The Futility of Raising Taxes
January 17, 2010
Governments everywhere today aim to pay for their immense and exploding debts by raising taxes. It won't work. It has never worked.
This graph, straight from the U.S. Congressional Budget Office, illustrates Federal tax revenues over the past fifty years:
Revenues, by source, as a share of Gross Domestic Product for Fiscal Years 1957-2007
More from the CBO
From this we make a few observations:
1) The trend is flat. There is no appreciable long-term rise or decline in revenues as a percent of GDP.
2) The minor variation in the trend corresponds to recessions and booms, not tax hikes or tax cuts. We can see a fairly large decline in the 2002 recession, another around 1992, another around 1982, another around 1971 and one in 1958. These are all recessions. We see no correspondance between tax revenue declines and major tax cuts, such as the Kennedy tax cut (1964), the first Reagan tax cut (1983), the second Reagan tax cut (1986, in which the top income tax rate fell to 28%), or the capital gains tax cut of 1997. 2003, the year of the Bush tax cut, was a dip, but that was because the Bush tax cut was coincident with the recession. Actually, this was the passage of the tax cut, which did not really take effect until the second half of 2003 at the earliest, for which there is no appreciable dip in revenues.
Likewise, the major tax hikes, such as the Nixon tax hike of 1969, the "bracket creep" inflationary tax hikes of the 1970s, and the Clinton tax hike of 1994, do not produce any substantial or sustainable increase in revenues/GDP.
See what I mean?
3) The makeup of taxes changes, but the total remains the same. As we can see, payroll taxes have risen by several multiples since the late 1950s. Corporate taxes have, on average, declined, although this decline really dates from the 1970s rather than recent years. (If you consider that a little more than 50% of the payroll taxes are actually paid by corporations, corporate taxes have remained roughly flat over the years. The increase in payroll taxes was also matched by a decrease in excise taxes.)
There you go: tax rates up, tax rates down, new taxes introduced, old taxes eliminated, none of it has made a whit of difference to the tax revenues of the Federal Government -- as a percentage of GDP. General economic conditions -- expansion or recession -- definitely have an effect, but that is transient.
Over that time, the U.S. tax system has been subject to all kinds of changes. The top income tax rate in 1957 was 91%! In 1979, it was 70%. In 1986, it was 28%, and today it is 35%.
What does this mean?
1) Raising tax rates will produce no new revenue (as a percent of GDP).
2) Cutting tax rates will not result in a fall in revenue (as a percent of GDP).
I am using the future tense ("will not") here. Of course, the future is not so certain. But, that is the best guess we can make with the evidence at hand.
3) Budget surpluses/deficits are entirely due to the variation of spending as a percent of GDP. So, pretty much all the "tax cuts caused/will cause budget deficit" and "tax hikes caused/will cause budget surplus" talk you've heard over the past fifty years is baloney.
Does this mean that higher/lower taxes "don't matter"? Absolutely not. It's one of the most important things there is. But it doesn't matter to tax revenue as a percent of GDP.
Low taxes are one part of our Magic Formula:
Why are tax revenues stable over time? I hypothesize that U.S. citizens have an idea of an upper limit of how much they are willing to pay the government, and they pay exactly that, and no more. If the U.S. government asks for more than they want to pay -- if the tax rate is too high -- then the people find a way to not pay. They cheat on their taxes, in small ways and large. They don't engage in highly-taxed activities, and do something else instead. They operate in the underground or under-the-counter economy. They pay lobbyists to pay Congresspeople to punch the tax code full of loopholes. Political support for lower taxes rises, and maybe there's an official tax cut. In the extreme case, people leave the country.
However, tax rates have a dramatic effect on GDP. So, even though tax revenue as a percent of GDP may be stable, the effect of lower tax rates can be to expand GDP significantly. This is not so noticeable in the U.S., because our tax system has been subject only to small tweaks over the past twenty years. However, it is very noticeable in the case of the big tax-cutters, who often enjoy an extended period of spectacular economic expansion. During the 1950s and 1960s, Japan's nominal GDP (measured in noninflationary gold-linked yen) expanded by about 16 times, as the government cut taxes every year. However, Japan's ratio of revenue/GDP remained quite stable during that period. This means, arithmetically, that Japan's tax revenues also expanded by about 16 times. So you see, tax cuts can be very productive of government revenue!
From this, we can see that:
1) If tax cuts don't affect the revenue/GDP ratio, and;
2) GDP can expand significantly as a result of major tax rate reductions, then;
3) Total tax revenues (revenue ratio * GDP) can rise as the result of tax cuts that accelerate economic growth.
1) If tax hikes don't affect the revenue/GDP ratio, and;
2) GDP is depressed as a result of the tax hikes, then;
3) Total tax revenues (revenue ratio * GDP) can be depressed as the result of tax hikes that depress economic growth.
Remember, there is some small variation in the revenue/GDP ratio, which corresponds to recessions. Thus;
1) If a tax hike results in a recession/period of depressed economic activity, then the revenue ratio may fall.
2) If the revenue ratio falls and GDP is depressed, then total tax revenues (revenue ratio * GDP) are doubly depressed.
1) If a tax cut results in an economic recovery/boom/expansion, then the revenue ratio may rise;
2) If the revenue ratio rises and GDP is accelerated, then total tax revenues (revenue ratio * GDP) are doubly expanded.
Can you see now why Low Taxes are a part of the Magic Formula. and why I am so adamant that you should not raise taxes in the middle of a recession?
But, there's more to it than that. We can see that:
1) If rising taxes can lead to depressed economic conditions, and;
2) Depressed economic conditions produce greater demands on the government to spend money on welfare, public works, hire more government employees, etc., and;
3) Rising taxes don't produce any improvement in revenues, then;
4) The result of rising taxes is depressed revenues and more spending, which results in a larger budget deficit, and;
5) This larger budget deficit often results in demands for higher taxes.
1) If lower taxes can lead to economic expansion, and;
2) Economic expansion produces fewer demands on the government to spend money on welfare and public works, and nobody wants a government job because the private sector is getting rich, and;
3) Lower taxes produce an improvement in revenue, then;
4) The result of lower taxes is expanding revenues and potentially lower spending, which results in a smaller budget deficit, and;
5) This smaller budget deficit/surplus can pave the way for more tax cuts.
If all governments were on the gold standard, then this would be the extent of it. However, in an environment where the ideology of central bank manipulation is ascendant, and currencies float, we can add more feedback loops:
1) If higher taxes lead to a depressed economy, bigger deficits, and pressure for more tax hikes, and;
2) Higher taxes tend to lead to a decline in currency value all by themselves (a depressed economy usually has a depressed demand for currency), and;
3) Central banks tend to bias towards an "easy money" policy in recession, then;
4) Tax hikes will lead to bigger deficits, more tax hikes, and currency depreciation/devaluation/inflation.
You can see this whenever the IMF shows up with its "austerity" plans.
1) If lower taxes lead to a resurgent economy, smaller deficits, and more tax cuts, and;
2) Lower taxes tend to support a currency;
3) Central banks can address this trend toward currency strength with an "accomodative" stance (no need to be restrictive), then;
4) Tax cuts will lead to smaller deficits, more tax cuts, a strong currency, and a central bank that doesn't need to be "hawkish."
This is roughly what was going on in the emerging markets during 2003-2007.
Item in the HuffPo:
January 13, 2010: How to Create Jobs