"Cutting taxes increases economic growth, which in turn increases government revenue."
I have heard that phrase more times than I can count from more Republicans than I even remember.
It has been the central theme with which the Republicans have built their reputation, and basically the only thing that they have done in Washington that has matched up with their rhetoric.
There’s a problem, though. And I want you to keep in mind when I say this, that I am a libertarian-Republican who would just as well like to see the income tax abolished. I repeat, I hate taxes, and if it were up to me I would lower them as far as possible – so if you somehow take this article to mean I am advocating tax raising, or increasingly progressive taxation or anything of the kind, please take a Valium and come back to read the article again later when your hysteria has gone away. We need to talk seriously about public policy if the Republican party is ever going to climb out of its hole.
Now, here’s the secret. It doesn’t work like that.
Oh, mind you, the economic growth argument is certainly true. You allow people to keep more of their own money, and you will in fact see a growth in consumer spending, which will lead to growth in business, and so on and so forth.
But, then we come to that tricky part about "growing government revenue". This, sadly, is not actually true – and if the Republican party wants to govern well when it eventually gets back into power (notice I said govern well, not "keep power") they need to understand this, so they don’t repeat the same foolish mistakes they made in the 2000s.
To prove what I’m talking about, lets start by talking about the Laffer Curve.
The Laffer Curve is central to the ideas inherent in supply side economics. In its most basic form, it is a bell curve that describes points where tax revenues are their highest, and when raising or lowering those rates will increase or decrease revenue to the government.
It argues that there is a point where once you start increasing taxes, you actually do not increase revenue, because you are actually punitively taxing people to the point where it decreases their incentive to work, thus lowering revenues overall as fewer people contribute taxes or climb up the income ladder.
Similarly, if you are in such an area of the bell curve (obviously, to the right of the crest) and you cut taxes, you are actually going to increase revenue to the government because more people will have a reason to work, and those people who do work will see higher profits which will allow them to re-invest into companies and employees, allowing them to hire new people and grow their business, which will of course increase new tax revenue going to the government.
But, what Republicans have long ignored with their (justifiably) militant stance on taxation, is what happens when you go to the left of "t" on the Laffer Curve. Ah yes – taxes go down, but at that point so do revenues. According to the holy grail of supply side economics, there is a point where you lower taxes that it will no longer garner you increased revenue.
Just think of it logically. If taxation was set at a 5% flat rate on income nation wide, do you really think lowering it to 4% would result in more money flowing to the federal government? No – of course not, because at that point the capitalists who are in the private sector churning out the products and services of the economy don’t see much of a difference in their bottom lines to a 1% drop in their income tax. It might provide for a little additional money to spend on a small project, or hire a few people, but in terms of the economy, its a small drop in the bucket that won’t end up leading to more revenue for the government – all that will happen is the lower tax rate will mean less money streams into the government.
Laffer believed that. Reagan believed that. Any self-respecting supply sider who really knows what the philosophy is about believes it. I believe it. Its just how it goes.
So the question really is – what is "t". In other words, what is that magic point on the Laffer Curve where tax revenues are optimized for their greatest revenue benefit to the government.
We need to identify that not to set our tax rates there, but instead so we can identify what will happen when we cut taxes.
When Ronald Reagan took office, the upper tax bracket in this country was 70%. That’s right, seven out of every ten dollars you made were you in that bracket went to the government. The 1981 tax bill dropped that number significantly to 50%. When he signed the 1986 tax reform bill, that top rate dropped to 28%.
Obviously, cutting taxes when they sit at 70% for the top bracket is likely to spur growth, expand business, and lead to (after some time) more tax revenue streaming into the government due to the increased availability of capital that has expanded the tax base.
But, where is that "t" level? Is it lower, or higher than where George W. Bush found it in 2000 (top bracket was at 39.6%).
I think that as time has passed, it has become rather obvious that we are in an area of the Laffer Curve that is to the left of the "t" line, which of course means that cutting taxes are likely to decrease revenue.
The best way to measure the effect of a change in tax policy is to compare tax receipts as a percent of GDP, because with a naturally growing economy (as ours is), we will basically always take in more in tax receipts than we did the previous year due to that growth, so that doesn’t tell us much. What we need to find out is if a tax cut/raise has increased receipts as a percentage of GDP, or decreased it.
If tax cuts lead to revenue growth, then receipts as a percentage of GDP would end up going up. If they didn’t go up, then the government would have received more revenue had taxes stayed where they were.
