I had an interesitng email exchange with a friend of mine regarding the impact tax policy could have on the current and expected budget deficit.  Excerpts below (he wished to remain anonymous, but this is all his analysis).  It’s not exhaustive, but just some simple back-of-the envelope math. The bottom line: income taxes is not going to make a meaningful dent in covering the deficit.  Moving in that direction, plus all the money that is being pumped into the bail-out moves us closer to a hyper-inflation scenario that my colleague Santo discussed previously.

“I did some analysis based on a conversation I had this weekend. The basic point was to see if it’s even logical to say that you can increase taxes on the rich, decrease taxes on the poor and make your way out of this mess.

Some data:

Average US household income was $53,100
The # of US households is 116,011,000
So, total US household income is $6.1 TT

Total Rich Household Income:
1.93% of households make over $250,000 (let’s call them “rich”).
So, 2,239,012 HH make over $250,000.
If you presume the average income of these HHs is $600,000 (generous I think), Total US “rich” household income is: $1.3TT.

Total Non-Rich Household Income:
So, that makes total non-rich household income $4.8TT.

Here’s the interesting thing:

If you incrementally raise the income tax on the “rich” by 5% (effectively by removing the Bush tax cuts), that’s only $67B in income. But, if at the same time you lower the taxes of the non-rich, by even 1%, then you’ve given up $48B in tax revenue. So, effectively, if you increase taxes on the rich by 5%, and lower taxes on everyone else by 1.5%, you’ve netted out at zero.

Another interesting thing. Let’s say you go crazy and raise taxes on the rich by an incremental 15%. So, you take the 35% tax bracket to 50%. The incremental tax revenue is $200B. That’s barely enough to cover the bailout of the auto-manufacturers.

Another interesting thing. If you wanted the rich to cover the projected 2009 US deficit of $2TT, even if you taxed the rich at 100% of their income and kept everyone else constant, you wouldn’t cover the deficit – you’d come $700B shy.

Another interesting thing. In order for the non-rich to cover the projected $2TT deficit, you’d have to raise taxes on them by 40% to create $2TT of incremental tax revenue. So, theoretically, take the 15% tax bracket to 55%.

So, what’s the point – you can’t dent this deficit by increasing taxes on the rich and lowering taxes on everyone else. Holding everything else constant (i.e. tax increases don’t decrease other revenue streams – like sales tax, etc.), the only way to cover the deficit from a tax revenue perspective is to raise taxes on everyone in an unrealistic way.

So, let’s say you think I’m being unfair by using the $2TT deficit number because of the stimulus packages that are hitting the books this year. So, let’s say I use a more steady state $1TT deficit. And, let’s say, you want to increase taxes on everyone, but you want to increase taxes on the rich at 2x the amount of the non-rich. In order to create $1TT of additional income tax revenue, you’d have to raise taxes on the rich by 28% and raise taxes on the non-rich by 14% to create $1.05TT in revenue. That means that the rich pay a at a tax rate of over 60% (33%+28%) and everyone else is around 30% (15%+14%).

Just for kicks, what if you did want to cover the $2TT deficit? You’d have to increase taxes on the rich by 54% (take the 33% bracket to 87%) and raise taxes on the non-rich by 27% (take the 15% bracket to 42%).

So, what’s the point. Not only can you not differentially tax (rich v. non-rich) your way out of this problem, you just can’t even non-differentially tax (rich and non-rich) your way out of this problem. It is flat out unrealistic and impossible. You have to cut spending. You have to stop bailing out everyone. And, you have to encourage productivity without spending money (which ironically often means lower taxes).