TAX RATES DON’T MATTER MUCH
Lower tax rates sound wonderful, and might be if combined with an actual strategy to lower deficits and debts. But at least in recent decades, they almost never are. Tax rates by themselves aren’t enough. If there is to be a real campaign to bring some fiscal sense and solvency to the U.S. government budget, it must be focused on the spending side. That’s because changing tax rates – up or down – really doesn’t have much of an impact on tax revenues. Nearly a century of U.S. revenue history show that tax rates don’t matter a lot in how much money they bring into the government. When tax rates go up, a certain percentage of people withdraw from paid work and a greater amount of work and economic activity goes underground, avoiding the tax man.
Conversely, when tax rates go down, more economic activity is brought out into the open and despite the lower tax rates, a comparatively higher percentage of economic activity becomes taxed, offsetting the lower rates. As I showed in an article back in December, as a percentage of Gross Domestic Product, federal revenues tend be very stable, generally between 16% and 18% of GDP, regardless of underlying marginal tax brackets. For example, in the 1970s marginal tax rates were rather high, yet tax collections were about average. In the 1980s marginal tax rates were lowered, but tax collections remained stable.
Is it possible that lower marginal tax rates are boosting GDP, therefore keeping the ratio of tax revenues to GDP lower than it otherwise would be (i.e., tax revenues actually are accelerating, but so is GDP). History also does not bear this out. The highest marginal tax rates in the U.S., combining personal income taxes and corporate, were generally in the 1950s and 1960s (see chart below), yet yearly GDP gains were generally very strong then, growing over 5% per year in real terms.
Since the 1960s, marginal tax brackets have steadily fallen, but so too have GDP growth rates, steadily falling to under 2% per year, despite the lowest tax rates in more than 80 years (see following chart).
Now tax rates are not the only variable that might affect GDP growth, but if lower marginal tax rates were highly correlated to higher economic growth, we would see this in the data. In fact, these two variables are strongly correlated, but negatively correlated. Lower tax rates are highly correlated (though of course, not necessarily causal, with the many economic variables that do exist) with lower economic growth. What is clear is that cutting tax rates by themselves have not produced strong greater economic activity.
I suspect the idea that lower tax rates lead to stronger economic growth might be more likely if tax rate cuts were combined with reduced government spending, but alas, since for most of the last century, Presidents, Congressmen and Congresswomen have been more concerned about re-election than making difficult, but sensible changes to fiscal spending, we don’t really know what possible economic benefits might have arrived from lower spending and tax cuts.
Now I am certainly not arguing against lower tax rates. Higher tax rates are inefficient (especially when filled with tens of thousands of pages of regulations and loopholes), leading to tax avoidance, and hundreds of billions of dollars of yearly lost economic activity. And for a debtor country like the U.S., lower tax rates are desperately needed to attract foreign money to these shores to offset the $500 billion or so of debt and overspending that is transferred outside of the country every year (the current account deficit). A fairer and more level tax structure will avoid some of the massive disincentives to greater economic activity.
But it should also be noted too, that while federal tax rates have generally fallen within the U.S. over the last half-century, state and local income, property and other taxes, have generally risen in most states in the country during this same period. A return to yesteryear federal rates combined with today’s high state and local rates would see even more of the economy turn inward and underground.
Here’s another problem. The tax-cuts-are-the-solution idea makes the presumption that it is a lack of consumer, government and corporate spending that is the problem. That if only more money were in the hands of taxpayers and corporations they would spend it (or “invest” it, in the case of corporations). Well, we can certainly see that corporations aren’t spending their large recent windfalls. A majority of the trillions of dollars of bond issuance since the last recession has been spent on stock buybacks to boost stock and option prices.
As far as consumers, when the financial crisis hit in 2008, they did the sensible thing: they cut back – on spending and on debt. To compensate for that, and to avoid a longer-term economic adjustment, the government picked up the slack with overspending. Over the last decade, the federal government has added over $10 trillion in yearly additions to public debt. So while consumers and businesses tried to save more and reduce their debt (for a while; they’ve picked it up again), governments added to theirs in record numbers. We see this in the chart below. When the recession hit, consumer savings (the green line) rose as they sensibly saved more, while at the same time, government (the yellow line) began a campaign of massive overspending to “take up the slack” from consumers, resulting in even lower government savings.
This fall in the national savings rate is important because, with low savings, there’s low investment, and with low investment, economic growth withers. This falling national savings rate over the last few decades has likely strongly contributed to the declining economic growth rates we have seen. And given such low levels of national savings in recent years, it should not be a wonder why economic growth has been so low during this economic “recovery”. It is savings which provides the economic fuel for expansion, and with such low levels of savings, there is little fuel for the future. And with more headwinds from ever-increasing health care and insurance spending and Social Security spending from baby-boomers, the lack of savings will further hamper economic growth.
