David R. Henderson  

California's Laffer Curve: Playing with Fire

Would the Private Sector Make ... Altering the Federal Debt Stru...

It's not Go Galt: It's Go to Texas.

As I have noted before, the Laffer Curve--the curve that relates tax revenues to tax rates--must be correct. The relevant question is where we are on the Laffer Curve. Are we on the part of the curve--the "prohibitive region"--where an increase in marginal tax rates will reduce revenues and a decrease in marginal tax rates will increase revenues? For the United States, I think the answer is pretty clearly no.

But what about for California? We are about to have an empirical test. Proposition 30 garnered about 54 percent of the vote earlier this month. One provision is a one-quarter percentage point increase in the sales tax rate.

But the other provision is a substantial increase in marginal tax rates for the highest-income taxpayers. I'll give the rates for married filing jointly and you can find the others here.

For taxpayers with taxable income between $250K and $300K, the marginal rate rises from 9.3 percent to 10.3 percent.
For taxpayers with taxable income between $300K and $500K, the marginal rate rises from 9.3 percent to 11.3 percent.
For taxpayers with taxable income between $500K and $1,000,000, the marginal rate rises from 9.3 percent to 12.3 percent.
For taxpayers with taxable income over $1,000,000, the marginal rate rises from 10.3 percent to 13.3 percent.

Why would I raise the issue of the Laffer Curve in the context of California's Prop. 30? For two reasons.

First, the way you're most likely to get into the prohibitive region is to raise the marginal tax rate on the highest-income people. This is because their marginal tax rate is already high and they generally have the most flexibility in arranging their affairs to reduce their tax.

This flexibility leads to my second reason. When state governments increase tax rates, people in those states have a relevant option that is not relevant to a discussion of increases in federal tax rates. Specifically, they can move to one of the other 49 states. So a simple estimate of the elasticity of taxable income with respect to marginal tax rates will underestimate the actual elasticity. Some of those other states with lower marginal tax rates on high-income--and that includes virtually all the other states--will be attractive substitutes. Texas, for example, has no income tax. Neither do Washington, Florida, and Nevada, to name just 3 others.

Notice one powerful implication of this second reason that makes the analysis quite different from the analysis for federal tax-rate increases. Whereas when the federal government raises tax rates, any loss in revenue is due mainly to people cutting back on their income somewhat, when a state government raises marginal tax rates, people who move to another state cut the income that the state taxes to zero.

A numerical example might help. Take someone making one million dollars annually who lives in California. He now pays approximately $88,000 in state income taxes. With the new higher tax rates, the California State government is planning to collect approximately an extra $19,500 from him, for a total of about $107,500 in tax revenue. But if he moves to another state, it collects a big fat zero. Revenue falls by $88,000. What if one out of every ten people making one million dollars a year leaves California and the rest don't change their behavior in response to the higher rates? Then the tax rates, which were estimated to extract an extra $195,000 from these people, instead extract $175,500 from the nine who stay ($19,500 * 9) but lose $88,000 from the guy who leaves. Net revenue increase: not the planned $195,000 but, instead, $107,000, or only 55% of the amount the government planned on. And, remember, that's if the other nine don't adjust their behavior at all.

Jerry Brown, who pushed hard for this tax increase, and the California voters who voted for this, are playing with fire. They started the fire; I didn't.

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The author at Roth & Company, P.C in a related article titled Tax Roundup, 11/19/2012: Pushing the AMT patch over the Fiscal Cliff. Also: Muscatine! writes:
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COMMENTS (32 to date)
Hana writes:

I think you have a typo. The first marginal increase is from 250k to 300k not 500k.

In addition to California, isn't there a national effect? Each of the non-income tax states have a significantly lower cost of living. If the COL in Austin is 35% lower than in California, wouldn't an earner be indifferent to 500k in income in California and 325k in income in Austin? If that is the case, then even setting aside deductibility of state income tax, the Federal government will receive less tax revenues.

The alternative of course is that the income is independent of location. In that case, the Federal government will receive more income by the relocation. If this were the case, the Feds should be encouraging all of the high income people to leave California and other high tax states.

If income is independent of location, the decision for the high income earners is whether or not at the 1,000,000 level living in California is worth an additional $3000 per month.
I think you are right that many will vote by moving, that it is not.

hana writes:

And then I have my own typo. Delete 'that it is not.'