In other words, if taxes were at 35% and accounted for 30% of GDP the government would have collected a certain amount of money. If we then cut that rate to 30%, and tax revenues go down to say 28% of GDP, then we now know that while we are in fact gaining more tax revenue than we had the previous year, had we left taxes at 35%, we would have actually increased the amount of money coming into the government by more than we did get at 30%.
In real terms, if we collected 2 trillion dollars under 30% taxes, than we may have ended up with 2.3 trillion under a 35% scheme, because of how much, relating to GDP, that is.
And, that is exactly what has happened with the Bush tax cuts, which more or less proves the point that we are on the left side of the Laffer Curve.
Between 2000 and 2002 (post Bush tax cut), total receipts fell 10.3 percent relative to GDP, from 29.2 percent to 26.2 percent. The magnitude of that decline in total receipts since 2000 is unmatched since World War II, and it is directly related to the tax cuts. The 2003 acceleration of the tax cuts produced similar numbers.
So what does all this mean? Should we raise taxes so we can get near that magic "t" line and optimize our tax revenue?
No. Of course not – that is absurd. In fact, I’d love to see taxes whacked down further, by a lot.
What Republicans need to understand, however, is that their tax rhetoric is completely divorced from reality. Tax cuts are easy enough to sell to people without deluding yourself into thinking that the magic of economic growth will suddenly result in higher tax receipts. It does on the right side of the Laffer Curve, but not on the left side – and I think its obvious we are currently sitting on the left side of the curve.
Now, what tax cuts actually do, is grow GDP and expand economic growth. There is no reason to take that quantifiable, proven and true economic concept, and then pollute it by saying tax revenues would rise higher because of that expansion of GDP and growth. Again – yes, we’ll get more revenue, but we won’t be getting more as a percentage of GDP.
The only argument that can be made to the contrary is that GDP may increase so dramatically that even though receipts as a percentage of GDP go down, the growth of GDP means that lower percentage still accounts for a higher revenue amount into the federal government than a higher tax rate would have.
A fair argument, but the amount of growth of GDP would have to be ungodly for that to mathematically be true.
The faulty assumption that we have all been flying through life believing to our core since the 1980s is directly responsible for Bush’s foolish budget management.
We are hovering around 11 trillion dollars of publicly held debt today (only to go higher with bailout after bailout coming down the pike) because we thought cutting taxes was the end all be all to economic policy. Why get your hands dirty cutting school lunch programs et all when you honestly believe your revenue stream will be better if you cut taxes anyway?
Its not. We can’t just cut taxes and wash our hands of things. It doesn’t work like that at this level anymore – not on the left side of the curve. Cutting taxes helps grow GDP and generates new economic activity, but at that level it is not increasing government revenue as a percentage of GDP, its decreasing it.
And that’s okay. That’s good, actually! We should love that, and want to see more of it. We should want to drive that Laffer Curve as far left as possible so that as many people can keep as much of their own money as possible.
But, by ignoring the actual effect of cutting taxes, it has left Republicans everywhere with the assumption that they won’t have to get their hands dirty with that nasty business of cutting government spending. "Just cut taxes, and we’ll get more money – we won’t have to cut anything and make people mad at us", the compassionate conservative may say.
Idiocy.
Cutting taxes will decrease the growth of revenue into the federal government. Its an easy sell, no need to hamstring yourself by buying into the idea that we’ll make more money by taxing people less. That may have been true during the 1960s Kennedy tax cuts, or the 1980s Reagan tax cuts, but we have reached an equilibrium now where that is no longer true.
So lets be honest with ourselves, and continue to advocate the slashing and burning of the tax code, but show the stones to actually do what will be necessary to do at the same time – cut spending.
The budget has to be balanced. We can no longer spend like this – its simply Chinese monopoly money at this point, and we have to start to retire the debt.
We’ll never get there by cutting taxes, and then retiring to the study for a smoke and a congratulatory foot massage. We have to get elbow deep in the messy work of taking the red pen to the federal monster. We have got to cut taxes and also cut spending, to get our budget back in balance.
Cutting taxes and running away from the hard work is an ultimate act of political cowardice, and is one of the major reasons why George W. Bush’s presidency has been a disappointment. When the GOP talks about cutting taxes to increase revenue so we can be "fiscally responsible", it has all the credibility of Hannibal Lector with a bottle of Chianti.
We all know it isn’t true, not its time to be adults, be honest with ourselves about the reality of public policy, and push a fiscally conservative agenda that understands that reality and makes it work practically for the American people. Hack the tax code down as far as you possibly can, just understand what you’ll be doing to the budget, and plan your spending accordingly.
Cut it.
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