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Follow Up: (Rush And) I Told You Not To Mess With Taxes…

July 14th, 2010 · 13 Comments
Buyer Beware · Follow Ups · Fun With Math · Policy

I wrote last year about how my BFF Rush Limbaugh doesn’t like taxes:

Personal income taxes for the uhh…upper middle class and the rich are about to skyrocket 31 percent for all New Yorkers making more than $500,000 a year. So I’ll tell you what I’m gonna do, I’m gonna look for an alternative studio somewhere outside New York. I’ll sell my apartment, I’ll sell my condominium, I’m gonna get out of there totally because this is just absurd, and it’s ridiculous…

Even though I am inclined to some degree to play the world’s smallest violin in honor of his tremendous hardship, I do respect that he certainly has a point in this regard. When you read in Principles of Economics textbooks that taxes raise tax-inclusive prices for consumers, lower prices (net of taxes) for producers and decrease the amount of economic activity in a market, it’s important to note that these models arise as a result of the assumption that consumers only care about the after-tax price of an item and producers only care about what they have left in their pockets after paying the tax.

Now, this assumption may be reasonable in some situations, such as when the tax is included in the price of the item as is the case with gasoline and alcohol. In other cases, however, it’s less clear that people and companies always behave in this way. Think about a sales tax- have you ever decided to purchase something only to realize at the register that the tax makes you wish that you had left the item on the shelf? (I have this feeling when I am shopping for nice clothes in New York, for example, since I am accustomed to Massachusetts sales tax rates and don’t internalize the difference until it’s too late.) Most people don’t decide to put the item back, probably due to some combination of wanting to avoid embarrassment and wanting to avoid a perceived loss, since your brain had likely habituated to the idea of you owning the item. In a situation particularly relevant to the issue at hand, how many of you out there specifically calculate the after-tax compensation of different job offers when making a decision? Yeah, I didn’t think so.

If producers or consumers don’t change their behavior due to a tax, the tax doesn’t result in a decrease in economic activity or a distortion in the market. In a way, this is actually a good thing- if there is no decrease in production and consumption, then by some measures there is no deadweight loss (read, economic black hole, pit of doom, etc.) created by the tax, and the tax creates a frictionless transfer from citizens and firms to the government. In another way, however, it’s a bad thing- objectively speaking, some consumers and producers are losing rather than gaining value from buying and selling, since ignoring the tax causes them to participate in transaction that are not profitable or utility-maximizing. Furthermore, if people ignore taxes, this makes it easier for governments to get away with raising taxes. Fun, huh? Hopefully it doesn’t shock you, given this discussion, that governments often raise tolls after they roll out their versions of the EZPass. From MIT:

In a landmark 2007 paper, “E-ZTax: Tax Salience and Tax Rates,” Finkelstein reported that when toll authorities implement electronic toll collection systems like E-ZPass, toll rates begin to creep up more than they would have under the old manual toll system.

Drivers appear to be much less aware of toll rates when they pay tolls electronically, which makes it politically easier to raise tolls. As a result, she estimates that–after the new system is phased in–toll rates are 20 to 40 percent higher on roads and bridges that offer electronic toll collection than they would be if all drivers still paid tolls by cash.

Hmph. I don’t know what to think about this- is the government taking advantage of its citizens’ psychological biases or is it being nice and enabling citizens to remain ignorant and blissful? After all, fundamental laws like gravity don’t kick in until you realize you’re falling, right Wile E. Coyote? Okay, maybe I do know what to think about this. At least the visual makes me feel a little better:

So back to the matter at hand…how similar is Rush Limbaugh to Wile E. Coyote? (You know I’ve been dying to make that comparison for a long time now.) One reader writes:

With rental prices falling with incentives like 1 month free, and selling prices down 30%, it’s a wash, especially when you factor in the extra commute time from outside the City and the lost opportunity cost. Time is money, and I really doubt Mr. Potato Head is going anywhere.

Sooo…Rush has had a house in Palm Beach for a while now, and he actually switched to doing his radio show from sown there for the most part. However, he wasn’t able to move his TV gig, so it got shelved. Who’s the big loser in this situation? David Henderson says it’s the state of New York:

A friend of mine who’s a friend of Rush Limbaugh told me that when Rush dropped his daily TV show, which was very successful, and moved from NYC to Florida, his loss in income from the lucrative TV show was less than his gain in after-tax income from moving to Florida.

Now I understand why it’s called the Laffer Curve, since, despite my tumultuous relationship with Mr. Limbaugh, I giggled a little when I read that.