John Fembup writes:

"Are we on the part of the curve--the "prohibitive region"--where an increase in marginal tax rates will reduce revenues and a decrease in marginal tax rates will increase revenues? For the United States, I think the answer is pretty clearly no."

Your discussion focuses on individual rates. It's my understanding that U.S. corporate tax rates are now the highest in the world. In your opinion, might the corporate rates be in, or approaching, the "prohibitive region"?

David R. Henderson writes:

Correction made. Thanks.
@John Fembup,
I think we may well be in the prohibitive region with the corporate income tax rate.

Mike W writes:

This same argument...and the same forecasts of dire consequences...get made everytime California (or NY) raises its taxes. But those folks making a million dollars...or even $250k...don't seem to be leaving in numbers that really make any difference. So the legislators keep pushing the envelope and raising taxes. Maybe those "millionaires and billionaires" just have the ability to raise their income so as to cover the additonal tax.

Steve Sailer writes:

Most touring golf pros live in the income tax free states of Texas or Florida. For example, native Californian Tiger Woods changed his state of legal residence from California to Florida on the day he turned pro in 1996 to avoid California's income tax.

On the other hand, the two big generators of wealth in California are Silicon Valley and Hollywood, and they aren't particularly easy to be active participants in if you live in Texas or Florida for tax reasons. These are industries where Who You Know matters. Remember the scene in The Social Network where Justin Timberlake convinces Mark Zuckerberg that he's wasting his life at Harvard, that he has to physically be in Silicon Valley to succeed?

Will that really change under marginal state income tax rates a few points higher?

wd40 writes:

Florida does not have an income tax (and given all the retirees it would not make much sense to have one). Instead, Florida has a property tax rate that is twice as high as that of California. So moving from California to Florida may not be as financially rewarding as your numbers suggest.

another Bob writes:

Ah, democracy - 3 guys vote that a 4th guy gets to buy them lunch. The 3 are shocked SHOCKED when the 4th refuses to have lunch with them again. But, never mind, 2/3rds is still a super majority.

You don't have to actually leave CA. Just buy a house in NV - very cheap.

another Bob writes:

I've made a $100 bet - the total CA state budget deficit in '13, '14 and '15 will be greater than '09, '10 and '11.

Steve Sailer writes:

A lot of people are grandfathered into their California homes by Proposition 13 keeping property taxes down. It cuts down on turnover in population. On my culdesac, four of the eight households have been in their homes since the 1970s.

David R. Henderson writes:

Those high property taxes in Florida are well known. Put on your economist cap for a minute. What does that mean about who bears the burden: the people who move there now or the current owners?

Methinks writes:

So moving from California to Florida may not be as financially rewarding as your numbers suggest.

This is not a problem. Property taxes are not a function of income and so you are free to make as much money as you want without punishment. Also, to increase your property taxes by $107,000, you'd have to buy a house worth about $10 Million dollars MORE than the one you already have in California. And my bet is that comparably houses are much cheaper in Florida than in California.

I made exactly this move from Greenwich, CT a couple of years ago to escape Connecticut's obnoxious and growing income tax. And the property tax rate in Greenwich is about one third of the rate I pay in Florida.

David Friedman writes:

There are two things you left out of your analysis. The first is sales tax. When your million dollar a year taxpayer moves to Texas, that costs California his sales tax as well as his income tax. If he spends all of that income on taxable items, that comes to about $75,000 to $100,000, depending on where he lives, bringing the net revenue from the tax increase, in your example, almost to zero.

The second is that, while moving to Texas saves the taxpayer all of his state income tax, reducing his taxable income saves him both state and federal income tax, which is a lot more. Your hypothetical tax payer faces a marginal rate, federal and state combined, of about 50%, which may make more leisure, or forms of income that don't show up on the tax forms, attractive.

Steve Sailer writes:

Lots of luck getting venture capitalists to invest in your tech start-up in Orlando or a network to pick up your sit-com in Houston.

David R. Henderson writes:

@David Friedman,
Good points.
On your second point, I was down in San Diego last week to visit my distance-learning class and teach in person. I took my sister-in-law out to lunch and we were discussing my nephew, who is a very successful web entrepreneur. I said to her, "With Prop 30 and Obama's re-election, both Barry and Jerry are after him."

