Cato Policy Analysis No. 148 February 21, 1991

Policy Analysis

How Rising Tax Burdens Can Produce Recession

by William C. Dunkelberg and John Skorburg

William C. Dunkelberg is dean of the School of Business and Management at Temple University, and John Skorburg is chief economist for the Chicago Association of Commerce and Industry.


Executive Summary

Last year's highly touted, grand-compromise budget agreement reached between President Bush and Congress will raise roughly $150 billion in new taxes over the next five years--making it the second largest tax increase in American history.(1) New revenues will come from increases in income tax rates, gasoline taxes, and beer and cigarette levies, and from a combination of other excise taxes. Altogether those taxes will raise the federal tax burden on American workers to an all-time peak.

Now it appears that the tax frenzy is not complete on Capitol Hill. To promote "tax fairness," Rep. Dan Rostenkowski, the Democratic chairman of the House Ways and Means Committee, has announced that he may soon introduce legislation to place a 10 percent income tax surcharge on Americans with incomes over $1 million. Others are calling for a new tax on energy usage to pay for the Persian Gulf War.

Politicians and many economists have been applauding the move to new taxes, insisting that higher revenues are necessary to reduce the deficit and thereby stimulate long-term economic expansion. President Bush, for one, has argued that the 1990 budget package sent a reassuring message to jittery U.S. financial markets that Washington is serious about tackling the deficit.

Yet so far the financial markets have responded not positively but negatively to higher taxes, contrary to the assurances of lawmakers. Ever since Bush announced his "yes, new taxes" campaign, the Dow Jones Industrial Average--one of the most reliable economic barometers--has tumbled in free fall (see Figure 1). On average, stocks have forfeited roughly 15 percent of their value since last summer when tax talks gained momentum.

Figure 1
Financial Market's Response to Bush's New Taxes and the Iraqi Invasion
(Graph Omitted)

Of course, part of the fall in prices is attributable to the Persian Gulf crisis. Still, the data in the figure underscore two points: First, the signs of a bear market originally emerged before the Persian Gulf crisis but after Bush capitulated on taxes. Second, the completion of the budget deal has done nothing to arrest the decline in stock prices that accelerated after the Iraqi invasion of Kuwait.

Yet with all the legislative sweat, the deficit is not going to decline as expected and will probably rise in the next several years. The Congressional Budget Office reported in December that the deficit would climb to record dollar totals of $250 billion to $300 billion in 1991 and 1992.(2) The CBO also has estimated that at least $100 billion in the purported five-year $490 billion in deficit reduction has already vanished because of continued deterioration of the economy. Others, including the Office of Management and Budget, are saying that the CBO is too optimistic and that the deficit will rise above the $300 billion mark.(3)

Why are the new taxes producing such unexpected consequences?

One primary reason is that the adverse impact of new taxes on the economy has been ignored entirely. President Bush and congressional leaders have carefully avoided discussing the possibility that the steep downturn in the economy is directly related to the contents of the anti-growth budget package itself. The economic models engineered by the OMB and the CBO do not assume any adverse economic effects from higher taxes--indeed, those models anticipate positive economic responses to more taxes. The OMB predicts, for instance, that because new taxes will lower government borrowing, interest rates on Treasury bills will fall by 1995 by 3 percentage points--to their lowest level in a quarter century.(4)

This study presents solid statistical evidence demonstrating that taxes do harm the economy in a significant and consistent way. Since 1960 tax increases (measured by total tax receipts as a percentage of gross national product) have led to slowdowns in economic growth, and often to recessions. Likewise, when Washington has reduced federal tax burdens over the past 30 years, there has been a statistically significant positive economic and employment stimulus in the following year.

The implication of this model is straightforward: by enacting tax increases last year that will bring the tax burden to record levels, President Bush and Congress have directly contributed to the current economic erosion, rather than combatted it. Specifically, from our historical model, we predict the following economic response to the budget package:

* Economic growth will be 0.7 percent per year lower than it would otherwise be.

* Four hundred thousand fewer jobs per year will be created than would otherwise be created.

* The tax burden will rise to 20.7 percent of GNP by 1992 (the greatest tax burden since World War II), which will increase the severity of any subsequent economic recession.(5)

* Approximately $330 billion, or roughly two-thirds, of the projected $491 billion in deficit savings from the budget package will be eliminated by the adverse economic impact of new taxes on the economy.

The model suggests that any realistic anti-recession economic package this year should contain three reforms. First, President Bush and Congress must begin to systematically repeal major tax components of the 1990 budget pact. Second, Congress should cancel any plans to raise more tax revenues in 1991, such as an income tax surcharge on the rich or an energy tax. Third, as measures to stimulate economic expansion and new jobs, Congress should consider pro-growth tax cut proposals, such as a reduction in the tax rate on capital gains or Sen. Daniel Patrick Moynihan's (D- N.Y.) rollback of social security payroll taxes and the proposal by Rep. Tom DeLay (R-Tex.) and Sen. Malcolm Wallop (R-Wyo.) to combine social security tax cuts with expansion of tax breaks for Individual Retirement Accounts and a reduction of the capital gains tax rate. Finally, deficit reduction should come in the form of expenditure reductions, not just reductions of projected increases in spending.

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