WHY NOT ZERO TAXES?
Given that the government is content with very low savings rates and massive yearly deficits, why not let individuals and corporations keep all their money and eliminate the waste and inefficiencies of the federal corporate and individual tax system? As it is, the federal government does not collect nearly enough to balance its books, so it’s not as if tax collections are keeping the government solvent.
Below are the yearly additions to federal debt since 2002. The debt increases here are those actual additions in Treasury bond or bill debt during the years, and which avoids some of the accounting tricks that make the yearly deficits look less frightening, the “official” yearly deficit. (Note that this does not even include the yearly additional promises to future beneficiaries (accrued liabilities). Once these liabilities are properly accounted for, yearly deficits are trillions of dollars higher.)
The U.S. government has added just over $11 trillion in federal debt over the last ten years, or about $1.1 trillion in yearly overspending. So if the theory is that lower tax rates (or lower taxes) will provide extra economic activity, and there is no economic or financial cost associated with the overspending, then why stop at lower tax rates? Why not eliminate federal taxes altogether? If we don’t need to worry about how large deficits and debts are don’t need to worry about budget deficits or debts, then why not just continue the $4 trillion or so in federal spending each year, and pay for it in the future? If $1 trillion yearly deficits are fine, then why not $2 trillion or $4 trillion?
Even if consumers (and stock market participants or government) cheer lower tax rates, at some level they must understand that there will be a price to be paid for the cuts. As long as lower taxes are not offset with spending cuts, the lower taxes of today will be viewed as temporary to be replaced with higher tax cuts in the future. In fact, if the government was properly taxing it citizens in order to pay for its expanding level of debt and bills, tax rates (and revenues) would need to be much higher, not lower, than they are already are.
While the majority of Wall Street, Congress and the media will ignore the problems of perpetual overspending or pretend they don’t exist, there have been a few notable advisors warning of the deep trouble that the government – and by extension, it’s citizens – are already in. Laurence Kotlikoff, an Economics Professor at Boston University, has become well-known in recent years for his research and for highlighting the dangers of chronic government overspending, and especially warns of the dangers of the extreme level of unfunded liabilities (promises to pay in the future) without setting aside anything to pay for it. In 2015 he spoke to Congress and explained how the actual amount of U.S. federal debt, once accrued liabilities are factored in, is over $210 trillion.
According to Professor Kotlikoff, these expected future payments are 58% higher than projected revenues, meaning that the federal government is currently 58% underfinanced. He further estimated that the level of U.S. government underfunding is more than twice that of the city of Detroit, prior to it declaring bankruptcy. As calculated by Kotlikoff, as of 2012, the U.S. government’s fiscal gap as a share of the present value of GDP was 13.7%. This is much worse than other developed countries such as Germany (1.4%), U.K. (5.4%), France (1.6%), Spain (4.8%) or Italy (-2.3%).
Based on Kotlikoff’s analysis, in order for the U.S. government to balance this fiscal gap, taxes collected across the board would need to be increased by 58%, immediately and forever. Or alternatively, total federal spending would need to be cut by 37% (i.e., reducing this year’s spending by about $1.5 trillion). And every year the government waits to act, the worse it will be in the future. For example, if the government waits until 2025 to deal with the problem, then spending cuts would need to be cut 40%, or tax revenues would have to be increased 64%, forever. And the unfortunate reality is that if taxes were ever increased to such a level, economic activity would go into quick decline, and stay there for years or decades, which would then worsen the fiscal equation and fiscal realities even more so.
The government has ignored this problem for so long it now appears there is no way out, certainly not without serious pain, despite the temporary enthusiasm for more benefits without costs. When even 5% spending cuts across-the-board or a 5% increase in taxes or cutting non-discretionary spending in any amount would be considered political suicide, closing such fiscal gaps will never happen voluntarily. Instead, a crisis will erupt, at some future time, maybe a year, or five, or fifty, at which time the consequences of delays become immediate, realized and magnified.
This is indeed a “brave” new world, where governments are comfortable with trillion-dollar deficits. Perhaps we are not far off from a world where they’ll be comfortable with $2 trillion-a-year deficits. Or five. Or ten. With past governments and in past centuries, when the government wanted to spend a lot more than it collected in revenues, it would have to do the uncomfortable thing and make the case to taxpayers to pay more in taxes (or occasionally revenue bonds, such as in the case of war). Today, such actions are hardly considered. The preferred course, regardless of who’s president or in Congress, is to print the money and pretend that taxpayers in the future will be willing to pay for today’s and past irresponsibility.