Krishnan writes:

A common assumption amongst many is that CA is just so attractive, that no matter what the STATE does, they will just keep taking the abuse. Yes, it may indeed be true that in the short run, the STATE can impose higher taxes, penalties, regulations on businesses - and none of it will appear to have an impact right away. Those that remain (and are somehow tied to what is happening in CA) will do their best to increase access to the politicians - and get themselves a better deal on their taxes, regulations, whatever - it simply increases cronyism - "rent-seeking".

It may also be very true that today, much of the venture capital/capitalists are concentrated on the West Coast/Northern CA in particular. Developing a critical mass of such people elsewhere will take some time, but it will happen. The loudest (prog)(reg)ressives will feel the pinch on their earnings/wealth as those they hire feel the pinch. It is definitely coming.

Methinks writes:

That's not a problem, Steve Sailor. A little thing called "technology" has made the world a lot smaller, freeing me from having to trek to a physical exchange daily and others from having to staple themselves to Silicone valley or even Hollywood. So long as you have all the pieces in place, VC firms and Hollywood studios don't care where you reside.

All it takes is a little imagination and you would be amazed at how resourceful and imaginative people become when we are faced with rising tax rates.

Methinks writes:

Also, remember something else: Personal income taxes are not applied in the state in which you do business but in the state in which you reside. Start-ups are cash flow negative, so starting them in California won't generate a big tax burden. Once they're successful, the entrepreneurs can move to the no-tax Washington or Nevada even while keeping their business situated in Silicone Valley. No need to move to the East Coast.

Also, as I've said repeatedly in the comment section of this blog (and will say again), there I expect more compensation in the form of pre-tax consumption. Instead of increasing taxable money income, firms will provide company housing, vacations, use of the private jet, a company car, and all kinds of non-taxable perks. I only came to this country in the mid-1970's and my English and awareness was not so great back then, but I do seem to remember such a model in the presence of a 70+% top marginal rate. This was definitely the case in Mitterrand's France.

When the sclerotic government goes up against thousands of smart, motivated people, my bet will always be on the government losing.

MG writes:

I agree that all the pieces are in place for a susbtantial Laffer curve effect. However, there are still some frictions that will delay the fall. To the extent that high income marginal income taxes at the federal level continue to increase and that the tax code is not reformed (the Admin's game plan), these increases will be mitigated by federal deductibility. Moreover, I suspet that high-income Californians must by now be experts at all kinds of way of deferring and reclassifying income to minimize the tax bite -- which now incudes providing employees valuable non-taxable benefits in lieu reportable income. And what they can't get broadly, many get by private action(Twitter and the city of SF comes to mind). As usual, then, this hikes will mostly hurt the aspiring rich, who may be a bit less flexible both in employment and may be too heavily tied down by real estate distorions.

wd40 writes:

David R. Henderson writes:Those high property taxes in Florida are well known. Put on your economist cap for a minute. What does that mean about who bears the burden: the people who move there now or the current owners?

The high income taxes are also well known In the limiting case there is little difference between high income taxes and high property taxes. Think of place T that is otherwise similar to the surrounding area, but has property taxes that are collected but totally wasted. Property values will be lower because of this. Now suppose that the property tax is abolished and in its place, an income tax is instituted that collects an equivalent amount from each citizen who lives in T (in a simple world people with twice as much income would own houses that were twice as expensive and pay twice as much in taxes regardless of the type of tax). Then property values would not change when taxes were shifted from property taxes to income taxes.

Of course the real world is more complicated because people differ in their preferences and different tax regimes have different effects on the margin. But this does not mean that one can completely ignore property taxes when discussing the role of taxes on migration.

tim writes:

Having recently moved from one high income tax state (MN) to another (CA) - here is something I have never witnessed - people moving out of a state due to the income tax rate. And as someone who is always trying to hire new workers - the income tax rate is never mentioned as a negative (well - it was on my list when we made the decision to move to CA). Its other external factors - schools, weather, environment, spouse being able to find a job, etc. And I spent the last year looking for new gigs in various low tax states. And what I found? Nothing. If you want to build a manufacturing plant and get paid next to nothing - go to Texas. If you want to build a new software product and get paid 150k+ - go to California. There are all sorts of reasons for this. But an income tax or lack of isn't one of them.

