The Myth That Tax Cuts Pay for Themselves

This will not please the tax cut fanatics and proponents of the Laffer curve. Here's a link to the report from the CBO discussed in this Economic View by Daniel Altman from the New York Times:

Economic View A Bit of Doodling About a Tax-Cut Danger, by Daniel Altman, Economic Scene, New York Times: Early last month, without much fanfare, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates." ... [I]t may be one of the most important government publications in years. As Douglas J. Holtz-Eakin, the budget office's director, writes ..., most predictions of the effects of tax-rate changes "do not include the budgetary impact of any possible macroeconomic effects of tax policies." In other words, the predictions don't take into account how tax cuts could affect the overall size of the economy. It is this omission - one often cited by proponents of tax cuts, especially in the White House - that the paper tries to correct.

The author ..., Ben Page, estimates estimates how an across-the-board cut in income tax rates could generate higher levels of economic activity, potentially replacing lost tax revenue. ... Mr. Page's [results] vary widely depending on his assumptions ... But even within their range, the results answer the fundamental question posed by the Laffer Curve. ... One motivation for Mr. Reagan's tax cuts was a guess that the United States was on the right side of the curve - that is, that lowering rates would actually yield more tax revenue over all. Some recent statements by Joshua B. Bolten, President Bush's current budget director, seem to indicate that he still believes this to be true, though rates are much lower now than when Mr. Reagan took office in 1981. ...

The recent analysis by Mr. Page at the Congressional Budget Office dismisses the idea that tax cuts may actually improve the government's fiscal situation. Even in his most generous scenario, only 28 percent of lost tax revenue is recouped over a 10-year period. The United States, it seems, is firmly planted on the left side of the Laffer Curve. Recent experience corroborates this prediction. In the second quarter of 2001, just before the first of President Bush's tax cuts took effect, federal receipts from personal taxes accounted for 10.3 percent of the economy. By the end of the post-recession slump, receipts had dropped to 6.4 percent. But in the third quarter of 2005, with the economy booming, they were still under 7.5 percent - an enormous difference. In dollar terms, federal receipts from personal income taxes, at $802 billion in 2004, are still lower than they were in 1998 ($826 billion) and much lower than in 2001 ($994 billion). ...

Comments

[Pancho Villa]

“…In the next chapter we’ll turn to the “supply-siders”, a movement of radical conservatives who believed that tax cuts would lead to a huge surge of economic growth. Most famous of these supply-siders was Arthur Laffer, who claimed that a tax cut would lead to so much more output that revenue would actually rise. The important thing to realize here is that neither Feldstein nor his followers made any such extravagant claims.
One example may take the point. In the Bush years (1989-93), the centerpiece of conservative demands for further tax cuts was the idea of reducing capital gains; indeed, Republicans came to put almost religious faith in the power of a capital gains cut to energize the economy. But in 1980, Lawrence Summers, in a paper that made a very strong case for reducing the rate of taxation on corporations and investors, estimated that even a complete elimination of the tax on capital gains would take almost ten years to raise U.S. output by a single percentage point….”

[Bruce Webb]

Supply siders didn't have to believe that their tax cuts would actually increase revenue. Some did, most didn't. What they universally believed was that tax cuts on the wealthy equated to tax cuts on the wealthy. The first order effects worked, who cares about the second and third order. "Oops we are sorry, it really didn't increase tax revenues overall, but thanks for the yacht"

[Mike]

Let's stop the myth that Reagan was a tax cutter. And let's use a conservative columnist to do it.

http://www.nationalreview.com/nrof_bartlett/bartlett200310290853.asp

[hirvi]

That's page 74 in my copy, Pancho :-)

[Dirk]

This explains how reducing tax rates increases tax revenues, reduces wealth concentration, improves family life, improves the entrepreneurial climate and lowers demand for government social services. This makes the case for tax rate reductions that I have never seen elsewhere. This my own work.

