QandO

July 26, 2004

The Argument Against Tax Cuts
Posted by Dale Franks

Bruce Bartlett, a supply-side prince who you'd think would usually be the last guy to argue against tax cuts, is now doing so in the Washington Times.

The problem is the original objective of tax cutting has been completely forgotten. Republicans now promote tax cuts simply for their own sake, with no concern for their structure, economic impact or fiscal consequences. As a result, I think they are creating a grave mess that eventually will have terrible repercussions.

In brief, the case for tax cutting made by Mr. Kemp and others was to increase incentives to work, save and invest. In this regard, the marginal tax rate — the tax on each additional dollar earned — was paramount. We rejected tax cuts that would have been easier to pass because they simply reduced revenues without improving incentives. We even worked to get rid of tax cuts already in law, such as the Investment Tax Credit, because they did not affect marginal incentives and did not belong in a neutral tax system that neither encouraged nor discouraged economic behavior — our ultimate goal.

Although not part of Mr. Kemp's agenda, he would not have succeeded if other Republicans didn't also view tax cuts as a way to constrain the size of government — taking away its allowance, as Ronald Reagan used to put it. That is why pillars of the Republican establishment like Alan Greenspan and Herb Stein supported the Reagan tax cut in 1981.

In the 1980s, both sides of the tax cut coin worked together. Marginal tax rates were reduced for all taxpayers and the top rate was slashed from 70 percent to 28 percent. Domestic spending was cut and the growth of total spending, which had expanded relentlessly for decades, slowed and finally began to fall. This would not have happened without tax cuts, which starved the government beast of nourishment.

The problem now is that both original rationales for tax cutting have been completely forgotten by virtually all Republicans. They now cut taxes willy-nilly without any concern for economic impact. The vast bulk of tax cuts since 2001, in revenue terms, have gone for tax rebates, kiddy credits and other measures having no impact on marginal incentives. True, rates have also been cut, but they are being phased in slowly, thus pushing off their economic benefits into the future.

Moreover, the old starve-the-beast theory is completely dead. Not only do Republicans make no effort to even restrain, let alone cut, spending, they have actually gone in the opposite direction and now raise spending for just about anything they think will buy them a vote. They have morphed into a caricature of 1960s Democrats, but with even less concern for deficits than Lyndon Johnson had.

Bartlett's arguments are enormously important. To understand why, we need to look at one of the central theses of supply-side economics, the Laffer Curve:

The Laffer Curve

What San Diego economist Art Laffer came up with is the idea--which the curve above illustrates--that there are always two tax rates that will provide the same amount of revenue to the government. If tax rates are too high, economic activity and economic growth are discouraged, which leads to lower tax revenues. If tax rates are too low, economic growth is encouraged, but the government's tax revenues are still decreased because they are not extracting revenues through taxation. Hence if tax rates are at point A or point B, they will produce the same amount of revenue, even though the rates may be quite different. So, there is, theoretically, an equilibrium point at which tax revenues are maximized, but economic growth is not hindered by excessive taxation. So, the goal of supply-side tax cuts was to fix tax rates as close as possible to this equilibrium point.

Now, this isn't as easy to do as it sounds. Notice that the curve doesn't show any actual hard and fast numbers, other than a 0% and 100% tax rate. The equilibrium point really falls at that rate at which the population consents to be taxed. During times of war, the population might consent to very high levels of taxation without any slowing of economic growth, because they perceive it to be a necessary adjunct to a great struggle for national survival. In that case, the equilibrium point might be way over on the right side of the graph. In peacetime, of course, the population may not wish to have high levels of taxation. Rates that were perfectly acceptable in wartime might in peacetime cause people to refrain from economic activity, because the rewards for doing so are too highly taxed. The equilibrium point has shifted to the left side of the graph, and the high tax rates are now hindering economic growth.

