The Agony and Irony* of Taxes

Since the release of President Obama's budget preview there's been a lot of noise made over the question of taxes, specifically relating to two issues. First, the federal government's long-term fiscal problems, which Tim wrote about yesterday. The second issue is the question of what impact higher taxes will have on entrepreneurship.

There's no doubt that Uncle Sam is flirting with budgetary fire--the numbers being thrown around about the long-term deficit are almost beyond belief. And quite frightening. It seems likely that some combination of higher tax rates and trimmed entitlements will be unavoidable. But it is also doubtful that higher taxes can make much headway against the enormous mountain of government debt, particularly given the towers of debt that households will continue to struggle with. California, moreover, is Exhibits A through Z as to the effects of relying solely on higher taxes to prop up the governmental edifice. 

Thus, it would seem that some sort of entitlement restructuring will end up being the only conceivable way to boost fiscal health. (I must admit, however, to being a tad mystified at the proposal to make Pell grants an entitlement--the rationale of making college more affordable for more people doesn't hold water against the evidence that rising tuition costs have been, in part, a product of expanded federal aid.)

The second tax issue--the effect on entrepreneurship--is much more ambiguous and thus emotionally-freighted. Will higher taxes on those with incomes over $250,000 dampen the entrepreneurial spirit? There is certainly reason to think it will: lots of small businesses, for example, file individual income tax returns and thus would face higher taxes. (Secretary Geithner maintains that this would be an incidentally small number.) The always-perspicacious Jim Manzi makes a persuasive case that higher taxes will in fact affect the probability calculations made by prospective entrepreneurs and dissuade many from taking the plunge.

Yet that can't be the whole story. For one thing, William Nordhaus has calculated that entrepreneurs capture only about two percent of the surplus they generate--consumers (society) capture the rest. Entrepreneurs take risks, to be sure, but it just doesn't seem quite right that they go through the analytical  probability calculations that Manzi outlines. In many cases, they are explicitly pursuing "psychic rewards," knowing that the pecuniary payoff might be less than that.

In a larger sense, let's put the whole tax issue in perspective: taxes might actually be one type of undergirding for entrepreneurship, so the dampening effect of a slight uptick in tax rates may be overstated. Last month there was a fantastic essay in The New Yorker on the struggles of free-market economists in Iran against the statist Islamic regime, which doesn't seem to understand anything close to basic economics. By depending almost exclusively on oil revenues, the Iranian government does not have any incentive to cultivate productive entrepreneurship--the citizenry depends on the government. In countries like the United States, the government depends on the people and entrepreneurs, and taxes are the mechanism of that dependency. This, needless to say, is much more salutary for economic growth and democracy.

*with apologies to Alkaline Trio

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