Why Taxing Only the Rich Doesn’t Raise More Revenue

tax_richOne of the byproducts of free people making different choices with their time, talents, and treasure is the unequal distribution of economic outcomes.  I suspect that no western tradition generates more passion among Occidentals than the concept of inequality.  Whether we like it or not, or whether it is true or not, many Americans believe inequality is one of America’s greatest moral failures.  During the 2012 presidential debates between President Obama and Governor Romney, large segments of the discussion centered on the topic of taxing the rich more while preserving the relatively low tax rates for everyone else.  As we will see, the policy of taxing the wealthy significantly more is not new.  I want to demonstrate from history why a steeply progressive tax code, where the rich pay significantly more and the poor pay significantly less, doesn’t achieve its intended purpose of raising more revenue.

Our Founding Fathers weren’t big fans of the income tax.  In fact, it wasn’t until 1913 that the 16th Amendment was ratified allowing the federal government to directly tax the incomes of individual Americans.  The ensuing Revenue Act of 1913 called for a tax that ranged from a modest 1% on incomes exceeding $3,000 to 7% on incomes exceeding $500,000.  It wasn’t long before a policy of “taxing the rich” significantly more was implemented.  In order to pay for WWI, Congress passed a law in 1916 that raised the tax rates on incomes over $300,000 to 70%.

Ironically, from 1916 until 1918, the number of Americans earning more than $300,000 dropped in half!  This caused President Woodrow Wilson himself to urge Congress to reconsider whether very high tax rates were productive in collecting revenue.  Wilson said that, beyond some point, “high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures, and produce industrial stagnation with consequent unemployment and other attendant evils.”  In the midst of a deep depression and hundreds of thousands of Americans unemployed, those who successfully implemented the steeply progressive tax policy found themselves elected out of office.

In contrast to the poor economy experienced during the Wilson administration from 1916 to 1920, the Roaring 20’s was a time of unprecedented economic prosperity.  Americans both rich and poor were buying radios, washing machines and automobiles.  Unemployment was virtually non-existent, and it was the first and only time in American history when blacks had lower unemployment numbers than whites.  What was the cause of such a positive economic turnaround? Many believe it was the reduction of excessive progressive era tax rates.  The treasury secretary at the time, Andrew Mellon, convinced both President Warren G. Harding and his successor Calvin Coolidge, that the most effective way to raise tax revenues was to flatten the tax code.  From 1921 until 1929, marginal tax rates shrunk from a high of 77% to 24%.

The result?  Record collections of tax revenues that were so large the government almost paid off the national debt.  As for getting the wealthy to pay their fair share, In 1918, when marginal tax rates were over 70% only 20% of taxes collected came from incomes over $300,000.  However, by 1926, 65% came from top earners!  Mellon proved that the way to raise revenue was not to raise marginal tax rates, but to lower them enough to make work and investment meaningful to wealthy people.

At first glance, lowering tax rates on high incomes for the purpose of raising revenue seems counterintuitive.  However, Secretary Mellon knew that productive Americans would not produce if taxes were too high.  Mellon wrote in 1924, “The history of taxation shows that taxes which are inherently excessive are not paid.”

One of the ways that the wealthy produce less income is they invest in tax advantaged investments that are usually less attractive when tax rates are lower.  Growth stocks, insurance annuities, sophisticated and expensive retirement trusts, and tax-free municipal bonds, all become incrementally more attractive to wealthy people as their income tax rates increase.

A second way wealthy people avoid income taxes is they invest overseas in countries where their investment income is taxed less.  There are many countries where investment opportunities are unattractive when U.S. tax rates are low.  However, at some point even risky overseas investments become relatively more attractive as tax rates on U.S. investment income are increased.

Finally, when productive people get taxed more, they produce less.  If you think I am fibbing, try this experiment at home.  Tell your children that if they clean their rooms by noon on Saturday, you will take them all out for ice cream; however, whoever cleans their room first will be forced to clean the bedrooms of their less efficient siblings.  Productive people tend to have less debt, so they don’t need much income to flourish.  When income tax rates are high, wealthy people spend more time in leisure activities and less time in activities that require them to pay excessive taxes on their productivity.

lglafferArt Laffer, a distinguished economist and advisor to Ronald Reagan, developed the concept of the Laffer Curve.  Laffer postulated that no revenue would be collected when tax rates were 0% (for obvious reasons), but he also believed no revenue would be collected at rates of 100% because no one would have an incentive to produce income.  Somewhere between 0% and 100% lies a sweet spot where the greatest amount of revenue will be collected.  History has demonstrated that tax rates above 24% tend to result in reductions of revenue collected.  With our national debt at unprecedented levels, our economy in dangerous waters, and our own economic futures uncertain, it is critical that we take into the voting booth with us an understanding and historical appreciation for tax policies that actually work.

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High Frequency Trading: Is The Small Investor Getting the Shaft?

