Tax Cuts Do It Again!
By Richard P. Halverson

In the summer of 2004 I wrote an article entitled “The Reagan Tax Cuts Did Not Cause the Reagan Deficits.” I closed with the summary thought that someday we will incorrectly hear, “The Bush tax cuts have resulted in the Bush deficits!” I am sure I could have easily predicted we would be hearing that right now, but I didn’t bother being that specific.

I had not thought to revisit this subject again so soon, but you would have to be living in solitary confinement during this highly charged political season not to hear that the government is running all time record deficits (which is not true as a percentage of the even more all time record gross national product), and that these all time record deficits are a result of the Bush tax cuts (which is absolutely not true when compared with the fact that tax revenues have been rising sharply and at an even higher all time record).

A Few Articles You May Not Have Seen with All the Shouting

It is nearly impossible to avoid being bombarded by political rhetoric about tax policy. It is far more difficult to find out the facts.

Recently, my attention has been caught by several articles that I dare say have not received much national attention. The first is a Wall Street Journal (wsj) editorial on October 6, 2006 entitled “Tax Tidal Wave,” with a follow-up article on October 12, 2006 entitled, “Declining Debt.”

The second is from Bloomberg News (bn) on October 11, 2006, entitled, “U. S. Budget Deficit Falls to $248 Bln, Four-Year Low.” But before making reference to their points, let me briefly summarize what I wrote in the article entitled, “The Reagan Tax Cuts Did Not Cause the Reagan Deficits.” If you want to read the article, click here. I would be flattered if you would review it.

In that article I made the following points:

First, tax cuts stimulate the economy. Taxpayers with more money in their pockets will spend or invest the money. The increased economic activity has a multiplier effect. The multiplier depends on many things including where the economy is when the tax cuts take effect. If the economy is in a recession when the tax cuts are implemented they can actually stimulate the economy so much that tax revenues rise — i.e., the taxes on the bigger economy exceed the loss of tax revenue associated with the tax cut.

A majority of economists agree with this and it is relatively easy to understand. Nevertheless, there continue to be arguments. One argument is the government could also spend the money. It is subtle but I would argue that consumers spending money on what they want using free market principles is far more stimulative and efficient than the government spending it on what a bunch of politicians and bureaucrats think people want.

A second discussion is that tax cuts should only apply to lower or middle-income people. The thought is that these people really need the money and therefore they will really spend it. The so-called “rich” do not need it and will save it rather than spend it. This, some people argue, does not stimulate the economy. Frankly, people who sincerely believe this fail to understand how a free capitalist economy works.

Briefly, assume Mr. Imsorich gets a tax cut. He already has all the bread and butter he wants so he saves rather spends his tax cut. This savings is injected into the capital markets, lowering interest rates. That makes cars and houses more affordable for everyone, which is stimulative.

Second, tax cuts encourage people to work more. This is commonly referred to as supply side economics. It is not intuitive how a tax cut can lead to more revenue through harder work, and many economists still reject this notion — despite substantial and growing evidence that it works.

Briefly, assume the government needed money and decided to put a small tax on all income over $200,000. (This is easy to sell to voters because most voters earn less and people are always in favor of taxing someone else.) The rich will complain but the government will get some tax revenue. Assume this works so well for the government that they impose a 100% tax on all income over $200,000, hoping to collect a lot. How much tax revenue do you think the government will get? Correct! Nil, nothing, zero. People will simply not work hard enough to earn $300,000, since the government will take everything over $100,000. (More likely they will find non-monetary forms of compensation.)

I am always amused to see some people who simply cannot comprehend this. I actually heard one candidate for U.S. Senate say the people who earn this much money should be happy to share their good fortune. (This economically astute candidate will likely be voting on your taxes next January.)

A graphic of this concept of tax revenues first rising as tax rates rise and then eventually falling as they rise further is known as the Laffer Curve. There are a multitude of unknowns relative to the Laffer Curve. Although it is obvious in extreme cases — e.g., both a 0% tax rate and a 100% tax rate result in zero tax revenues — no one knows where the tipping point is. Do taxes become a disincentive to work at 10%, 30%, 50%, 70%? What is the shape of the curve? The answer probably is that there are different Laffer Curves for every taxpayer, and even those individual curves change as circumstances change. Such uncertainty makes using the Laffer Curve for policy difficult and a source of argument. However, no one should dismiss it. The evidence is building up that it works and the United States in aggregate is beyond the peak.

Third, higher revenues cannot result in higher deficits. This is not economics this is accounting. If you get a raise but you have a deficit at the end of the year it means you increased your spending more than the amount of your raise. That is what the government did during much of the Reagan and Bush II years. Tax revenues increased due to the tax cuts but government spending went up more — a lot more. It is a spending problem, not a revenue problem.

So What Actually Happened Because of the Tax Cuts?

The government has just reported a deficit of $248 billion for the fiscal year ending September 30, 2006 — $48 billion less than the government forecast in August (bn). The deficit is 1.9% of gross national product down from 3.6% in 2004. This achieves President Bush’s goal two years early and is well below the average of 2.7% for the past 40 years (wsj). Note that the decline in the deficit was due to a sharp increase in revenues of 14.6% in 2005 and 12.0% in 2006 and not a decline in spending, which actually rose 7.9% in 2005 and 9.0% in 2006 (wsj).

This surge in tax collections is coming from corporations whose tax payments have increased 76% in the past two years and personal income taxes that have increased 30.3% in two years despite the fact that the top tax rate was cut from 39.6% to 35%.

IRS tax-return data indicates that a near-record 37% of those tax receipts is coming from the top 1% of earners (wsj). These are the wealthy whose tax rates were cut the most. I said in my 2004 article if you really want to soak the rich, cut their taxes. It worked during the Reagan years, and it is working again.

Go figure. That’s Politics

So here’s what’s happening. Taxes have been cut, so tax revenues are exploding. The richest of the rich are paying more than ever. The economy is doing about as well as any economy in our history. Still, since the government can’t quit acting like the government, spending is expanding more than twice as fast as the economy and inflation.

It seems as though half the candidates for political office are running on the idea that things are terrible and we need a tax increase to fix them — and many of those candidates are likely to win. If they succeed, a lot of this good news will be reversed. Whose side are they on, anyway?

OK. Now I am confused.