Does Lowering Taxes Increase Government Revenue?

December 15, 2010

Mitt Romney published an op-ed in USA Today a couple of days ago arguing against the compromise tax plan between President Obama and congressional Republicans. His main reason for opposing it is its temporary nature – uncertainty over tax levels makes businesses less willing to take risks and hire new workers. It’s a valid point, one explored in detail in the Wall Street Journal article linked to earlier on this blog. But then Romney goes on to say this:

In many cases, lowering taxes can actually increase governmentrevenues. If new businesses, new investments and new hiring arespurred by the prospects of better after-tax returns, the taxespaid by these new or growing businesses and employees can more thanmake up for the lower rates of taxation.

The idea that lowering taxes can raise revenue, or that the tax cuts “pay for themselves” as some say, is not new; it’s been around since at least the 1980s, and it’s a fundamental tenet of supply-side economics. The argument is that it’s possible for tax rates to be so high (and therefore such a burden on the economy) that lowering them allows the economy (and the tax base) to grow fast enough that the extra revenue from the larger base is more than the lost revenue from the lower tax rate. During the Nixon administration, the economist Arthur Laffer, who was later a member of Reagan’s Economic Policy Advisory Board, created an illustration now known as the “Laffer Curve”:

laffer

Hardly anyone disputes the basic concept shown here. At a tax rate of 0%, the government gets no revenue. It can increase revenue by increasing tax rates, up to a certain point, called the "revenue maximizing point" (labeled t* here) beyond which increasing tax rates any further damages the economy enough to cause revenue to go down, all the way back to zero at a rate of 100% (where the government takes everything you make, eliminating your incentive to work at all.)

Note that this is a greatly simplified picture – we have a progressive income tax, and different groups of people pay taxes at different rates depending on their income, in addition to the existence of various credits, deductions, and the like (the instructions for the Form 1040 alone are 175 pages long). So there is obviously a problem inherent in attempting to boil down our entire federal income tax code into a single number. But the broader concept is applicable, regardless of these complications.

The big question is, what is t*? Is our current tax system below t* (at a point like t1) where decreasing tax rates decreases revenue, or is it above t* (at a point like t2) where decreasing tax rates increases revenue? It’s not an easy question to answer, because of the complications mentioned above. Additionally, if you want to look at historical tax cuts, there’s no control to compare revenues against – even if it appears that a tax cut raised government revenue, there’s no way of knowing for sure what revenues would have been without it.

Romney, for his part, seems to be saying that the Bush tax cuts raised revenue, implying that Clinton-era tax rates were at the point t2 on the Laffer curve. There are hardly any economists who would agree, and it’s hard to believe Romney if you look at the data. Here is a graph of government revenue and tax rates from 1980 to 2006:

taxRates

I've used per capita figures to adjust for population growth.  Supply-side economists usually argue that the marginal rate is the most important, and I’ve included it here, as well as average effective rates for each income quintile , calculated by the Urban-Brookings Tax Policy Center here, to get as broad a picture as possible of the level of taxation for each year.

The Bush tax cuts were first enacted in 2001, and it’s easy to see the drop in tax rates beginning in that year on this chart. If Romney’s argument is correct, we should see a jump in federal revenues beginning that year as well, but we don’t – in fact, revenue falls rather sharply from 2001 to 2003, when the tax cuts were being phased in.

There is a huge caveat here: The United States experienced a recession in 2002 and 2003, which accounts for at least part of the drop in revenue. And many argue that the increase in revenue visible after 2003 is evidence that the Bush tax cuts grew the economy. Did they grow the economy so fast that revenue began to exceed what it otherwise would have been without the cuts? At least from a basic analysis like this one, it’s impossible to know for sure if revenue would have been higher had Clinton-era tax rates been kept, but a growing economy is the norm, and the general trend in the long term, clearly visible in the graph, is for revenues to rise as per capita GDP goes up. Furthermore, revenue did not start to rise until after the Bush tax cuts were fully phased-in; during the period when tax rates were falling (from 2001 to 2003), revenue went down. The correlation visible on the graph is striking.

It’s unfortunate, therefore, to see prominent public figures like Romney making such an argument – an argument that hardly any economists take seriously. Given current budget realities, it amounts to little more than wishful thinking, and makes life harder for reformers who are serious about the deficit. Proposing tough options like spending cuts or tax increases, necessary to solve our long-term budget problem, becomes harder when people believe there’s an easy fix. And it undermines his larger argument for permanently extending the Bush tax cuts, because there are many valid reasons to favor their extension that don’t rely on the fallacious idea that doing so will raise revenue. For example, there’s a clear argument to be made that the Bush tax cuts helped spur economic growth and were a factor in ending the early 2000s recession, even if they didn’t increase government revenue. The ultimate goal of any economic policy is not to maximize government revenue, it’s to maximize long-term economic growth. Getting back to the Laffer Curve concept, there’s no particular reason why a tax rate of t*, the rate that maximizes government revenue, is the socially optimal rate of taxation. That’s only true if you’re someone who believes that the size of government should necessarily be as large as possible, and that’s certainly not true for any conservative like Romney.

Correction: This post originally stated that the Laffer Curve concept was developed during the Reagan administration; it was actually during the Nixon administration.

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