Similar tradeoffs have come into the public eye recently as well- I mean, who among us hasn’t stopped to consider the tax implications of Lebron James leaving Ohio for state-income-tax-free Miami-Wade county? (Hee.) Stephen Colbert almost has it right:

This Thursday LeBron James begins his free agency, and he’s being courted by Chicago, Miami, Dallas, New Jersey and the L.A. Clippers. Of course, according to the NBA rules, those teams can only offer him $95 million over five years, while his current team, the Cleveland Cavaliers, can give him $125 million over six years, meaning we will soon have the answer to the eternal question: would anyone choose to live in Cleveland for $30 million?

What he forgot is that the differential is smaller given the differences in tax rates. Granted, athletes have to pay state incomes taxes for the states in which they play away games (not even kidding, and apparently states are cracking down on this in order to generate some cash). Now, last I heard, LeBron’s numbers weren’t finalized, and technically the maximum is $96 million rather than $95 million, so let’s compare $96 million to the 5-year Cleveland amount of $104 million. (Yes, I realize that there is value in the guarantee of the sixth year, but let’s not make things difficult.) So he’s missing out on $8 million pre-tax, but he is saving somewhere in the neighborhood of 6 percent on half of his income by being based in Florida. So let’s see, 6 percent of half of $96 million is…drumroll…$2.88, let’s say $3 million. (Gotta love how i just turned an amount that is likely larger than my annual compensation into rounding error.) By this calculation, he’s still out $5 million by choosing Florida…but he’s up some sandy white beaches and hot Latina women and down some, well, depressing rusty bridges and cold winters. (Before you go jumping down my throat, keep in mind I grew up in Miami but most of my family lives outside of Clevelend. Feel free to call LeBron “econgirl 2.0″…on second thought, don’t.)

There’s also another piece of the puzzle to consider- LeBron also keeps some more cash in his pocket from his endorsement income, and if this is large enough he could actually do better financially in Miami than in Cleveland. Or at least he could as long as the NBA doesn’t follow the NFL’s lead and start moving games to London:

Usain Bolt won’t compete at next month’s Crystal Palace Diamond League meeting because of British tax rules.

Speaking at a news conference ahead of Friday’s Areva meeting at the Stade de France, the Olympic and world champion in the 100 and 200 meters said he decided to skip the event after his agent informed him he would lose money by competing in London.

Bolt’s agent Ricky Simms told The Associated Press the British tax law stipulates that foreign sports stars have to pay taxes on their worldwide endorsements, a situation that “in recent sports has kept a lot of the big stars in other sports away from Britain.”

“Usain is possibly the first athlete to have endorsements at the level where he stands, but he would see his fees greatly diminish after taxes,” Simms said.

According to British newspaper the Daily Mail, if Bolt competes once in Britain and only five races elsewhere, the British tax will demand one-sixth of his global earnings.

Simms said it was unlikely Bolt will compete in Britain again unless the country changes its tax rules.

Oops. Good thing that there is an exception in the law for the Olympics, or this could get real ugly real quickly.

So, we’ve established that tax differences across regions do in fact provide a mechanism where areas compete for resources, and we’ve shown that, at least in some cases, these tax differentials affect the behavior of at least a subset of very wealthy individuals. What separates these people from me is, aside from height and athletic ability for the most part, the fact that they probably have accountants making them all too aware of these tax consequences. What about use regular folks who have to fend for ourselves in this big scary economic world?

I wrote last year about the effects of tax rate changes in a few states. Here’s what Maryland had to say:

Maryland couldn’t balance its budget last year, so the state tried to close the shortfall by fleecing the wealthy. Politicians in Annapolis created a millionaire tax bracket, raising the top marginal income-tax rate to 6.25%. And because cities such as Baltimore and Bethesda also impose income taxes, the state-local tax rate can go as high as 9.45%. Governor Martin O’Malley, a dedicated class warrior, declared that these richest 0.3% of filers were “willing and able to pay their fair share.” The Baltimore Sun predicted the rich would “grin and bear it.”

One year later, nobody’s grinning. 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.

No doubt the majority of that loss in millionaire filings results from the recession. However, this is one reason that depending on the rich to finance government is so ill-advised: Progressive tax rates create mountains of cash during good times that vanish during recessions. For evidence, consult California, New York and New Jersey (see here).

