Another Tax Myth Bites The Dust

Either I wasn’t clear enough, or people need to read a bit more carefully.

In last week’s Myth-Busting Monday column, I set out to prove that a sudden spike in dividend tax rates wouldn’t trigger a bear market.

My evidence? The fact that average annual stock market returns were actually highest when dividend tax rates were highest. Not just in the modern stock market era, but going all the way back to 1913.

As I wrote, “It’s totally counterintuitive. But the facts don’t lie.”

Case closed, right?

That’s what I thought, until I received this cheerful note from Pat W.:

“The dividend rate and stock chart does not prove any correlation or causation between the two variables. Politicians use this faulty reasoning. You should be better than that.”

Talk about a low blow. A politician?

It turns out that Pat wasn’t the only one calling me names or indicting me for the same crime. Plenty of others swear that I said a “causal” relationship existed between tax rates and stock market returns.

For the record, I never said high dividend tax rates caused higher stock market returns. In fact, the only time “cause” appeared in my article was in the word “because,” which I used four times. (Yes, I went back and counted.)

All I said was, based on history, “tax hikes will not derail the stock market.” Accordingly, we shouldn’t bail on stocks. Instead, we should focus on using strategies to limit the dividend taxes we pay.

Again, I’m not saying that higher tax rates caused – or will cause – higher stock market returns. I’m just saying higher tax rates won’t get in the way of equity returns.

Now that we’ve cleared up that confusion, let’s move on to another tax myth that desperately needs busting…

Higher Taxes = Higher Revenue?

Way back in 1974, American economist, Arthur Laffer, inadvertently popularized his so-called “Laffer curve” theory after drawing it on a napkin in front of a Wall Street Journal reporter.

If you’re unaware, the Laffer curve posits that as taxes increase from low levels, tax revenue collected by the government also increases. But at a certain point – when tax rates rise too much – people stop working or figure out ways to dodge taxes, thereby reducing tax revenue.

And at the extreme end of the spectrum – with tax rates at 100% – nobody works because everything would go to the government.

So, in theory, there’s a tax rate between 0% and 100% that will result in maximum tax revenue for the government.

The problem with theories? As Yogi Berra quipped, “In theory there is no difference between theory and practice. In practice there is.”

Sure enough, whether or not the Laffer curve holds up in reality has been a topic of much debate and study over the last several decades.

I don’t have time to rehash all the old arguments, though. Instead, I’m going to look at the most recent evidence.

In this case, reality matches theory. At least when it concerns tax rates on the top earners.

~ Exhibit A: Maryland

From 2007 to 2010, Maryland increased the tax rate on incomes over $1 million from 4.75% to 6.25%. The result? A net 31,000 residents fled the state, costing the government $1.7 billion in revenue, according to anti-tax group, Change Maryland.

Considering the source of the data is a group that’s opposed to higher taxes, the figures might be exaggerated slightly. But there’s no denying the impact. Higher tax rates led to lower revenue.

And that’s not the only time it happened in recent history…

~ Exhibit B: United Kingdom

On April 6, 2010, the top income tax rate in the U.K. jumped from 40% to 50%. The result? The number of people declaring incomes of more than one million pounds plummeted from 16,000 to 6,000, according to The Telegraph.

Fast-forward to 2012, and U.K. Chancellor, George Osborne, announced that the top rate would be reduced to 45% in April 2013.

Surprise, surprise! “Since the announcement, the number of people declaring annual incomes of more than one million pounds has risen to 10,000,” The Telegraph adds.

It’s Not Just a Tax Issue

Why bring any of this up? Because the prevailing wisdom in the debate over the Fiscal Cliff is that the U.S. government can simply tax its way out of a budget deficit.

Not true, according to the Laffer curve. Or recent history. Or reality.

Even if we let all the Bush tax cuts expire, the increase in revenue would only fund the government for about one week.

Ironically, rolling back the payroll tax holiday would raise more revenue – about $120 billion, according to Deutsche Bank’s latest estimate.

Bottom line: America has both a spending problem and a revenue problem. And trying to fix both by only raising taxes won’t work. Too high of a rate hike could actually make our revenue problem worse.

As I shared over a year ago, “More than anything, America needs economic growth – not more taxes or less spending – to escape from its current fiscal mess.”

Of course, economic growth isn’t going to pick up until the uncertainty regarding the Fiscal Cliff is eliminated. And that’s going to take politicians compromising on tax hikes and spending cuts.

So instead of pestering me, I think it’s time for Pat to send a few nasty-grams to Washington, telling them to hurry up.

Can I get an “amen?”