Some Tax Trip-Ups in the Democratic Debate

Senator Sanders and Governor O’Malley made some inaccurate references to past tax rates during their presentations last Saturday night. All three candidates, including Secretary Clinton, failed to mention the economic consequences of past policies of the sort they suggested.

Senator Sanders was asked how high he would raise the top tax rate. He answered, jokingly, that he would boost it a lot, although perhaps not to the 90% top tax rate in the Eisenhower Administration; that he, the Senator, was not as much of a socialist as Eisenhower! In fact, the top tax rate was 91%. At the end of World War II. It was bumped up to 92% during the Korean conflict, which was when Eisenhower entered office. Eisenhower only reduced it to 91% in the tax revisions of 1954. This was in stark contrast to the sharp rate reductions from a peak rate of 77% in World War I to 56% in 1922 and to 24% by 1929.

One result of Ike’s policies was that he presided over three recessions in his eight years in office. Presumably, the Senator would not want to repeat that outcome. The last slump cost Nixon the 1960 election. JFK ran on a platform of tax reductions and a pledge to “get the country moving again.” He cut taxes on businesses (faster depreciation via Treasury regulation in 1962, an investment tax credit – ITC – in the Revenue Act of 1962, a corporate rate cut in the Revenue Act of 1964) and a cut in tax rates across the board for individuals, with the top rate reduced to 70%, in the 1964 Act. The economy did move. (The 1964 Act was proposed by JFK, and enacted after his death under LBJ.)

Governor O’Malley stated that the top tax rate was 70% in the Reagan Administration, as if that were an acceptable level. In fact, the 70% rate had been reduced to 50% on wages and salaries in 1969, under Nixon. In 1981, it was still at 70% for dividends, interest, and non-corporate business income. Reagan ran on a pledge to cut tax rates across the board, like JFK. Reagan’s Economic Recovery Tax Act of 1981 cut the 70% rate to 50%. In the Tax Reform Act of 1986, it was lowered further to 28%.

The Senator recommended ending the reduced tax rate on capital gains and dividends, taxing both at ordinary income tax rates “to tax all types of income alike.” But capital gains and dividends are subject to double taxation, which is one reason for the differential. The double tax on dividends, in addition to the corporate level tax, is obvious. Capital gains taxes are double taxes too. As a business invests to raise future earnings, the future earnings will be taxed. The higher earnings also raise the current value of the business, because the market value of an asset, such as stock, is the present value of the expected after-tax future income. To tax the increase in current value as well as the future earnings that made the value higher is double taxation. The income tax treats income used for saving and investment much more harshly than income used for consumption. There is nothing even-handed or “alike” about it.

In the 1986 Tax Reform Act (TRA86), Reagan agreed to tax capital gains at the ordinary income tax rate, as the Act lowered that top rate to 28%. The top capital gains rate had been 20% since the 1981 Act. The rate hike was a disaster. People took nearly 40% fewer gains as a share of GDP. As realizations rates collapsed, so did capital gains tax revenues. They remained severely depressed compared to baseline projections until President Clinton and Speaker Gingrich cut the rate back to 20% in 1997.

For fun, we ran a set of higher tax rates up to 70% on the wealthy through the Tax Foundation Taxes and Growth model. We created new brackets of 50%, 60%, and 70% for joint returns with $600,000, $900,000, and $1.2 million in adjusted gross income (lower for single filers). We ended the tax rate differential on capital gains and dividends. The result was an 8.9% loss in GDP and labor income after all economic adjustments, and a loss of about 2.5 million full time equivalent jobs. Depending on the timing of the economic slowdown, there could be a revenue gain in the early years of up to $2.5 trillion over the ten-year budget window before the full drop in GDP. However, that is without any of the reduction in capital gains realizations and dividend payouts that must surely follow the end of the tax rate differential. Based on the reaction following the 1986 Act, over half the projected total revenue gain would be lost due to lower gains realizations and smaller dividend payouts.

Furthermore, the GDP loss over the decade would exceed $11.6 trillion. That’s about $4.66 in economic damage per dollar of revenue raised. Between the tax and the economic losses, each dollar of government spending funded by the tax increases would have to worth $5.66 to the public to make the trade a good deal. By the tenth year, almost 90% of the expected revenue gain would be lost to the lower incomes. Factoring in the inevitable drop in capital gains realizations and dividend distributions, the tax rate increases could lose revenue longer term.

The TRA86 also slowed depreciation write-offs and ended the ITC. Even with a cut in the corporate tax rate, the net effect of the1986 Act was a higher tax on new capital formation. Investment already in the pipeline was completed, but later in the decade investment growth slowed. Further hampered by payroll tax hikes in 1988 and 1990, the economy slid into the 1990-91 recession.

Senator Sanders would raise corporate income taxes in some manner, although the current U.S. corporate tax rate is by far the highest in the developed world, and, unlike most other nations, the U.S. tax is imposed on world-wide income. The high rate, and our global system of taxation, is driving U.S. companies with multi-national operations to move their headquarters abroad, or to sell out to foreign companies. An even higher rate would compound the damage.

All the candidates favor legislating a higher minimum wage and/or other benefits. All complained about Wall Street, and none favors the pending Trans-Pacific Partnership trade deal. Put these ideas together — higher tax rates, antagonism toward trade, penalties for the financial sector, and wage floors — and you have all the elements, writ small, of the Hoover-Roosevelt policy mix of higher taxes, tariffs, and regulatory interventions in the market that (with a little help from the Federal Reserve) began and prolonged the Great Depression. The outcome would not be as bad this time around, but it would surely reduce the current unsatisfactory economic growth rate even further.

Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” Policy makers who do not remember economy history make the rest of us repeat it.