If the tax rate on Monday was 100% and the tax rate on Tuesday was 10% would you report for work on Monday? Would you work harder on Tuesday? What tax rate would make you show up for work on Wednesday, Thursday and Friday? Will your rate at which you are willing to work be the same as everyone else's? If you would stay home Monday and would go to work on Tuesday you understand Voodoo economics.
Voodoo economics says tax revenues increase when tax rates go down. How does this happen? It happens because high tax rates cause a decrease in economic activity. Lower tax rates stimulate economic activity. Rewards for taking business risks are higher when tax rates are lower.
This concept can be demonstrated graphically. The basic concept is taken from the Laffer curve. However for ease of developing the concept further the ordinates are exchanged. The horizontal axis is tax rate, zero to one hundred percent and the vertical axis is tax revenues. Tax revenues are derived from the tax rate times the tax base. At zero tax rate tax revenues are zero. At 100 percent tax rate tax revenues are again zero. No one can afford to go to work if all their compensation is forfeited to taxes.
We know however we do have tax revenues and a tax rate greater than zero and less than 100%. So the question is what is the shape of the curve that connects the three points? For the sake of the illustration assume the current tax rate is about 30% and the revenues are about 1/4 the height of the vertical axis. There are three possible basic revenue curve shapes, depending on the slope of the line through this non zero revenue point. The slope can be positive, negative or zero. Proponents of raising tax rates to increase tax revenues say the slope is positive, proponents of Voodoo economics say the slope is negative. No one makes a case the slope is zero.
What does real world experience reveal of the true shape of the revenue curve? Empirically tax rate reductions have yielded growing economies, In the early 1960s John Kennedy stimulated economic growth with tax rate cuts, in the 1980s Ronald Reagan lowered tax rates and the economy boomed, George H. W. Bush raised tax rates and was rewarded with a recession that cost him his reelection. In the 1990s Republicans forced Bill Clinton to reduce tax rates on capital gains and the economy boomed again. (note that income will be taken at the lowest tax rate possible) George W. Bush pushed for tax rate decreases that have pulled a 9-11 shocked economy back into growth. In the depths of the 1930s depression tax rate increases increased the unemployment rate from 25% to 35%. These examples suggest that the correct shape of the curve is negative slope at our current tax rate.
Examples can be seen in other countries, low flat tax rate Estonia is booming after suffering decades under Soviet communism. Ireland has gone from being the poorest country in Western Europe (with a high tax rate) to the richest (with a low tax rate). Russia itself has seen tax revenues jump after implementing a low rate flat tax after high tax rates failed to provide revenues. Many other countries from the former Eastern block have implemented low flat taxes and these countries economies are showing far better growth than the Western Europe high tax economies that are mired in low growth and high unemployment. Recently it has been pointed out the US has created over 50 million new jobs since the 1980's where high tax rate Western Europe has created only 4 million, and most of these are government jobs.
Draw graphs to show the three slope possibilities at a tax rate of 30%, with an added curve above the revenue line being the size of the tax base, ie the size of the economy. This size of the economy curve is derived from the tax revenue amount divided by the tax rate. Note that with all three slope scenarios the slope of the economy is negative, that is, the higher the tax rate the less economic activity there is to tax. And at tax rate 100% there is no on the books economy.
What does this decreasing size of economy with increased tax rates mean to you? It means little or no job creation, and certainly lower overall employment. There must be economic activity to have jobs and the level of economic activity can be a good proxy for the number of jobs in the economy. Draw another graph using the size of the economy as a proxy for the number of jobs. This would be a downward sloping line ending with zero jobs at 100% tax rate.
Compare the number of jobs in the economy with the size of the available workforce. The size of the available workforce remains basically constant independent of the number of jobs available. Draw a horizontal line across the center of the graph. Where there are more available workers than available jobs, as under high tax rates, there is downward pressure on wages paid to workers. Where there are more jobs available than workers in the workforce employers must pay more to attract workers, wages are bid upwards. So would you rather look for work under high tax rates or low tax rates?
Another overlooked effect of high tax rates is wealth concentration. High tax rates are said to be needed to tax from the rich and give to the poor to redistribute incomes. But high tax rates actually concentrate wealth. How? Under high tax rates jobs are few, workers plentiful, and compensation is low. The employer can pay far less than the value of the workers contributions and pocket the difference between the compensation paid and the value the worker generates for the employer. With large numbers of employees getting paid far less than the value of their contributions the employer can still profit greatly even if the tax rate is high, the net after taxes is still large.
Under low tax rates jobs are plentiful and employers must pay more to retain valuable employees. Because employers are forced to pay a higher percentage of the value of the employees contributions to the employee there is less wealth concentration. Wealth created by the business enterprise will be more evenly spread among the creators of the wealth. Employers will earn less from each employee, but will pay a lower tax rate and may not suffer as much damage to their net as one might expect.