Wayne Lusvardi writes:

The problem with the above theoretical analysis is that in the real world only a little less than 1 percent of all millionaires in California migrated out even during the peak out-migration year of 2005.

Stanford University recently conducted a study titled "California Millionaire Migration" - link here:

The data in that study indicates the percentage and total number of millionaires that fled the state from 2001 to 2007 was:

2007 - 0.77% (N=774)
2006 - 0.87% (N= 600)
2005 - 0.98% (N=665)
2004 - 0.78% (N=857)
2003 - 0.74% (N=665)
2002 - 0.74% (N=600)
2001 - 0.88% (N=774)

Let's assume from the above data that about 10 percent of millionaires fled the state from 2001 to 2010, at the rate of 1 percent per year. The problem is that there are nearly as many number of millionaires moving IN to the state as leave each year. So California doesn't care about millionaire outmigration because the odds are 99 to 1 against it; and even if we count the cumulative impact over 10 years the state still isn't concerned because of millionaire in-migration from elsewhere washes the percentage out. So that is why the state's attitude is "good bye, good riddance").

Note: In 2004, California voters imposed a new millionaires tax to support mental health services. As shown in the above data, millionaire outmigration roughly doubled afterward in percentage terms. But the number of total millionaires was growing over the same period so the percentage of millionaire outmigration remain mostly unchanged.

What is perhaps more important is if the new tax rate increases in California retard new millionaires from migrating into the state (not out of the state). Once again, the impact would only be about 1 percent of millionaires per year at the highest.

If you run your theoretic calculation with 1 percent departing millionaires instead of 10 percent, your conclusions are bound to change.

Dan writes:

I live in Calif. While I'm not moving due to the rates--I have to stay because my business is already here--one of my key investors has already sold both of his homes in CA (he put them on the market months ago, expecting 30 to pass).

The next me isn't going to have that investor around when he or she starts a business.

Velocity writes:

I know people that have left California for Texas. I know people in Texas who have been offered jobs in California, but won't relocate. Although taxes, cost of living, etc. are some of the reasons for this, more importantly Texas was seen as offering a better quality of life. California wins out over Texas on climate, but on nearly every other aspect Texas is being perceived as a better alternative.

Silas Barta writes:

@Steve_Sailer: Indeed, as a worker near SV, I'm often perplexed how an industry where output can usually be sent over a wire [1], in reality, depends on physical presence. Though a higher proportion of the work done there can indeed be done outside of the office.

[1] even for hardware, SV's output is the specs/design, not the hardware itself, hence the iPhone's bold declaration on the back that in making it, the "brain work's done in California, drudge work in China" ("Assembled in China, designed in California")

Steve Sailer writes:

"So long as you have all the pieces in place, VC firms and Hollywood studios don't care where you reside."

You'd think, but the opposite has been happening regarding Silicon Valley. Thirty years ago, there were two "Silicon Valleys:" SV and Route 128 in suburban Boston, and a million plans to create more across the country. Instead, Route 128 faded (see "The Social Network"), and Silicon Valley is even more dominant.

MikeP writes:

Just so I can say it once, I have to agree with Steve Sailer here.

Millionaire earners in California are generally in highly networked industry sectors. Their expected income will drop by much more than 10% if they move away from California.

The real impact is seen in people who retire from those sectors. They will in fact move to Florida or the like. And, being retired, their income may not reach a million per year any more, so they won't show up in the millionaire migrant table above.

However, I worry that a significant threat to Silicon Valley -- after, of course, the government -- is newly minted millionaires retiring there, making it even more expensive for new workers to move in. So to some degree highly progressive taxes may make Silicon Valley more affordable and productive.

The bottom line is that living in California still has a sizable consumer surplus. Government keeps skimming more and more of it away, but I don't think they've taken it all yet.

Methinks writes:

Steve Sailor,

That may have been true in the past, but just as Route 128 faded, so too can SV in the future. Never count on permanence in such matters. A change is one creative person's previously unimagined solution away.

