“Joe the Dentist:” A Case Study in Marginal Wealth Taxation

It seems that far too many Americans have a fundamental misunderstanding of basic economic principles.

Sure, there are economic theoretical intricacies that even experts quibble over, but there are also simple concepts that the layman can understand, withstanding lack of interest and/or shoddy education.  So there are the ignorant, but there are also those who lack not the information and understanding of free market principles, but simply dismiss them outright on ideological grounds.  The former case (that of simple ignorance) frustrated me to no end during our last election cycle.  Good, well-intentioned people were swept into the notion that raising taxes only on the super wealthy would have either no effect on themselves…or even a positive effect on them!  I recall one person commenting that after talking with her employer (the owner of a small pizza parlor), she felt assured that raising taxes on incomes over $250,000 would have no impact on her particular place of employment or herself.   And so, she announced, she would be voting for Barack Obama.

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I present here A Case Study in Marginal Wealth Taxation.

In 1977, when Jimmy Carter took office, the federal personal income tax rates for the bottom and top brackets were 14% and 70%, respectively.  Yes, that number was 70%.  But people making over $200,000 in 1976 could certainly afford to pay taxes at a rate of 70%, you say!  Well, sure, but in just a moment we’ll learn that whether or not they could afford to, or whether or not you think it’s fair that they did, is frankly irrelevant.  First off, the way marginal tax rates work is like this:  The bottom bracket, taxable income up to $1,000, was taxed at a rate of 14%.  Even people in the top bracket only paid 14% on their first $1,000, then they were taxed at the next rate for the next segment of their income, and so on until they reached $200,000.  Every dollar they earned above that threshold was then taxed at 70%.  And these were just the federal rates, folks.  State income and sales taxes, property taxes, luxury taxes, etc., etc. all were in addition to this.  So what was the effect on the overall economy of a marginal rate that burdensome?  Did it really affect anyone besides just the rich guys?

My father moved to California around that time and witnessed firsthand a remarkable example of the power that tax rates have to affect the behavior of high income earners…which thus affects the economy as a whole.  His cousin was a self made, well established dentist.  He moved to southern California when it was nothing but orange groves and grape vines and worked his tail off to build a practice there.  This man was a very hard worker and was making a good living for himself.  He worked four chairs at a time to keep his practice hopping Monday, Tuesday and Wednesday…and then he would take a four day weekend.  This dentist, we’ll call him “Joe,” realized that if he worked any harder…if he produced any more wealth…he would have to fork over to the government more than 80¢ on every extra dollar that he earned.  On top of the fed rate of 70%, the California state income tax rate was 11.6%.  Joe figured he was already earning enough money to make a comfortable living and that his time was worth more than just 20¢ on the dollar, so he took the long weekend to pursue hobbies and spend more time with his family.  How selfish of him, you say!  But that 80¢ could buy so many food stamps and build so many housing dumps projects, you say!  We’ll address this later.

Here’s where it gets really interesting.  While Joe was on vacation Thursday and Friday, so were his receptionist…and his hygienist…and his x-ray technician…and his assistants, and whoever else works in a dental office.  When he wasn’t working the entire office was closed and thus everyone else employed there wasn’t working either.  So now not only was Joe earning a lower income, but all of his employees were earning less as well.  (Huh, I wonder if that affected the amount of tax revenue to the government?)  I don’t know if you remember, or know, anything about the Carter years, I wasn’t even born yet, but the economy was in quite a slump.  By the end of his term inflation was at 13.5% and unemployment was at 7%.