The Maryland state revenue office says it’s “way too early” to tell how many millionaires moved out of the state when the tax rates rose. But no one disputes that some rich filers did leave. It’s easier than the redistributionists think. Christopher Summers, president of the Maryland Public Policy Institute, notes: “Marylanders with high incomes typically own second homes in tax friendlier states like Florida, Delaware, South Carolina and Virginia. So it’s easy for them to change their residency.”

Hmm…so ordinary non-famous millionaires behave more or less like Rush and Usain…can we get some regular people to chime in? I suppose for this we have to go to New Jersey:

That’s a good idea that would give the Garden State the lowest tax rate in the Northeast after New Hampshire. Mr. Lonegan says this will ensure that when New Jersey incomes “move-up,” the residents “don’t move out.” Over the past decade, New Jersey has suffered the fourth highest rate of out-migration of all the states, with nearly half a million residents fleeing to the likes of Delaware, Florida and even New York.

Now, New Jersey can’t exactly complete with Florida (on this dimension or others), but a lower tax rate would at least tip the scale somewhat in its direction…at least if people pay attention to such things. And it seems like, while they may not with a sales tax on their morning coffee, they do when it “matters.” In that case, I will give you a very important piece of advice: those morning coffees add up, so the sales tax shouldn’t be thought of as a minor rounding error. At the very least, it’s nice to know that there are some competitive forces at work to keep taxes down for us little people.

Tags: Buyer Beware · Follow Ups · Fun With Math · Policy

13 responses so far ↓

  • 1 Chuck Dolci // Jul 14, 2010 at 6:09 pm

    Insightful article as always, but to respond to one question posed in the article.
    “… have you ever decided to purchase something only to realize at the register that the tax makes you wish that you had left the item on the shelf?”
    OK, maybe you don’t put the item back on the shelf. But when you leave the store and pass the Big Daddy Starbucks coffee shoppe and think “Ohhh. A nice cool triple latte, frapacinno double somersault would be nice right now.” and then dig into your pocket/purse (“It’s not a purse it’s a carryall”) and find that the money you thought would be there is not because the tax on the new shoes was so high, you forego that transaction.
    Score: State 1 – Starbucks 0

  • 2 Chuck Dolci // Jul 14, 2010 at 7:25 pm

    Oooh, oooh (a la Officer Gunther Toody in “Car 54 Where are you) I was just thinking (which, I know, is something a man ought not do). I think focusing too much on how much money someone leaves on the table by moving to a low, or no, income tax state may be wrong. OK, maybe millionaire X might have made more money if he had stayed in New York. But I think that ignores the affect of diminishing marginal returns. The input that keeps increasing is the time/effort/risk one puts into one or more money making endeavors. However, because of a progressive tax system and high marginal tax rates, as the person increases input (i.e. time/effort/risk) the return per marginal unit of input diminishes. Who knows, in some jurisdictions the marginal return might become negative. So the person says “Sure, I could make more money, by doing X, but it is no longer worth it. The marginal return is too small. So I will work less and fish more.”
    Just a thought.

  • 3 Matt D // Jul 14, 2010 at 8:04 pm

    Concur with Chuck’s comments.

    Also, state tax rates certainly do influence where a person determines to live and work. Military personnel move constantly, and are usually able to claim residency in any state they choose. Guess which states they choose to claim residency in? The no-tax states.
    When military personnel end their time in service or retire, they are free to choose where to live and often are in the unique position of having lived in many different states with varying rates of taxation, regulation, and fees. So the military retirees chooses where to settle down, receive their pension, and start new careers (earning additional income), they more often than not choose states with the lowest taxes.

  • 4 John F. Opie // Jul 15, 2010 at 5:25 pm

    The only other country with as arcane tax laws as you find in the US is Germany: tax avoidance is a matter of course for many in the higher income brackets, and until recently (okay, until around 10 years ago) there was an entire industry dedicated to exploiting loop holes in tax law and the quirks of interpretation between tax offices in various areas of the country in order to avoid taxes.

    This was finally changed, and as a result you have exactly the same kind of wealth flight from Germany to countries like Switzerland, where there can be a significant positive incentive to move to a lower-taxed canton because within a year you’ve recouped the moving expenses via lower taxes.

    Any good multi-millionaire is going to have diversified real-estate holdings as part of his speculative investments: done properly, this allows them to maintain multiple residential addresses that can be exploited for tax avoidance (tax evasion is a crime: tax avoidance is not) with the right tax lawyers. Once your income heads into the 7-figure region, the expenses start to be fairly trivial and the savings start to become serious money.

    What will happen to New York and elsewhere is that they will lose these taxpayers and with them many of the most productive members of society: they will also lose those who give serious bucks to the arts, further worsening the problem.