There are a variety of other effects of higher wages stimulated by low tax rates.
1. Capital investments will be made to increase productivity. Productivity increases correlate strongly with increased living standards. Productivity growth also moderates inflation.
2. Low paying jobs often lead to two income earner families which expands the active workforce. With workers earning more, fewer families will need two income earners. More families will have a single income earner with a stay at home parent. This could have a cascade effect on the job market in that this will reduce the active labor force, potentially forcing wages higher. And a stay at home parent usually means good things for children.
3. More jobs = less government assistance needed. With more jobs available, the whole of the work force that wants to work should be able to find a job, the chronically poor and last hired minorities could find a job. This should reduce the demands on a variety of governmental assistance programs, including unemployment programs, welfare, medicaid, social security.
4. Workers can join the investor class by saving more of their earnings and accumulate wealth that they can invest or use to start their own businesses.

So the big question is where are we on the tax curve now? Most certainly we are on a point on the negative slope and decreasing tax rates will increase revenues. How far should tax rates be reduced? Should they be reduced to the zero slope point (the highest point on the revenue curve) on the curve? This would maximize revenue to the government, but this is not the point where standards of living would be the highest, or where the fewest people would require governmental assistance. The goal should not be to maximize government, but to maximize the standards of living for the population of the country. This would indicate lower tax rates, to the left of the zero slope point, where economic activity is highest are desired.

[Pete]

Some who left comments need this link: Myth.

[aggieboy]

could anyone name some authors so that I could explore this supply-sider theory in more detail? is there a study that reviews both sides of the arguments?

[Dirk]

mythbuster:see the graphs at end of the article below
http://www.treas.gov/press/releases/js3039.htm

[Northern Observer]

Dirk,
Interesting. My basic disagreement would be where we are on the curve. There is growing empirical evidence to suggests that we are past the point of diminishing returns when it comes to future GDP growth per basis point of current tax cut.

If these systematic tax cuts had promoted broad based income increases it might be worthwhile. But they haven't. It has been narrow income increases and massive increases in the amount of national income going to capital as opposed to labour or land.
In the long run this is a receipe for economic flame out and it replicates the boom-crash pattern we saw in the 1920s of:
lower shares of national income going to wages.
higher shares going to capital (retained earning)growing income inequality despite robust economic growth leading eventually to the collapse of the wage earning consumer.

There are also some interesting variables to add in about Ireland. Although corporate income taxes are low (12.5%), personal income taxes are not (top rate 44%) and there are massive direct sales taxes (21% VAT), to make up the budget. There is also the fact that Ireland received billions in aid from the European Community during the 70s and 80s. Now the Irish were smart and invested a lot of this EU aid in education and infrastructure (roads and ports). So it is interesting that massive government intervention in the Irish economy helped to lay the basis for an investment driven economic boom in the 1990s.

This is also factually wrong:

"in the 1980s Ronald Reagan lowered tax rates and the economy boomed"
Not exactly. He dropped them in 1980 and raised them every year after that. The economy boomed in the face of rising taxes.

I would direct you to this post:
http://www.typepad.com/t/trackback/3770741