Then in waltzed Reagan in 1981 who, not without a fight, cut the top marginal rate to 50%, effective 1982.  Suddenly, Joe began working six days, adding Thursday, Friday and Saturday to his workweek; and all of his office staff were working more…and earning more…as well.  Suddenly there was more incentive for Joe to work harder…the government was now “letting” him keep 40¢ of every dollar he earned, rather than a measly 20¢.  Why sit home four days out of seven anymore?  But Joe didn’t stop there…as his incentive to work (the percentage of his money that he had earned and was allowed to keep) increased, so did his ambition.  As the tax rates continued to come down, he began to expand his practice accordingly. By1987, the top rate was down to 38.5% and then to just 28% in 1988 (the threshold for the top tax bracket was also drastically cut during this time, so more people were all being taxed at this same percentage).  It reached it’s highest rate since under Clinton, at 39.6%.  All of this data can be found here.  Since Joe was such an ambitious fellow and hard worker, he expanded his practice by opening a second office…and eventually a third!  And with the new offices, Joe now employed even more people.  He was now really working his tail off, and reaping apt rewards.  He had a large timeshare in a houseboat and had a small private plane…as well as a couple of vacation homes (purchasing such luxury items, as well as maintaining them, stimulates a variety of  industries that have nothing to do with dentistry).

Do you see now why talk of raising taxes “only on the wealthy” is a dangerous thing, especially during a recession?  Tax cuts stimulate growth; tax increases stifle it.  Not only that, but tax revenues actually increase with lower rates, because people earn more income which can in turn be taxed.  History has shown that “the reduction of high marginal tax rates actually increas[e] tax payments by ‘the rich,’ [and] also increas[e] their share of total individual income taxes paid.” (JEC Report, April 1996)  So by cutting the rates and thus increasing the revenue, there is actually more money to buy food stamps and build housing projects.  Huh.  And now that Joe has more discretionary income than before he can also donate more of his personal income to charities of his choosing, thus further benefiting society.  He also has more money to spend on consumer goods and services, which stimulates the economy as a whole.  And he has more money to invest, which also stimulates growth.  You get the point.  Our economy, our country, is made up of lots and lots of Joes.  The fact that one person achieves financial success does not necessarily mean that another one is thus unable to achieve it, or is somehow restricted in his ability to do so.  The more successful people there are, the more the economy as a whole (and everyone participating in it) benefits.

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This is not complicated to understand when illustrated with a real life scenario such as this…in fact, it is frankly common sense.  So then why are there intelligent people, some economists even, who argue against the natural laws of economics?  Ideology, folks.  A determined liberal, and certainly a socialist, doesn’t like the results of a capitalist economy.  Never mind that more people are working, more people are producing, more people have more, and there is more tax revenue to actually help those who don’t have as much….  It’s still just not fair that some people are rich and some people are poor!  Never mind that socialism, and certainly communism, has never in the history of the world…for all the times and places it has been tried…succeeded in creating an equally prosperous existence for everyone involved.  It has succeeded somewhat it creating a fairly equally miserable existence for everyone involved.  But ideologically driven foolishness idealism fuels such thinking nonetheless.

A leftist would respond to the story of “Joe the Dentist” and say, first off, that Joe is selfish not to work six days out of seven under such a heavy tax burden, simply for the good of society.  But isn’t that what inspiring demagogues orators like Barack Obama are for?  The sheer magnitude of his personality should inspire Joe and all citizens to “do their part.”  Reality check:  this is the USA, not the USSR…and even in communism the idea of “from each according to his ability, to each according to his need” fails miserably when put to the test.

The leftist would next respond, well…there is only so much work to go around anyway, so it is good that Joe only works three days.  That gives other dentists the opportunity to pick up the work that Joe is not performing…after all, no one dentist should be allowed to accumulate too much disproportionate wealth.  This mentality is based on the notion that there is a fixed amount of wealth in the world and that governments should seek to distribute it as fairly as possible.  The problem is that such thinking is bunk.  The wealth in a specific economy, or in the world as a whole,  is like a balloon…it can expand or deflate.  Or there is the pie analogy.  A leftist believes that there is only one pie and everyone should have as equally sized a piece as possible (that makes for tiny little slivers of pie); conservatives say, let’s just bake more pies!  Let’s create an atmosphere where as many people as possible can create and accumulate as much wealth as their abilities, ambition, and hard work will allow.  But I am getting off on a tangent here; the subject of wealth creation shall be another post for another day.