    What we’ll probably end up seeing is something like what you have in Switzerland: low-tax, rural areas offering enormous financial incentives but a relatively poor life style competing with high-tax urban areas. It’s all a question of commute and availability of services, and the latter will follow the money.

    It will be a race to the bottom, but the bottom is not zero, but rather those communities that have the fewest social problems and hence the lowest costs. Hence look for further stratification of society…

  • 5 Timothy Cullen // Jul 15, 2010 at 9:35 pm

    Econgirl, doesn’t automatic withholding, the payroll tax on employers, and value added taxation also exploit individuals’ ignorance and psychological biases by disguising the cost of government? What about excessive use of debt to fund government?

    Might people if faced with the true price of government subsequently demand less of it?

  • 6 Amarsir // Jul 16, 2010 at 3:22 am

    Not that Rush (or Lebron) are full-on Objectivists, but I wouldn’t be surprised if for some people there’s an Atlas Shrugged-style moral objection as well. Then it’s not just a simple choice between options, but an effort to effect long-term change by sacrificing short-term benefit.

  • 7 Howard // Jul 17, 2010 at 4:46 am

    Hi Jodi,

    I feel that most of the above commentators analyses are somewhat simplistic.

    I don’t want to deny the effect of taxes on behavior in general, but the above authors reduce people’s behavior to one dimension: response to taxes. This completely denies the complexity inherent in human evaluations of utility.

    To listen to these “analysts”, one would conclude that all possible places to live are fungible: one is a good an another, only the tax rate matters. But if you enter the real world, people actually prefer to live in certain places (e.g., NYC, San Francisco) than others (Rural areas, suburbs, etc.) (And, of course, the reverse.) for a variety of reasons: enthic diversity/tolerance, culture, religion, type of work, etc. Can our “analysts” imagine that?…

    One writer above uses anecdotal evidence from military personnel to “prove” that most folks prefer to live in low-tax areas. Does the above person know what a “biased sample” is? Military people are not representative of the adult population for at least a few reasons: a) They probably come from lower-than-average income families, and b) They tend to be conservative, which means they likely don’t prefer to live in urban areas. Look at it this way: If someone from another country wanted to survey American attitudes to Bush’s foreign policy, would that person get an accurate view if they sampled only people from Manhattan’s Upper West Side?..

    One person prophesies that in the future, New York and it’s ilk will lose all it’s rich, and all that they bring, due (apparently solely) to too-high taxes. In addition to my above comments, this prediction reminds me of the plethora of movies (Escape from NY, Deep Impact, etc) that envision the destruction of NYC. One doesn’t have to be Freud to see the rather pathetic jealousy or anger inherent in such movies and predictions.

    One particular example of NYC vitality. My wife loves dance. She recently found out that the Alvin Ailey Company (a NYC tradition, btw), has a building in midtown west. It was financed by donations from a wealthy supporter (I forget the details), who apparently loved Alvin Ailey and NYC (yes, despite those pesky taxes). Now my wife takes classes there every Saturday. Yes, its only one example, but I don’t think NYC is on the way out just yet. Oh, and wasn’t NYC just the hottest thing during the 90’s? (Despite significant (by Conservative standards) city and state taxes.)

    And one last little point. If you look at, per capita, the ratio of federal tax dollars received/federal tax dollars paid, well what do you know: It seems that many of the conservative states have a ratio > 1.0, while NY, NJ, CT, MA, and CA have values < 1.0. No, the correlation isn’t perfect, but the trend is obvious: We Liberal states are financing the welfare dependence of the Conservative states. Maybe we should end that…

  • 8 Matt D // Jul 17, 2010 at 1:20 pm

    Howard,

    I did not intend to generalize the military’s preferences to that of the entire population. I am pointing out that for one subset of the population, taxes and regulations are one significant consideration. (I have no evidence other than what I’ve observed in the last decade).
    Certainly, there are a myriad of variables people must weigh when considering where to live. Taxes are certainly one of them. Although I have no access to data, I suspect that generally, people and capital move to locations where taxes and regulations are low.
    Places like NYC and Southern California have cultural and environmental appeal that may outweigh higher taxes and regulatory burden. But we can eliminate these variables. Many people & businesses have a choice between locating in areas that offer similar degrees of cultural amenities, activities, weather. Should I keep my business / family in high tax central WI or move to OK ? Where are automobile manufactures locating their new plants? Take the military retiree, or any other “conservative” population group. Chances are they have little desire to move to Greenwich Village or Hollywood. But they might consider upstate NY, the Midwest, the south, there are several locations that meet their diverse criteria – and then taxes become more salient.
    You are right in pointing out that NYC offers a significant amount excitement, culture, education opportunities, and entertainment to draw an influx of people and businesses. No doubt that despite high taxes, people will be drawn to this place which is unique in America. How much more would it thrive if it controlled spending and reduced taxes? How many finance jobs are moving from NYC to Dubai?

