President elect Obama has proposed raising taxes on incomes over $250,000. He has sold that by saying the rate will be no higher than what prevailed under Clinton. The implication is that behavior of taxpayers will not change because they’ve paid this rate before. In tallying tax revenues in his plan, a static analysis is used where the higher rate brings in higher revenue in proportion to the rise in the rate. But taxpayers aren’t dumb; behavior changes (via AP):

Next year’s major league minimum is $400,000. Agent Scott Boras, negotiating eight- and possibly nine-figure deals for free agents Manny Ramirez and Mark Teixeira, already has thought about the possibility of asking for larger signing bonuses payable this year in some of his contracts.

“There’s some consideration to be had with the impact of the election,” he said.

Free agents can’t start negotiating money with all teams until Nov. 14. Only a relatively small percentage of contracts are finalized before Jan. 1.

Still, for a big-money free agent earning $10 million in 2009, Obama’s plan could increase his federal tax by more than $400,000.

Baseball players won’t be the only ones trying to shift income to this year to avoid the higher rate next year. The wealthy have more options than the middle or lower classes and will take actions to shift income to this year or alternatively to capital gains rather than regular income. If the individual rate exceeds the corporate rate, we will also see a lot of subchapter S corporations shifting to C corps. That’s the problem with a system with so many different rates for different types of income.

I’m not advocating raising capital gains and corporate rates to match the higher individual rate. That would be economic suicide. It seems to me that we should start rewarding investment and savings over consumption. That could be accomplished by cutting or eliminating corporate and capital gains taxes. Yes, the wealthy would shift their income, as much as possible, to those activities and avoid some personal income tax, but the benefit of increased investment would be shared throughout the economy.

Tax rates do affect behavior. To deny that is to deny reality. What a smart politician would do is try to take advantage of the change in behavior rather than deny it.

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