In 1980, Ronald Reagan made an excellent argument for tax cuts, for a number of reasons. First, there were a multitude of tax brackets that raised tax rates all the way out to 70% of income. Second, none of the tax brackets were indexed to inflation. This became especially troubling as inflation ran rampant in the 1970s. Wage increases that were barely able to keep up with the rising cost of living would drive workers into ever-higher tax brackets, thus reducing their real income.

At the same time, economic growth was slowing throughout the 70's, leading to an economic condition called "stagflation": stagnant economic growth and high inflation. This was seen as paradoxical, because one of the usual causes for inflation (outside of the government going crazy with the printing presses at the US Mint) was too rapid economic growth, as wages and prices rose because production was insufficient to keep up with demand. Low rates of economic growth were supposed to lead to disinflation, as demand for goods and services dropped. Instead the 1970s saw the worst of both worlds with the stagflation phenomenon.

So, the supply-side argument at the time was quite straightforward. Supply-siders argued compellingly that inflation was caused by an excessively loose monetary policy, and that stagnant growth was caused by high levels of taxation.

Appointing Paul Volcker to chair the Fed solved the first problem. He simply turned off the money spigot at the Fed. The process made 1981-1982 an unpleasant couple of years, as inflation was wrung from the economy by increasing the Fed Funds rate to 19% (it's at 1.25% now), but the rate of inflation declined from 12% in 1980 to 4% in 1983, and its trended down to around 3% or less since.

Electing Ronald Reagan solved the second. Reagan's tax plan, which was implemented in 1981, reduced the number of tax brackets to three, indexed the brackets to inflation, and cut the top rate from 70% to 28%. So, as soon as the Fed let up on the monetary brakes, the economy went off on a tear from 1983 to 1990--the longest peacetime economic expansion in US history, up to that time. And, following a mild recession in 1990, the economy again began to expand throughout the 1990s, until 2001.

But, as Bartlett points out today, the Republicans seemed to have learned the wrong lessons from Ronald Reagan's tax cuts. The whole point of Reagan's tax cuts were to produce an economically neutral tax structure, not tax-cutting for the sake of tax cutting. Now, the Republicans seem to have concluded that tax cuts, in and of themselves, are a good thing. That is by no means, true, however. Tax cuts may be politically popular, but they may also be economically unwise. Political popularity, of course, is always a compelling argument to politicians, though, so Republicans have begun to make "tax cuts" of one kind or another an annual event.

The 2001 tax cuts were a good idea. Eliminating taxation on dividends is a good, pro-investment, and hence, pro-growth tax policy. Cutting capital gains taxes is even better. Lowering income tax rates was a good idea, too, since based on the historic record, a 36% upper bracket was a skoche too high.

Since then, though, the race towards tax breaks has not been caused by a race toward economic neutrality, but for tax cuts as means of buttressing Republican political popularity. We've done rebates, and kiddie tax credits (It's for the children!), and a whole host of things that don't provide any long-term economic incentives to savings, investment, or growth. That's just simple revenue cutting.

Now, I'm certainly not against cutting revenue. In fact, I'm all for it if it would force the government to tighten it's belt, too. But that isn't what's happening. The growth in government spending seems to have been completely unrestrained by the reductions in revenue. And spending growth has been increasing not by a little bit, but by a substantial margin. So, where is the money going to come from to pay for all that extra spending?

Republicans would like to tell us that--as Reagan proved--cutting taxes increases revenue, so it'll all come out in the wash. The trouble with that argument, however, is that it assumes that we are still way over on the right side of the equilibrium point as far as taxes are concerned. Reagan cut taxes at a time when tax rates were indisputably on the right side of the Laffer Curve. Arguing that we're still there today, when, two decades later, we are almost precisely where taxes were in 1982, strikes me as a pretty foolish argument. I think we are at best spot on the equilibrium point, and more likely a bit to the left of it. And I wouldn't argue that was a bad thing, or that additional tax cuts wouldn't be nice if we reduced spending at the same time.

But cutting revenues and increasing spending, as we're doing now, is a recipe for fiscal disaster. There are still a lot of things the government has to do. We need a State Department to talk to foreigners. If that fails, we need a Defense Department to kill them. In a heavily urbanized society, we need a national transportation infrastructure, to ensure that we have enough Brussels sprouts for everybody in town.