  • 9 Michael L. // Jul 19, 2010 at 2:20 am

    I have two objections to your points:

    “Think about a sales tax- have you ever decided to purchase something only to realize at the register that the tax makes you wish that you had left the item on the shelf? ”

    Is it possible that consumers already made this calculation before they even approached the counter? Yes people may forget from time to time but still people may be discouraged from buying the item from they’re calculations. This results in the deadweight loss to society, nothing was bought so no revenue was raised either.

    Second, “how many of you out there specifically calculate the after-tax compensation of different job offers when making a decision? Yeah, I didn’t think so.”

    Actually in Mankiw’s book in Chapter 8, an article talks about in countries where the tax rates are the highest, people work the least.

    With the uttermost respect for you and your website, I feel as if the behavioral side of you forgets that economics is supposed to assume rationality and when we see evidence of possible irrationality, we do not dismiss the principal yet find ways in which it fits rationality.

    In the SR, your analysis is correct. In the LR, it leads to the classic text book examples.

  • 10 Steven E. Landsburg // Jul 19, 2010 at 2:49 am

    Wait wait wait wait wait wait wait.

    You’re telling me that because I’ve internalized my knowledge of New York State’s high sales tax to the point where it does not surprise me at the counter—because, in other words, at some level I am fully aware of it—it therefore follows that I *don’t* react to that tax?!?!

    To be deterred from making a purchase, I don’t have to put an item in my shopping cart, wheel it up to the counter and then change my mind. All I have to do is not put the item in the cart in the first place—which is what happens when you live someplace long enough that you know about the tax structure.

    Tell me I’ve misread you!

  • 11 econgirl // Jul 19, 2010 at 1:35 pm

    @ Michael L.: Of course some customers make the sales-tax calculation before they reach the register and make their decisions accordingly- the typical microeconomic assumption is that everyone makes that calculation before they reach the counter and everyone calculates accurately. I do not mean to imply that no one does this, merely that the tax is likely not fully internalized in these sorts of situations. To take that point a step further, the likely outcome is that taxes distort markets more than zero but less than what would happen if everyone thought about taxes “perfectly.”

    Your point about people working less in the face of higher taxes is somewhat different from the point I was making with the job comparisons. A lot of people see the choice between the $50K job and the $60K job as “would I give up $10K to take the first job?” when taxes and/or locations differences make it so the real difference is not $10K.

    @ Steve: No, I don’t think that that’s what I am saying, and I think that my point above applies here too. My point is more that a tax can only deter you from making a purchase before you get to the check-out if you actually think about the tax and add it in when making your decision of whether to purchase, and people sometimes treat the tax as rounding error rather than as something substantial.

  • 12 Joshua // Jul 19, 2010 at 5:27 pm

    Great post! I thoroughly enjoyed it.

    I’ll point out that there are services from taxes that are usually not associated with taxes in the consumer’s mind (roads, protection, etc.) Also, consumers should be looking for the best price, and if that price is free (or near-free) because a state chooses that route, then, individually, that makes sense for the consumer, but not the state. In time, states that don’t pay for infrastructure or protection (&etc.) become less attractive.

    Now, how to deter people from leaving? A federal income tax works, but “mobility” among the wealthy makes higher progressive income taxes problematic. In California, at least, we could have a high property tax… sigh.

    I do have one issue with one comment in your post:

    “In a situation particularly relevant to the issue at hand, how many of you out there specifically calculate the after-tax compensation of different job offers when making a decision? Yeah, I didn’t think so.”

    First, I do. Second, progressive income tax structures are stepped, so it doesn’t matter, unless you are comparing offers from different states, in which case you also need to compare cost-of-living, in addition to many other qualities, some of which are also quantifiable (say, parents close by for free laundry service and babysitting, vs. high-power job in Metropolis.)

  • 13 Amarsir // Dec 22, 2010 at 10:09 pm

    Oregon decided to demonstrate this as well:

    http://online.wsj.com/article/SB10001424052748704034804576026233823935442.html

    Their projected $180m from Measure 66 came in at $130m instead.

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