Why Raising Taxes Lowers Government Income (over time) – Part I

The reason increasing taxes doesn’t increase income to the government long term, but reducing taxes does… or at least can.

In advance, I want to express my understanding that I am oversimplifying what has become a very complex issue.  Let me also make clear that this principle doesn’t work ad infinitum (you cannot increase tax revenue by reducing tax to 0%, for example).  However, this simple example will express the principle:

Imagine that I am a feudal lord and I have serfs.  A peasant family lives under my rule.299_1527.jpg

My serf is able to produce 100 units of wheat every year.

I tax him 10% each year.

10 units a year.

His family eats 50 units.

He sells 40 units of wheat each year in order to buy seeds to plant the acreage needed to produce the 100 units.

This adds up to the 100 units.
Harvests                     100 units
Taxes                          10 units
Family                         50 units
Plants                         40 units

This goes on year after year.

I asked my child what I, as the lord, should do in the case that I realize I want to make more income for some reason.  My child answered, “Increase the taxes.”

This is precisely what I would think most Americans would say.  They could be correct in the short run (sometimes VERY short), but not in the long run.

Scenario 1:

I increase his taxes by another 10% to a total of 20%

His new breakdown Year One is:

I now tax him 20 units.

The family eats 50 units (this is a static number, keep in mind).

He has 30 units to plant…

This is 25% less to plant than last time…

So I assume he produces approximately 25% less wheat… now only 75 units are grown.

Year Two:
Harvests                     75 units grown
Taxes 20%                 15 units (still more than the 10, but less than the 20)
Family                         50 units
Plants                         10 units (all that is left, unless he is going to starve his family)

He is now planting 75% less than the year before the tax increase.

Year Three:

Harvests                     25 units grown
Taxes 20%                 5 units
Family                         20 units (less than half what they need)
Plants                         0

This is an extreme case for the sake of simplicity and I am certainly aware that things are

peasant-carrying-harvest-to-barn-vector-background-illustration.jpgmore complex than this, but there is a basic accuracy here.  The principle is that the government initially and immediately takes in more, but in the end acts as a virus that kills the host it was drawing from.

In year 4, now the government draws 0 taxes from the serf.
Solution?  Next week.

6 thoughts on “Why Raising Taxes Lowers Government Income (over time) – Part I

  1. I think the U.S. is already in the place where “the crops planted each year” are diminishing. People forget that people respond to incentives, so in the example it leads to a family starving, but in America it might lead to a wealthy person deciding not to invest in new companies/ technologies (thus creating jobs), and instead live off what he has already earned. Since he creates no new wealth, the taxes he was paying on capital gains went from something to nothing.

  2. I like this and think it’s a good, logical example. The only thing I’m wondering about is if it accurately describes where we are, because the example/model assumes that the status quo is sustainable (which I don’t think that is the case for the US). How do we figure out where we are on the spectrum?

    1. Great insight – I was thinking that as well (not that that is the sign of a great insight) I agree, that sadly, the status quo may not be maintainable… I recently heard that an African nation had $200 in the bank after paying their bills… which puts them 16 trillion dollars ahead of us. However, I think the only real way to improve that is to return to a status quo that can be maintained… by cutting expenses. We all should know that raising income is like playing double or nothing once you are ahead – it is a fool’s game. You cannot raise income indefinitely. So, this principle still applied and maybe doubly so. We must make drastic, painful cuts to spending and then begin to apply these principles ASAP. Increasing the rate of removing money from the system speeds our doom loop. Fortunately, our foundations are not dependent on these things (if you remember your identity classes)

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