60 MinutesLast Sunday 60 Minutes aired a segment about high frequency trading titled: “Is The Stock Market Rigged?”  Since its airing many of our clients have voiced concern over high frequency trading, so I have decided to share my thoughts.

To be honest, I knew very little about it prior to the 60 Minutes segment, but I did quite a bit of reading on the subject this week, and I now feel better prepared to weigh in on the conversation.  For those readers who don’t know what high frequency trading (or HFT) is, here is a little background.

Over the last few decades, technology has allowed the financial markets to make bigger and bigger buy and sell transactions faster and faster.  Trades that used to be done with handwritten orders and ticker tape can now be transacted by supercomputers in milliseconds rather than in minutes.  As it has become easier to fill large stock trades more rapidly, a cottage industry has sprouted up that exploits this new efficiency: the high frequency trader.  The high frequency trader sees your order to buy stock at a particular price, but before your order gets to the stock exchange (in less than a second), the high frequency trader buys the stock ahead of you and sells it to you at a slightly higher price.

Think of HFT like this:  suppose you want to buy your girlfriend a dozen roses, so you call the florist and ask what the price will be.  The florist quotes you $24.00. You tell the florist you live 15 miles away, but you will drive right down to buy the dozen roses.  Unbeknownst to you, a high frequency rose merchant eavesdropped on your phone call with the florist.  Knowing your intention to buy 12 roses at $2.00 apiece, he drove down to the florist shop from his office only 2 miles away and bought the roses in the store for $2.00 apiece.  Knowing you are on your way to buy roses, he is willing to sell them back to the florist for $2.01 apiece. When you get to the florist, the florist tells you that since you called earlier, the price of roses has risen to $2.02 (the florist added a penny per rose for his trouble).  Although you are perturbed because you are paying more than you were previously quoted, you pay $24.24 for the roses and you surprise your girlfriend.

In this scenario, the high frequency rose trader knew you were interested in buying roses, so he raced to the florist before you and bought the roses at the price you wanted to pay. He also took the risk you would buy them back at a penny or two higher when you arrived to get your flowers.  If you had balked at the price increase, the florist wouldn’t have bought them back at $2.01 apiece, and the high frequency rose trader would have been stuck with an order of roses he really didn’t want or need.

That is exactly how HFT works in the securities markets.  Electronic trade orders can’t move faster than the speed of light, and the stock exchanges are located at different locations around the world.  When an order is placed electronically, those HFT firms located between the buyers of stock and the stock exchange where the order will be filled, can buy the stock you ordered at the price you were willing to pay a millisecond sooner. The HFT then sells you the stock at a penny or so higher per share.

HFT sounds pretty rude at best, and downright dishonest at the least; but, is HFT really a bad deal for the individual investor?  I guess the best way to answer that question is to ask “compared to what?”

When it comes to buying and selling stocks, liquidity is extremely important.  A market with sporadic buyers and sellers is an illiquid and inefficient market indeed.  As distasteful as HFT looks on the surface, it appears to help ensure a large number of buyers and sellers in the market, thus shrinking price spreads and increasing the odds an investor can sell their stock in the future.

Secondly, HFT seems to be more of a burden on large institutional traders than on smaller individual investors (See Morningstar article: “About That Rigging Claim.”  From my floral analogy above, you can see that buying a dozen roses at $2.00 apiece and selling to you for a 12 cents profit doesn’t sound like a smart way to strike it rich on Wall Street; however, when you are buying 100 million roses (or shares) and immediately re-selling them for a $1 million profit, you can see where HFT can be enticing.  To date, there doesn’t appear to be widespread HFT front-running on small trades entered by individual investors.

Since the dawn of civilization, there have always been stories of markets being “rigged” against the little guy (see Proverbs 20:23).  The mission of the U.S. Securities and Exchange Commission (SEC) is:  “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  When I look back over my 20 year financial career, the markets are fairer, less costly, and more orderly and efficient today than they have ever been.

In the past, small investors had huge barriers of entry that made investing difficult.  There were odd lot differential fees which made small trades extremely expensive, but today, few brokerage firms charge odd lot penalties.  Until 2001, stock prices were quoted in eighths of a dollar which increased price spreads (and trader profits), but now stocks are priced down to the penny, reducing price spreads and trading costs for all investors.  30 years ago there were almost no discount brokerage firms available to the small investor, but today there are numerous low cost opportunities to fit the needs of practically any interested investor.

Is the stock market rigged, like the 60 Minutes segment implies?  Yeah; probably, but it has always been rigged.  Even though middlemen have been skimming profits on stock trades at the expense of investors since the invention of the stock market, that hasn’t stopped millions of long term investors from accumulating vast sums of wealth.  In my financial career spanning two decades, I have observed substantially more money has been lost by NOT investing than has ever been lost BY investing.  In spite of HFT, markets today are less expensive, more transparent, and less sleazy than ever.  With the airing of the 60 Minutes segment, I suspect HFT will percolate to the top of the SEC’s list of Wall Street shenanigans to investigate.  But, I hope any regulatory cures they implement are better than the alleged financial ills of HFT.

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