The socialist paradise called France actually tried the above strategy; the government mandated by law that no one was allowed to work more than 35 hours per week.  A sliver of sense returned to the country after a decade of the nonsensical policy.  From the Associate Press, July 25, 2008:

“Reforming the 35-hour law was one of President Nicolas Sarkozy’s pledges during last year’s presidential campaign.  Sarkozy says the 35-hour law was an economic mistake that did not create jobs as it was intended to do…

“…[the] move was the latest rollback to the controversial work-share scheme introduced by a Socialist government 10 years ago.”

You see, with Joe working more, and his employees working more, and just about everyone working more…there is higher earning potential and more disposable income available to just about everyone.  So now  there is more dental work to be had.  Someone who was previously unemployed or underemployed may have been putting off dental work for months or years because they simply couldn’t afford it.  Someone else may now have the money to pay for cosmetic dentistry that they hadn’t even considered before.  So not only is there enough work for Joe to expand his practice, but there is an opportunity for another dentist to move in and start a practice of his own.  It’s an upward spiral…this is economic growth, and it benefits everybody (except for perhaps Democrat politicians who thrive on class warfare rhetoric).  It works to the contrary as well.  I have a friend who works in a dental office that has seen its workload decrease dramatically with this downturn.  People are simply opting to put off their nonessential dental needs.  Because of this my friend, who is part time, was simply not needed for a few months straight…so during that time she had less income to spend (and to be taxed).

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A few highlights from the Joint Economic Committee Report of the U.S. Congress, April 1996:

“During the summer of 1981 the central focus of policy debate was on the Economic Recovery Tax Act (ERTA) of 1981, the Reagan tax cuts. The core of this proposal was a version of the Kemp-Roth bill providing a 25 percent across-the-board cut in personal marginal tax rates. By reducing marginal tax rates and improving economic incentives, ERTA would increase the flow of resources into production, boosting economic growth. Opponents used static revenue projections to argue that ERTA would be a giveaway to the rich because their tax payments would fall.

“The criticism that the tax payments of the rich would fall under ERTA was based on a static conception of human behavior. As a 1982 JEC study pointed out,[1] similar across-the-board tax cuts had been implemented in the 1920s as the Mellon tax cuts, and in the 1960s as the Kennedy tax cuts. In both cases the reduction of high marginal tax rates actually increased tax payments by ‘the rich,’ also increasing their share of total individual income taxes paid.”

“High marginal tax rates discourage work effort, saving, and investment, and promote tax avoidance and tax evasion. A reduction in high marginal tax rates would boost long term economic growth, and reduce the attractiveness of tax shelters and other forms of tax avoidance. The economic benefits of ERTA were summarized by President Clinton’s Council of Economic Advisers in 1994: ‘It is undeniable that the sharp reduction in taxes in the early 1980s was a strong impetus to economic growth.’”

“…reduction in high marginal tax rates can induce taxpayers to lessen their reliance on tax shelters and tax avoidance, and expose more of their income to taxation. The result in this case was a 51 percent increase in real tax payments by the top one percent. Meanwhile, the tax rate reduction reduced the tax payments of middle class and poor taxpayers. The net effect was a marked shift in the tax burden toward the top 1 percent amounting to about 10 percentage points. Lower top marginal tax rates had encouraged these taxpayers to generate more taxable income.

“The 1993 Clinton tax increase appears to [be] having the opposite effect on the willingness of wealthy taxpayers to expose income to taxation. According to IRS data, the income generated by the top one percent of income earners actually declined in 1993.”

I seek not to persuade leftists firmly set in their ideology, but rather to inform the ignorant and misinformed…those people who have not yet jettisoned common sense entirely in exchange for the comforts of liberalism.   As Rush says, “ignorance is our most expensive commodity.”  Rightly so.  Let us rise above the rhetoric and base emotions of class warfare and rely on common sense instead.