Tax Cut Facts and Fantasies

This article was published in the Washington Times, April 4, 2003.

In 1980, President Carter and his supporters in the Congress and news media asked, “how can we afford” presidential candidate Ronald Reagan’s proposed tax cuts?

Mr. Reagan’s critics claimed the tax cuts would lead to more inflation and higher interest rates, while Mr. Reagan said tax cuts would lead to more economic growth and higher living standards. What happened? Inflation fell from 12.5 percent in 1980 to 3.9 percent in 1984, interest rates fell, and economic growth went from minus 0.2 percent in 1980 to plus 7.3 percent in 1984, and Mr. Reagan was re-elected in a landslide.

Now a quarter-century later, the same debate is being replayed, with the opponents demonstrating collective amnesia and ignorance. Those opposed to President Bush’s tax proposals make two major arguments: the tax cuts will increase the deficit and benefit the rich. Those who support the tax cuts argue that such tax cuts will increase economic growth and liberty, and reduce poverty.

To have an honest debate, it is important to know the facts. Claims are made that a tax cut will “cost” $700 billion or so, over 10 years. Such numbers are almost meaningless. First, they tend to be static revenue estimates, which assume no change in behavior because of the tax cut, which is totally unrealistic. Second, gross domestic product (GDP) is expected to be approximately $140 trillion over the next 10 years, which means the proposed tax cut is approximately one-half of 1 percent of total national product (in static terms). Even though political commentators, like David Broder of The Washington Post, refer to the tax cut as “massive” (March 30, 2003), it is almost too small to be meaningfully measured.

The correct way to measure tax revenues and government outlays is as a percentage of gross domestic product, in the same way the burden of your home mortgage is directly related to your income. You may be shocked to learn that even though federal government tax revenues and spending have increased almost twentyfold in the last 40 years, they have barely budged as a percent of GDP.

For instance, federal tax revenues were 17.5 percent of GDP in 1962 and were an almost identical 17.9 percent of GDP last year. Over this 40-year period federal tax revenues have never been lower than 17 percent (1965) or higher than 20.8 percent (2000) of GDP. Likewise, federal expenditures have ranged from a low of 17.2 percent (1965) to a high of 23.5 percent (1983) of GDP over this same 40-year period.

Despite the fact that federal revenues have varied little (as a percentage of GDP) over the last 40 years, there has been an enormous variation in top tax rates. When Ronald Reagan took office, the top individual tax rate was 70 percent and by 1986 it was down to only 28 percent. All Americans received at least a 30 percent tax rate cut; yet federal tax revenues as a percent of GDP were almost unchanged during the Reagan presidency (from 18.9 percent in 1980 to 18.1 percent in 1988).

What did change, however, was the rate of economic growth, which was more than 50 percent higher for the seven years after the Reagan tax cuts compared with the previous seven years. This increase in economic growth, plus some reductions in tax credits and deductions, almost entirely offset the effect of the rate reductions. Rapid economic growth, unlike government spending programs, proved to be the most effective way to reduce unemployment and poverty, and create opportunity for the disadvantaged.

The nonpartisan Congressional Budget Office (CBO) has just released its analysis of the effects of the President Bush’s tax and spending package. They found that without the president’s tax cut, federal tax revenues will rise to 20.6 percent of GDP, up from last year’s 17.9 percent; but even with the president’s tax cut, taxes will still rise as a percentage of GDP to 18.8 percent in 2012. As we get wealthier, tax revenues increase as a percentage of GDP because of our progressive tax system. In order to keep the tax burden constant, we need to have periodic tax cuts even larger than the ones the president has proposed.

Some of the critics of the proposed tax cut claim the planned deficit spending will increase interest rates. Here again, the facts do not support the criticism. What is important is the total federal debt burden, not year-to-year changes in the deficit.

If the total debt burden rises as a percentage of GDP, it can crowd out private investment thus causing a reduction in investment or a rise in interest rates. However, again according to CBO, the total debt burden will actually shrink as a percent of GDP under the president’s plan (from 34.3 percent in 2002 to 33.1 percent of GDP in 2012). The fact is the U.S. could run a small deficit forever and still reduce the debt burden, in the same way as an individual can take on more debt each year provided that the cost of servicing this additional debt is smaller than the rise in the individual’s income.

At current levels, the debt is not a problem. At the end of WW II it was more than 100 percent of GDP and as late as 1995 is was almost 50 percent of GDP, and we did just fine. Ironically, the only time our debt burden was less than 30 percent in the last 60 years was in the 1970s, which were characterized by high inflation and interest rates and low growth.

What kind of tax cut should we have? Nobel Prize-winning economist Robert Lucas presented an important paper in January of this year, in which he says: “There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows.” Mr. Lucas found that reducing capital income taxation from its current level to zero (using other taxes to support an unchanged rate of government spending) would result in overall welfare gains of “perhaps 2 to 4 percent of annual consumption, in perpetuity.”

President Bush’s proposal to eliminate the double tax on dividends is a good first step but, if we would remove all taxes from productive savings and investment, such as taxes on interest and capital gains, almost all Americans including the poorest would see their real incomes grow at roughly twice the present rate — forever. Those who oppose tax cuts on savings and investment because they think the rich would benefit are in fact punishing the poor. President Reagan understood that one wins a war, the Cold War, by being resolute; and he understood that one strengthens the economy not only by having good policies, but also by educating the press and the American people every day as to why those policies are right and necessary. President Bush is being resolute on the war on terrorism, but he also should create an army of knowledgeable supporters to educate the press and people about the needed growth-enhancing tax policy to avoid losing the economic war.

Richard W. Rahn is an adjunct scholar of the Cato Institute.