Sunday, October 26, 2008

The True Effects of the McCain and Obama Tax Plans

The long term effects of taxes can be hard to comprehend. Greg Mankiw does a great job of explaining those effects. He calculates the effect of one dollar with a rate of ten percent over 35 years. He calculates separately what would happen with no taxes, under the McCain tax plan, and Obama tax plan according to the Wall Street Journal. The results; after 35 years one dollar would become $28 with no taxes, $4.81 under McCain's tax plan, and $1.85 under Obama's tax plan.

This does an effective job of showing the dampening effect of taxes on people's desires to do more work to leave more money for their children; assuming they understand or know the effects. They would be sacrificing time they could otherwise spend with their kids. If that means giving their children a much better or easier future then it may be worth it. Set the taxes to high and you remove the incentives.

Hat tip to Instapundit (

"Let me try to put each tax plan into a single number. Let's suppose Greg Mankiw takes on an incremental job today and earns a dollar. How much, as a result, will he leave his kids in T years?

The answer depends on four tax rates. First, I pay the combined income and payroll tax on the dollar earned. Second, I pay the corporate tax rate while the money is invested in a firm. Third, I pay the dividend and capital gains rate as I receive that return. And fourth, I pay the estate tax when I leave what has accumulated to my kids.

Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:


For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years.

If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario. In a sense, putting the various pieces of the tax system together, I would be facing a marginal tax rate of 93 percent.

The bottom line: If you are one of those people out there trying to induce me to do some work for you, there is a good chance I will turn you down. And the likelihood will go up after President Obama puts his tax plan in place.

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