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.

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
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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Comments

Your points about cutting non-essential spending are well taken for the most part, and should be done as a matter of course and of principal.

But as to the rest of your fears... what of the increases in revenue we've been seeing, Dale? This is exactly the same argument the anti-supply types could never understand and still don't to this day.

Posted by: Bithead at July 26, 2004 01:02 PM

I think I addressed that by pointing out the 2001 tax cuts provided long-term incentives, didn't I?

I mean, the whole point of this post was to contrast the revenue-creating tax cuts of 1981 and 2001, with the revenue cutting rebates and credits of the past couple of years, wasn't it?

And Bruce Bartlett has been one of the country's chief supply-siders for 25 years. If we're both on the same track, doesn't it strike you that what we're saying is a different from the criticisms the left has been making?

Posted by: Dale Franks at July 26, 2004 01:04 PM

The argument in 81 was really rather simple; cut the taxes to get the economy moving. (And I doubt many readers of this blog or mine will argue against the statement that after 8 years of Clintonomics, it certainly needed the help.)

Our economy is moving again, now, and as a result, the tax take has gone up rather dramatically.

Perhaps I can illustrate this a bit better this way; Where would our government debt sitrep be, had the steps NOT been taken?

Posted by: Bithead at July 26, 2004 01:15 PM

That's an interesting question, but not really relevant to the point I was making in the post.

Posted by: Dale Franks at July 26, 2004 02:01 PM

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?

Posted by: Gary and the Samoyeds at July 26, 2004 03:03 PM

What you say makes a lot of sense, but the current tax structure still makes it a political playhouse with the deck stacked against the taxpayer. What do you think about the efficacy of either a flat tax or the so-called fair tax, a tax on retail sales, only? Both would seem to simplify the Orwellian tax structure, and would seem to offer a boone to businesses of all stripes.

John F.

Posted by: John F. at July 26, 2004 04:23 PM

The problem is not tax cuts. It's the spending. it does not matter what our tax levels are, if we do not stop the runaway spending the countries fiscal future is bleak. Maybe I'm too pesimistic, but I see it as a choice between higher taxes now and higher taxes later or lower taxes now and higher taxes later. I don't think repealing tax cuts are going to head off the fiscal trian wreck ahead.

Posted by: Frank Castle at July 26, 2004 05:21 PM

I have what is perhaps a minor semantic quibble... You say that "...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." However, it is not the goal of supply-siders to fix the tax rate at the equilibrium point as most supply-siders I know don't wish to maximize government revenue. They wish to minimize the economic drag of government. Therefore, they want the lowest possible tax rates. The Laffer curve, then, shows that a 20% increase in the tax rate (as in, from 20% to 24%) won't result in a 20% increase in revenue. (Or, conversely, a 20% cut, e.g., from 20% to 16%, won't result in a 20% drop in revenue.) It does not, however, show the rate that maximizes economic growth.

As to the point of your post, let me wholeheartedly agree with you.

Posted by: Nate at July 26, 2004 05:35 PM

Nate, I think that a good number of supply-siders felt a bit more pragmatic than you describe. I think there was a hope that taxation could be minimized, but a realistic expectation that lowering taxes too much was politically undoable, and that hitting the equilibrium point would raise revenues, thus disarming the critics of supply-side theory, while reaching the more important goal of neutralizing government impact on economic growth. Once you drop below the equilibrium point, taxation's effect on growth is minimal, since the equilibrium point, by defintion, is the point at which fiscal policy's effect on growth is neutralized.

The Laffer curve doesn't show that "a 20% increase in the tax rate (as in, from 20% to 24%) won't result in a 20% increase in revenue" in the sense that precise percentages can deduced from it. The Laffer Curve lacks any specificity about tax rates and revenue, except to show that at 0% and 100%, government receives no revenue from taxation. The actual shape of the curve, and, hence, the relationship between taxes and revenues at any place besides the end points, is really unknown. The shape of the curve, therefore, is purely notional in Laffer's presentation. The curve may be substantially flatter, or it may be skewed towards one end or the other. Indeed, there may not even be a set equilibrium point, but rather a plateau at which a contiguous range of tax rates all provide the same revenue.

Indeed, I suspect the latter is true, so that marginal rate changes between, say, 30% and 35% may have no effect at all.

Everything is really dependent on whether we are on the left of right side of the equilibrium point, or equilibrium plateau as the case may be, as well as oither, non-economic conditions that may obtain. At different times, the same increase in taxation may result in more revenue, less revenue, or be revenue neutral.

Or not. We really don't know, and I don't believe that we have either the historical data or the econometric modeling ability to prove it one way or another.

The curve is a nice teaching tool, but a pretty unspecific one. It just isn't suited for making accurate predictions about the revenue effects of small changes in moderate taxation rates.

Posted by: Dale Franks at July 26, 2004 07:05 PM

Thanks for letting me down gently. :) My view on the matter is a little longer term than a term of office, so bummer... But if you increase the growth of the economy by one percentage point from 4 to 5% by lowering the marginal tax rate some amount, in 56 years, (52 years if you increase growth from 3 to 4%) you have approximately double the economy in the higher growth rate model. In the longer term (okay, in the really long term, that's trivial as ((x + epsilon) / x) ^ N grows without bound as N increases) a little extra growth rate will result in a heck of a bigger economy, such that the lower tax rate of a much bigger economy will yield much larger government revenues. In the example of Europe growing at 1% per year, and the US's average of closer to 3%, our economy will double in size in about 23 years, while Europe's will take almost 70 years to double. (in that 70 years, our economy would be eight times the size it is now!)

So, I'd like to think I was a little bit pragmatic. Or just thrifty. As Poor Richard said, "Plough deep while sluggards sleep, and you will have grain to sell, and to keep."

I apologize to economists everywhere for my incoherent babbling.

Posted by: Nate at July 26, 2004 09:25 PM

2 Quick question: Why would the effect on the economy be neutralized at the equilibrium point? Revenues may go down more rapidly than economic activity would increase, but I see no reason to think that growth wouldn't increase.

Also, is there something which would prevent the possibility of local optima? Given the number of variables involved, there may be a series of peak points.

Posted by: Phlinn at August 2, 2004 12:42 PM