Dollar's demise traces roots to tax trap

The history of financial markets suggests that crashes are painfully common. Steady bad news very often leads to a rout. Sadly, the scenario that turns the dollar's bear market into a crash is beginning to look like a sure thing.

If a dollar crash were to occur, it might happen because foreign investors decide that the U.S. has fallen into a so-called tax trap. A tax trap occurs when a nation finds itself unable to increase revenue by lifting tax rates. Such a circumstance, if 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. If doubt about the latter deepens, all bets are off.

Why might the U.S. be in a tax trap? The problem is that the U.S. income tax, a primary source of federal revenue, is very progressive, and has high rates. When rates are already high, it becomes harder and harder to raise money by lifting them more. This is, of course, the observation that made economist Arthur Laffer famous, and for the U.S. it is a real concern.

First, our corporate tax rate is the world's second highest, and a number of recent studies have found that such rates don't lead to more revenue. This version of the Laffer curve is now fairly widely acknowledged.

But what is less commonly understood is that our graduated income tax also 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 US$250,000. But lifting only that top marginal rate can have perverse revenue effects.

Here is why. When tax rates go up, wealthy individuals have many options to reduce their tax bill. They can work a little less, they can purchase municipal bonds that pay tax-free interest, and they can take a vast number of other similar steps.

If we start with a tax rate of 35 percent, then 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 percent to 45 percent — 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.

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