The consequences of changing tax rates on tax revenues are not very clear. While those on the left tend to see lower tax rates as leading to lower tax revenues, those on the right often make the case that lower tax rates may even raise the amount of tax revenues. As usual in such disagreements, the truth appears to be closer to the middle. Historical evidence indicates that, by itself, changing tax rates, up or down, doesn’t result in significant change to the amount of taxes collected by the federal government. Lower tax rates in general encourage more business expansion and entrepreneurial activity, and encourage more “underground” activity to come above ground. This generally offsets the marginal declines in tax revenues. The reverse is true during times of higher tax rates, when more economic activity becomes bartered or eliminated, offsetting increases in tax revenues from the marginal tax increases on other taxpayers.
Below is a chart showing federal tax revenue (it does not include state and local taxes) as a percentage of Gross Domestic Product (GDP) in the U.S. going back to 1929. We see that over the last 70 years or so, federal tax revenues have remained rather consistent. The majority of this time, tax revenues ranged within the narrow range of between 16% and 18% of GDP.
The relative stability of tax revenues is despite what are sometimes large differences in marginal tax rates. For example, tax revenues were not unusually high in the 1970s despite marginal tax rates that were very high. A $14,000 income in the late 1970s would have put you in the 31% marginal tax bracket and $44,000 would have taken you to the 60% bracket. In the early 1980s marginal tax rates were cut sharply, resulting in an initial decline in revenue (though still not excessive), and a quick recovery of tax revenues in the years that followed. Tax revenues of the 1980s were nearly the same in the 1970s despite much lower interest rates in the latter period. The rise and fall of tax revenues over the last two decades was more closely associated with economic expansion and contraction, booms and busts. There has been almost no change in marginal tax rates in the U.S., but tax collections have changed in line with economic booms and busts. In addition, the extent of proposed tax cuts are so broad and deep that it seems impossible to believe that tax revenues won’t fall, at least for a time.
What about the argument that lower marginal tax rates will result in more economic growth? This seems reasonable enough. If lower tax rates put an extra $1,000 in a consumer’s pocket, he or she will then spend that $1,000, or most of it, putting that money to work in the economy and growing it for everyone. The Tax Foundation (a conservative organization) has looked into some of the empirical studies http://taxfoundation.org/article/what-evidence-taxes-and-growth covering such tax changes and find that generally, lower taxes are beneficial for economic growth. There are many difficulties with such studies, starting with the number of variables that need to be controlled, so the effect of tax changes can be isolated – an almost impossible task. In addition, individual income taxes are not by a long shot the only taxes consumers pay, nor the only ones collected by the federal government. Taxes need to be analyzed as a whole, including those paid at the state and local level. If tax rates are simply lowered for one tax while raised on another tax, no aggregate economic benefit should be expected. It should also be noted that the economic benefits from lower tax rates tend to occur over time. In the short run, the most significant effect of lowering tax rates are a reduction in federal tax revenues (again though, generally reversed in the years thereafter)
Another problem with analyzing studies of the economic impact from past tax law changes is that the past has different economic foundations. For example, the amount of government debt has soared over the last several decades. In my last article I put this graph up showing the growth of U.S. federal debt and interest payments on that debt since 1988. Quite simply, federal debt has soared in these three decades, increasing nearly eight times in the less than 30 years. In that article I also showed the potential growth of federal debt, and interest payments on that debt, if government “stays the course” regarding massive deficits, particularly when they are combined with higher interest rates. (And interest rates have already climbed significantly higher since the election.) A new administration has done nothing to change the laws of mathematics.
Further, because of now near-record high ratio of debt to GDP, twice average historic levels, it is possible that consumers and taxpayers are becoming even more “immune” to tax “cuts”. Worse, if consumers believe that such debt accumulation will eventually backfire for the economy leading to runaway inflation or some form of financial Armageddon, such consumers may actually save more than the amount they were supposed to spend from the tax savings. So $1,000 in tax savings may ultimately result in thousands of dollars more of reduced consumer spending. Without evidence that the government is serious about decreasing its debt, consumers will see any tax cut as temporary and may not act the way government hopes or expects. That is to say, they may act rationally.
Next time I will talk about the spending side of government and myriad problems associated with large government “stimulus” programs, including the one proposed by the new administration.