I find it interesting that people often claim that "the rich won't leave". Well, ALL the rich won't leave obviously. And those who stay won't necessarily pay higher taxes either. My bet is California won't collect the taxes its hoping to whether or not high earners stay.

Charley Hooper writes:

Why does the mob extort money from businesses? Because it can.

Why does the state of California have high tax rates? Because it can. Governments everywhere want high tax revenues. Only those that happen to be in places where people want to live (have a large consumer surplus) will be able to pull it off. I think the price of real estate is the best indicator of the net consumer surplus.

@David Friedman and David Henderson

Was there another piece missed in the blog? What if that high-income person owned a business that employed ten workers? Moving the business to Texas will deprive California of the taxes from those workers who move to Texas and those who didn't move, but are now without jobs.

DF writes:

Perhaps, the author's math is a bit off?

Assuming 1000 millionaires (faux number).
Assuming $1 million taxable income:
2012: 1000 millionaires x $88,000 = $88 million.
2013: 1000 millionaires x $107500 = $107 million.

Let's say 10% of millionaires leave in 2013:
- 900 millionaires x $107,500 = $96.75 million.

20% of millionaires leave in 2013:
-800 millionaires x $107,500 = $86 million.

Conclusion: California would have to lose nearly 20% of its millionaires (taxable millionaires) before it would lose more tax revenue than it would gain from raising the rates in 2013.

The elasticity of the millionaire tax flight correlating to state income tax rates in California is likely a bit different than they are in other states, but it depends on the industry/occupation, etc... Overall, the 2013 tax likely to help California more than it will hurt it. Math is below.

2012: 88000 x 1000= 88000000 or $88 mill
2013: 107500 x 1000= 107500000 $107
2013: 107500 x 950 = 102125000 $102.12
x 900 = 96750000 $96.75 million
x 850 = 91375000 $91.38 million
x 800 = 86000000 $86 million

David R. Henderson writes:

I think your 20% conclusion is correct and it doesn't differ substantially from mine. So I don't get why you say that my math is a bit off.

DF writes:

I believe the number should be 45%, not 55%. Here’s why I think your math is off:

If 1 of 10 millionaires leaves, CA would still increase their revenue (from 2012 to 2013) by $87,500/per group of 10 (2012 CA millionaires).

In other words, CA may have lost $88,000 from the one that left, but CA still gained $87,500 from the nine that stayed. This amts to an increase of nearly 10% of 2012 revenues. Not only did CA make up for the $88,000 (of 2012 revenue from the one that left), they increased it by nearly the same amt ($87,500).

Perhaps, I can explain it a better way. I’m a salesman. I have 10 customers. I earned $880,000 in 2012. I planned on earning an extra $195,000 in 2013 by charging my 10 customers more on the same products. In other words, my target income for 2013 will be $1,075,000. However, due to one of my customers leaving (because he didn’t like my cost increase), I only earned $967,500 in 2013. Instead of earning an extra $195,000, I only earned an extra $87,500.

Should I be disappointed that I only increased my total revenue by 10% (instead of my target 22%) or should I be happy that I increased my wealth by $87,500 (instead of $195,000), despite losing one customer? I believe the real number is that I met only 45% (not 55%) of my 100% revenue increase goal ($87,500/$195,000). In other words, I only increased my revenue by $87,500 instead of my goal of $195,000. 45% of $195,000 = $87,500.

So, the real question is: What is CA's expectations of millionaire flight in 2013 and what will the actual be?

For the record, I'm not for taxes when this could be prevented in the first place. However, I'd love to know how many of these people are millionaires because of corporate welfare given by the state of CA. This may provide some clues as to why some (or many) of the millionaires aren't fleeing the state. Does the Laffer Curve assume a free market or does it acct for corporate welfare given by state governments?

Here's my math below. I look fwd to learning more. Thanks.

22.16 - Expected Rev Increase (%)
9.94 - Actual Rev Increase (%)
44.87 - % of Achieved Expectation

2012 Actual Revenue $880,000 ($88K*10)
2013 Target Revenue $1,075,000 ($107.5K*10)
2013 Actual Revenue $967,500 ($107.5K*9)

2013 Target Rev Increase $195,000 ($1,075,000-$880,000)

2013 Actual Rev Increase $87,500 ($967,500-$880,000)

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