Editor’s note: This is the second of two columns on the economics of tax cuts. The first column is Economists agree: Tax cuts don’t create revenue.
Tax cuts don’t raise revenues. Economists identified with both political parties believe that. However, many in the general public think they do, and that argument has been a mainstay of Republican platforms for 30 years.
Last week, I detailed how many of the most respected Republican economists think the idea of self-paying tax cuts is both wrong and harmful to our long-term economic well being. But that convinces few true believers.
A common rejoinder is “These college professors are all closet liberals, Republicans in Name Only. Anyone can look up the numbers and see that tax revenues went up after Ronald Reagan cut taxes.”
That is true; inflation-adjusted federal revenues for fiscal year 1989, the last one for which the Reagan administration prepared a budget, were up 21 percent over FY 1981, the last Carter year.
But this ignores important details. First, while overall revenues were up, the biggest part of that came from increased Social Security taxes. These were raised, not lowered, during Reagan’s term in response to the Greenspan Commission’s recommendations to fix Social Security for baby boom retirements. About $190 billion of the nearly $300 billion increase in overall annual revenues came from this tax increase on wage and salary income. (All dollar figures are adjusted to 2010 price levels.)
Secondly, while corporate income tax revenues did increase 24 percent, that was skewed by two factors: In 1981, the country was in a recession that stemmed from the Volcker Fed’s harsh clamp-down on the money supply to end inflation. And 1989 was a particularly high year compared to the three years before it or the three years after it.
The 1989 revenues were still 8 percent below the levels hit in 1977-1979. Those highs were not reached again until 1994. In the meantime, below-trend corporate tax revenues helped contribute to the doubling of the national debt in eight years.
Individual income taxes make a more plausible story. These revenues increased 14 percent over eight years and were not skewed by high or low years as much as corporate taxes. The problem with using income tax revenues as evidence of self-funding tax cuts is that revenues rise over every decade or presidential term regardless of tax rates.
Revenues rose 21 percent in four years under Carter, 59 percent during Clinton’s eight years and 53 percent for the Kennedy-Johnson years, when the top marginal rate was 70 percent. They even grew 8 percent during the Eisenhower administration with a 90 percent top rate.
Such revenue increases even when taxes were high, as in the 1950s and 1960s, or following tax increases as in the 1990s, belie the argument that high tax rates reduce revenues and low tax rates increase them.
As an economist, I need to point out that this exercise of looking at revenues at the beginning and end of a presidential administration is bogus in terms of explaining causation. It is worth doing only because that is the level of analysis one hears in arguments that tax cuts pay for themselves. But one needs to look further to explain causal relationships between tax rates and revenues.
Other factors like Fed monetary policy, exchange rates, the overall phasing of the business cycle, external shocks like oil prices or new technology all affect national output and thus all affect tax revenues and government outlays. That is why one must rely on researchers like Martin Feldstein, Joel Slemrod and others cited in my column last week. Their models are sophisticated enough to tease apart such intertwined economic strands. And virtually all such researchers come to the conclusion that while lower tax rates may motivate increased work or investment, they do not add enough revenue to offset the direct effect of tax rate cuts.
Taxes, however, are only one reason the gross national debt, adjusted for inflation, was five times as high at the end of 2009 as it had been 30 years earlier. Spending, particularly on Social Security, Medicare and other federal health programs, played a large role.
However, the argument one often hears that Reagan-era deficits resulted from a Democratic-controlled Congress forcing large social spending increases on an unwilling president are specious.
Spending at the end of Reagan’s term was up 24 percent over 1981. But the composition of increases is interesting. Defense spending was up 41 percent. Net interest on the national debt rose 80 percent as a result of the increase in the debt from 35 percent of GDP to 56 percent over eight years.
Social Security and Medicare spending did burgeon, up 22 percent and 59 percent respectively in real terms. But this did not result from any significant increase in the scope of these programs. Demographic changes and increases in health care costs drove it.
Non-Medicare federal health spending including Medicaid, Veterans Administration hospitals and so forth rose 32 percent for the same reasons. But spending on “income security” programs that include Food Stamps, welfare, student financial aid, Supplemental Security Income and so forth was flat, with no increase whatsoever. Everything else, covering the bulk of cabinet departments, fell 13 percent.
A final explanation of why the “self-paying tax cut” is a fallacy is that the predicted chain of causation never occurred. Tax rate cuts were supposed to motivate more work and more investment. But after the cuts were made, there was no significant increase in hours worked or other labor measures. And the long decline in national and personal savings rates began precisely when tax cut advocates claim they should have risen.
Argue that low tax rates motivate more work and investment, all other things being equal, and thousands of economists will agree with you. Argue that the size of the federal government should be slashed and you will be among hundreds. But argue that tax cuts will increase tax revenues and you will find yourself in a small group of cranks, charlatans and cable TV entertainers.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.