98%. In other words, guess why the Beatles lived in New York City.

The bottom line is that even moderate marginal tax rates discourage economic activity. At some point competent business professionals calculate how much they have to earn to get their house painter or similar contractor a dollar of after-tax income and they decide that they would be better off if they painted the house themselves. This may be a good decision for Home Depot and Lowe's but it isn't a good economic decision. The painter doesn't get the job so his standard of living falls, unemployment benefits increase, the economy loses the productivity of the business professional who took the time off to paint the house, and the government loses tax revenues. High income-tax rates just don't make any economic sense.

At a point in our economic cycle where politicians are looking for new sources of revenue to maintain their spending habits, the alternative of raising taxes to accomplish this goal should be carefully evaluated within this transactional analysis before making the decision to raise taxes. Cutting taxes makes a lot more sense.

— Tom Nugent is Executive Vice President & Chief Investment Officer PlanMember Advisors, Inc.