Taxation exercise

taxesMy friend Oak Norton has a nice little writeup on Taxation and the Monetary Policy that I found to be a very worthwhile mental exercise. I’ll try to summarize it here for you.

Scenario 1: Let’s assume that the tax rate is a flat 10%. One dollar ($1.00) is put into circulation and that one dollar never gets put into the bank, but instead continually circulates into the economy, by changing hands of regular buyers and sellers. How much money will the government get in taxes from that $1? The answer is simply $1. For those who didn’t come up with that answer, let me explain, for everyone else skip to scenario #2. The first person to receive the dollar will pay 10 cents in tax and have 90 cents left over to spend elsewhere. The second person receives 90 cents, pays 9 cents in taxes and has 81 cents to spend. This continues until 73 people have benefited from this money, and the original one dollar is now gone by being taxed out of existence. If you add up all the money each of the 73 people received you would get $10.

Scenario 2: Take the above scenario and only change one variable, the tax rate, and change it to 20%. How much money will the government get from that $1? The answer is still $1. So what did change by increasing the tax rate to 20%? The the net benefit of money being circulated is cut in half to $5. The number of people benefiting also drops in half to 35. And finally, although the government didn’t get any more tax revenue from doubling the rate, they did get it twice as fast.

As you continue to raise taxes the amount of money collected always stays the same, but the amount of money being circulated decreases at a faster rate resulting in a smaller net benefit, and that money touches fewer hands.

Don’t misunderstand me here. Obviously these isolated scenarios don’t take into account the many other variables at play inĀ  the real world. When the tax rate goes up, of course government collects more in tax revenue as a whole. In the real world as money changes hands additional money is added from the person’s own pocket each time a transaction is made to make up for the loss in being taxed. The scenarios above don’t take this into consideration.

Has this taxation illustration changed the way you think about taxes? leave a comment below