Posted by: Dirk | February 28, 2012

75% on the 1%

As the WSJ reports, French Socialist candidate Francois Hollande proposes a marginal tax rate of 75% on the super-rich:

French presidential hopeful Francois Hollande floated the idea of creating a new 75% tax bracket for top earners if he wins the elections this spring, toughening his leftist rhetoric with another attack against the super rich.

“I’ve been told about the considerable increase of the paychecks of CAC40 executives, two million euros per year on average. How to accept it?” Hollande said late Monday on a television show.

The Socialist candidate has already said he plans raise taxes on high incomes, cut tax on profit for small and medium-sized companies and scrap billions of euros of tax breaks introduced by President Nicolas Sarkozy.

Before cries of socialism are uttered, let me point out that Mr Hollande is, in fact, a socialist. Let me then point out that the same policy was conducted during the Civil War in the US, as Marc Egnal, a professor of history of Toronto’s York University, reports in the NY Times today on his blog about the birth of the greenback:

Instead, leadership came from a small group of Congressional Republicans, including representatives Elbridge Spaulding and Thaddeus Stevens and Senator John Sherman of Ohio. Before the war these men had been strong advocates of the economic measures – such as a protective tariff and internal improvements – that marked the Republican Party. They now set forth a bold program: It began with printing $150 million of legal tender Treasury notes, which bankers and soldiers alike would receive in payment for their services. These bills would be supported by extensive taxes, including an income tax. Once those initiatives were in place, Congress would implement Secretary Chase’s plan for a national banking system.

Spaulding, Sherman, Stevens and others who worked with them had a broad vision of American growth, built on a vibrant national economy with a strong central government. They extolled a harmonious nation of free farmers and manufacturers, with special interests kept in check by national laws. And they emphasized the need for sacrifice in the common cause: Spaulding, for example, made clear that the next step – heavy taxation – must soon follow the emission of Treasury notes. “Direct taxation, excises, and internal duties are new features within the United States,” he remarked. “They will be heavy burdens on the people, but essential to sustain the circulation of demand Treasury notes. The tax-gatherer will be an unwelcome visitor to most people, but his face must soon be familiar.”

If funds need to be raised, either for financing a war or a government deficit, an increase in taxes is often the only way out. After all, budget deficits are the result of the past’s tax incomes that have failed to cover expenses. In the end, a distributional problem is in the background. Government spent money, but politically could not bring about a balanced budget. As a result, government debt rises over times. There might be a point when government debt becomes a problem. In France, the government cannot print itself out of government debt problems, therefore it poses a real problem. (For most developed countries, the central bank can always help to pay the government debt. No action is necessary, the problem will play out with a bit of inflation and should not lead to bigger economic troubles, like a hyperinflation).

At the background of this you find that there is a certain view of what money is. While some people think that there is something of intrinsic value in money, the tax-driven money theory seems to be closer to the truth. We don’t accept money because it is of value or because we expect that others think it has some value, but we accept money because we and others can pay taxes with it. Period.

If the economic problem diagnosed in our economy is a zero interest rate caused by the rich wanting to save but the poor not being eligible to borrow, then increasing taxes on the rich will be the right thing to do. This will produce a drop in savings of the rich, and therefore the amount of funds for borrowing available will be smaller. This will surely lead to interest rates moving back up again (although France is part of the euro zone and perhaps foreign capital will flow in and stop a rise in interest rates). At the same time, lowering taxes on the non-rich should increase (expected) demand and, therefore, new investment opportunities should spring up. Also, government spending can increase. I think that it should not be that difficult to find projects that would transform social problems into opportunities for people (banlieu, anyone?). This should make the cake bigger, although the distribution will change.

If the diagnosis above is right, then the idea of high taxes leading to growth can work. Even more so since the rich have more incentives to invest in risky projects. Think of a 50-50 chance of a project returning either 0% or 220% on your investment of a million euros. With tax rates at, say, 40%, the unsuccessful outcome means that at least you get a tax deduction of 0.4 times a million euros, which is €400,000. If tax rates are 75%, however, then the tax reduction would go up to €750,000! Therefore, high tax rates increase incentives to invest into risky projects. That is just what we would need now. If tax payers go offshore or move to Monaco in huge numbers, all of this would probably not work as nicely. But then, diminishing the amount of capital available was exactly the point, wasn’t it?

UPDATE 05/03/2012: The tax rate calculations are based on the paper by Domar and Musgrave (1944) titled ‘Proportional Income Taxation and Risk-Taking’ (JSTOR).

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