Does Lowering Marginal Tax Rates Actually Increase Government Revenue?
It is admittedly frustrating to see a theory that has been debunked by experience, time and time again, continue to be touted as a doctrinal truth by its most ardent supporters.
The assertion that lowering tax rates raises total government revenues is such a theory. Lowering tax rates does not increase total government revenues. It never has, and it never will, barring politically impossible circumstances (I will discuss this in further detail a bit further down).
The Bush tax cuts provide a primer. It is common for supporters of this theory to point out that total revenues grew between 2003-2006, after the Bush administration signed its tax cuts into law. This is true. But what is also true is that revenues would’ve been even higher if the tax cuts had never been passed. That is according to numerous government offices, committees, research groups, and the Bush administration”s own economic advisors:
The Congressional Budget Office, the Treasury Department, the Joint Committee on Taxation, the White House’s Council of Economic Advisers and a former Bush administration economist all say that tax cuts lead to revenues that are lower than they otherwise would have been – even if they spur some economic growth. And federal revenues actually declined at the beginning of this decade before rebounding. The growth in the past three years that McCain refers to brings revenues back in line with the 40-year historical average as a percentage of gross domestic product.
The Bush economist referenced above is Alan D. Viard. He had this to say about the Bush tax cuts:
“Federal revenue is lower today than it would have been without the tax cuts,” Alan D. Viard of the conservative American Enterprise Institute told the Washington Post last October. Viard, who worked in the Treasury Department’s Office of Tax Analysis and the White House’s Council of Economic Advisers under President Bush, told FactCheck.org that “nobody can absolutely prove that.” Proof would require time travel and a reversal of tax policy. “But among economists, there’s no dispute…Tax cuts can be a sound economic move that spurs growth, [b]ut it doesn’t mean that [the cuts] gained revenue.”
Here’s what’s actually going on: When you cut taxes, the economy tends to grow, which expands the tax base and, in theory, increases revenue. But the increase in revenue from expanding the tax base never accounts for the total loss of revenue incurred by the tax cuts. The only time this will ever happen is if aggregate tax rates on the overall population are already so high that negative economic incentives are causing a substantial arrest of economic activity. This situation, however, would never happen for 2 reasons:
1) People always need to make a living. Nobody will ever decide that they are going to completely leave the work force because their taxes are too high. Taxes may diminish income, but leaving the workforce completely means either zero income or scraping by on handouts. The economic incentives will clearly favor continuing to work unless the average tax burden reaches a politically impossible level. This is even more compelling when you consider that the type of people who hate paying taxes the most (Conservative voters) are generally also the type of people who view hard work and self-sufficiency as noble virtues. They also tend to look unkindly on those who take handouts or rely on other people for their subsistence. So the people most likely to leave the workforce in protest of high taxes also happen to be the least likely to leave the workforce generally.
2) Even if you don’t buy the first point, it’s irrelevant, because we will never get to this point. The country’s economy would grind to a halt before it ever happened. Also, keep in mind that the type of expropriative taxes i’m talking about here would apply to everyone. Taxing a wealthy individual at federal rate of 39.5% is ok, because they will have more than enough income after meeting their tax burden to provide themselves with a comfortable standard of living. But if every taxpayer, regardless of income, was subject to a 39.5% federal tax rate, you would have untenable nation-wide suffering. No one making below 25,000 a year would be able to pay their rent, since rents alone exceed 50% of income for over 12 million Americans. But a policy shift of that magnitude would not only be politically impossible; it would also have to happen, if at all, gradually over time. And public pressure to reverse course would become strong enough to stop it long before it was ever implemented to that degree.
This entire fiasco really got its genesis when people wildly misinterpreted something called the Laffer Curve:
If you’re unfamiliar with it, the Laffer Curve is an economic model created by Art Laffer that explained the economic incentives inherent to taxation. wikipedia has a great explanation:
The curve is constructed by thought experiment. First, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist at least one rate in between where tax revenue would be a maximum.
This is obviously an oversimplification. There is a specific tax rate relative to given levels of income that will generate the most total revenue overall. In other words, the more you make, the more you can afford to be taxed before your standard of living becomes unacceptable in relation to the amount and type of work you do in order to receive that compensation. Conversely, the less you make, the less you can afford to be taxed before your standard of living becomes unacceptable in relation to the amount and type of work you do in order to receive that compensation.
So if you are in the Right hemisphere of the Laffer curve, then lowering taxes will probably result in an increase in total government revenue, because they are expropriative enough to create a sufficient number of negative economic incentives that make further taxation counter-productive. conversely, if you are on the left side of the Laffer curve, then raising taxes will probably lead to a total increase in government revenue as well, because taxes are low enough that additional taxation will not create enough negative economic incentives, relative to people’s ability to purchase a desirable standard of living, to make additional taxes counterproductive.
If you want to use the Bush tax cuts as a prism, the lesson is this: current tax levels have not yet put us in the right hemisphere of the Laffer curve. We are in the left hemisphere. In fact, we were in the left hemisphere before the tax cuts were even enacted, because keeping tax rates at pre-2001 levels would’ve generated more revenue than the lower rates enacted in 2001 and 2003. The Bush tax cuts only pushed us further into the left hemisphere.
Conclusion? There are conceivably times when raising taxes results in less revenue. However, realistically speaking, the average tax rate has to be so high that the majority of people are unable to meet even basic financial responsibilities. We are not now in those circumstances, and have not been for a long time, if ever. For anyone to continue to say that tax cuts always lead to increases in total government revenues, they have to do two things: 1) completely ignore factual data which contradicts their claim, and 2) completely misunderstand Art Laffer.
What is most frustrating, is that I think most people who make the claim that tax cuts lead to greater revenue actually know they are misstating Art Laffer’s theory. They are just shamelessly repeating it because it’s a great talking point. Unfortunately, it happens to be wildly untrue under our current economic circumstances, and will continue to be so, barring politically impossible and economically infeasible changes to our tax policy.