But that--and whatever else the government does--all costs money, which means that someone has to pay for it. At the moment, we seem to be deciding that that someone will be our kids and grandkids. And I don't think they're going to be too happy about it. We've already saddled them with trillions of dollars of unfunded liabilities in Social Security alone that will require our kids' FICA withholding alone to be somewhere around 33% of their salaries. We could go back to the 1960s rates of 70%, but, since that would result in a tax rate of 103%, paying one's tax bill would seem to be problematic. Unless, of course, everyone stopped working altogether, in which case they'd owe no taxes at all. But, take a look at the Laffer and see how much revenue a 100% tax rate brings in.

And, it's not as if the government isn't chock full of stuff that we can live without. What, for example, does the Rural Utilities Service do? I lived for two years in darkest North Dakota, happily catching the HBO feed from the G3 communications satellite. I think I can safety say that when you can watch satellite TV in Kief, ND, the RUS's job is pretty much done.

But, if you want government services, and apparently we do, then they have to be paid for, which makes tax cutting for tax cutting's sake is a prescription for fiscal disaster. I mean, I suppose it would make everybody happy to cut taxes to 0%, while delivering the same government services. But, that's the fiscal policy of Never-Neverland, not a rational commercial republic.

In the real world, trying to do what we're doing now means that, in the not-too-distant future, we will be looking at massive tax increases, to pay off the party we're having today. Even Bruce Bartlett thinks so.

UPDATE: This question has been asked by Gary and the Samoyeds (from the sig, it's unclear whther Gary is asking, or whether one of the dogs has a keen interest in fiscal policy):

Well, what about further rate cuts? Not credits or exemptions. Would trimming the top rate to 31% (where it was when Clinton took office) increase or decrease revenue?

Or, for that matter, what about corporate rates? Have they been raised or cut since the 80s?

First, personal tax rates have already been reduced to 31%, as part of the 2001 tax cuts, and inheritance taxes have also been cut. Corporate income tax rates have remained fairly steady, but taxes on dividends and capital gains have been cut.

The question of whether a cut in marginal tax rates from 36% to 31% will cause revenue to rise or fall is essentially unknowable. Bill Clinton's 1993 tax increase took the top rate from 31% to 36%. Despite all the bitching and moaning from supply-siders at the time that raising taxes would lead to irreparable budgetary harm as revenues collapsed, the exact opposite happened. Between 1993 and 2000, Federal receipts rose from $1.23 trillion to $1.88 trillion¹, an increase of 52.3%.

In the 1990s, the information revolution and the huge increases in productivity it engendered more than compensated for any effect the Clinton tax policies might have had. Indeed, while it is true that revenues for the Federal Government grew by 28.4% from 1983-1988, following the recessions of the early 80s, that performance is worse than any six-year period of the Clinton administration. Indeed, in the six years after the Clinton tax increases, revenue grew by 36%. Supply-Siders are fond of blaming the tax increases of President George H.W. Bush for the 1991 recession, but have more difficulty explaining why the Clinton tax increases didn't have the same effect.

So, when tax rates are already at fairly low levels, the result of playing around with a few percentage points on marginal rates is unclear.

What made the Kennedy tax cuts so effective in the 1960s when the top rate was cut from 90% to 70%, or the Reagan cuts in 1981 so effective was that they implemented large, structural changes in both the rates and brackets of taxation. In both cases, the changes were designed to provide incentives to savings, investment, and economic growth.

That situation no longer obtains. Tax cuts do not provide revenue growth forever. If that was true, the Federal government could cut tax rates to 0% and would be rolling in dough.

Still, at least that kind of tax cut would provide an economic incentive towards economic growth. The trouble is that the types of tax cuts the Republicans have been pressing for since 1991 neither increase revenue nor provide any incentives for growth. They merely reduce revenues. That isn't a prescription for success.
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¹ All figures are calculated using constant dollars to account for inflation.

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