T
he U.S. dollar has slowly tanked this year. The scenario that turns the dollar’s bear market into a crash is beginning to look inevitable.
A dollar crash might happen because foreign investors decide that the U.S. has fallen into a so-called tax trap, which occurs when a nation is unable to increase revenue by lifting tax rates. This circumstance, paired with mounting deficits, can lead to wholesale flight from a nation’s assets. The Chinese will only lend money if they think we will pay it back
The graduated U.S. income tax probably has reached the point where higher rates raise little new revenue, at least given the political landscape. President Barack Obama has pledged to only increase taxes on those with incomes higher than $250,000. But lifting only that top marginal rate can have perverse revenue effects.
When tax rates go up, wealthy individuals have many options to reduce their tax bill. With a tax rate of 35%, for every dollar of income reduction, the government loses 35 cents. After the adjustment occurs, the government collects revenue via the higher rate applied to what is left. If you lift the marginal rate from 35% to 45% — assuming taxpayers adjust their incomes lower — then you lose 35 cents for every dollar of income reduction, while getting back 10 cents on every dollar that is left in the top bracket. The revenue effect depends on how much income adjusts, and how much income is left in the top bracket after that adjustment.
Let’s take the tax changes the Democrats have planned for next year. They want to let the top marginal rate go from 35% to 39.6%, and to reduce the value of itemized deductions in a way that adds a little more than 1% to the marginal tax rate, making the total 40.8%.
The top income tax rate kicks in for a married couple at $372,951. Everyone with an income above that will face the higher rate, and some adjust their taxable income down accordingly. A study at the University of California-Berkeley suggests that these taxpayers would reduce their income by about 5.2%.
If so, the tax increases will raise very little revenue. In fact, for every individual with income below about $613,000, the government will actually lose money because of the tax hike. The 35 cents lost for every dollar of income reduction isn’t offset by the roughly 6 cents gained on the income that remains.
The numbers are even worse if we analyze the 5.4% millionaire surtax that just passed the House as part of the health-care bill. Within the top tax bracket, the lower the income, the more people there are with that income. You have to collect a lot more money from the richest taxpayers in the bracket to offset the revenue losses from those at the bottom of the bracket as they make moves to avoid the tax by lowering their income. The net revenue raised by these tax changes is likely to be tiny.
The government deficit already looks like it will approach $1-trillion a year over the next decade. But in fact, the higher tax rates, especially those that are, as in the health-care bill, paired with higher spending, are going to make it worse.
When investors see that higher taxes deliver little new revenue while spending soars, they will head for the exits.
The dollar will be dead, and the tax trap will have killed it.
