Do tax cuts help?

Recently, over on dox^2’s blog, the question was raised about the effect of tax cuts. Do they in fact increase the revenues, or do they merely give some segment of society a break? This is, of course, a matter of no little interest in economics as well as politics, so the number of opinions (reasoned or not) is at least three times greater than the number of people debating the topic.

The fundamental idea behind this is that there are some who believe that reducing taxes increases the amount of money in circulation, thereby increasing the net wealth and thus leading to higher net revenues [12]. If you earn $100,000 and get taxed at 70%, then you only have $30,000 to spend which limits the amount of purchasing that you can do. But if you get taxed at 30%, then you have $70,000 to spend allowing you to purchase more, thereby creating more real wealth [13]. This is reasonably sound, as far as it goes. However, the real questions underlying this idea are “Does this actually work?” and “Which tax levels should be reduced the most in order to stimulate the economy and so increase total receipts?”

For example, after the latest round of tax cuts, the Bush43 administration claimed that the increase in revenues showed that the idea was working. But had the revenues increased more than we would have expected without the tax cuts? In other words, had the decrease of taxes actually led to an increase in receipts that was larger than otehrwise would be the case?

Being a scientist, I wanted to move from the realm of speculation to the real of fact. So, in order to examine this question, I went to the White House’s web site for FY2009, where they have historical tables for tax revenues (“receipts”), revenues by source, outlays, and GDP. The current administration is committed to the idea that tax breaks create more revenues, so if a bias exists in this data set, it should be toward showing an effect. In addition, I went to the National Tax Payers Union web site to get historical tax rates, and to the Bureau of Labor and Statistics to get the Consumer Price Index (CPI) which measures how much the real cost of things has changed [1].

In order to obviate secondary effects, I plotted not the nominal amount [2], but the change in the amount of revenues, outlays, and GDP. Looking at the data since 1934, an obvious and interesting pattern emerges right away – the changes are a lot smaller now than they were back in the 1930’s! This probably has two causes. First, there are more regulations in place on banks and other industries, creating a more stable working environment. More stability means fewer wild swings, which means more prosperity [3]. Second, there are fewer large conflicts than there were in the early part of this century. World War II and the Korean conflict are clearly visible in the receipts, outlays, and GDP lines, whereas the Iraq war barely makes a blip [4]. Though a large-scale war does stimulate the economy in the short term, it has an even larger quelling effect once it is over.

To see the effects over time, the annual change was summed; also plotted is the CPI. Again, WWII and Korea are clearly visible, as is the more subtle effect of the “peace dividend” from the end of the Cold War. Interestingly, the CPI is relatively flat, despite rising incomes (as seen in the increased receipts), showing the rise of the middle class [5]. However, after 1970, the CPI begins to trend steadily upward, paralleling the rise in receipts and GDP. Thus, the baby boomers had life pretty good, with rising incomes and steady prices, whereas later generations have had things more difficult as prices keep pace with income [6].

It is important to remember that these graphs show the relative change in receipts, outlays, and GDP, not the absolute dollar amounts. Thus, though the graph shows that the change in receipts matches the change in outlays (or vice versa), the net effect is a widening gap between the two [7] because the outlays were higher to begin with.

Focusing in on the period from 1970 onward, the data is even clearer. Outlays and receipts track the GDP almost perfectly. There is a 99.42% correlation between the GDP and receipts, and a 99.64% correlation between GDP and outlays. In other words, 98% of the change in both outlays and receipts can be related to a change in GDP. Increase GDP and receipts increase (as do outlays, unfortunately). Of course, this is where most economists start to arguing. What causes what in this strange loop? Does increasing outlays increase the GDP? Or is it the other way around?

Zooming in on those years also shows something very important. The sharp changes in the tax codes during the Reagan and Bush41 administrations show clearly as sharp decreases in receipts with no corresponding decrease in outlays. The percent change in revenues doesn’t catch up with the outlays until the last part of the Clinton administration (remember the surplus?) – and then is promptly whacked back down by the Bush43 administration. Based on this plot, it will take at least two decades for receipts to catch back up with outlays [8]!

OK, so maybe tax cuts don’t lead to higher receipts or even a higher rate of receipts. But at least they shift the burden from you and me to corporations, right? Unfortunately, no. Look at the plot on the right, with the tax rates and percent of receipts from corporations. Back in the mind-1940’s when the top tax rate was a staggering 94% (and the bottom rate was an equally staggering 23% – we’ve got it good right now!), corporate taxes made up ~45% of receipts. They hit a maximum of 62% in 1941, when the top tax rate was 81% and the bottom rate was 10%. Ever since then, the proportion of our tax burden that has been born by corporations has decreased. In 1983, corporations paid only 11% of the total tax receipts; in 2001, it was almost as small a proportion at a mere 13% of total tax receipts.

Another interesting feature is that the tax code has become progressively flatter over time [9]. During the period when the middle class grew the fastest (1945-1970), the highest tax rate was consistently 3-4 times higher than the lowest. During the past two decades, however, the gap has narrowed. When the Regan tax cuts were found to be too generous, they were balanced primarily by increasing taxes on the lowest tax payers from 11% to 15% – while the taxes on the highest bracket fell from 39% to 28% [10]. It wasn’t until Bush41 and Clinton increased taxes on the highest brackets that the budget began to come back into alignment.

Thus, continuing the present tax rates is a prescription for disaster – unless, of course, we also cut back on spending. We would need to cut back on spending by at least 16% [11] in order to balance the budget without raising taxes. In FY2009, the US will take in $2,699,947,000 and will spend $3,107,355,000 (not counting off-budget items). We are spending ourselves into the poorhouse, and the tax cuts have made the trip shorter not longer.

How would I solve the problem? First, cut spending by 10%; cutting it by more risks creating a recession, especially in these days of stagflation. Pork-barrel spending accounts for about 1% of the budget, so that can be cut with little effect on the economy overall. The other 9% will have to come from big budget items in the military (the next generation fighter plane, large aircraft carriers, etc – not from pay or support for the troops!), Homeland Security, and other wasteful government departments. Second, increase taxes on the uppermost brackets by 5%, for a top bracket of 40%, while simultaneously decreasing taxes on the lowest two brackets to 10% and 12% respectively. This will stimulate the economy by encouraging more circulation of money, which is the ultimate wealth creator. The net effect will be to increase receipts to $3,162,795 while decreasing spending to $2,796,620,000 – giving a surplus of  $366,176,000 or approximately 6% of the  debt. Use the surplus to pay down the debt would in essence tell the rest of the world that they are undervaluing the dollar while simultaneously reducing the influence of foreign governments on our policies. In other words, a win-win-win situation.

How would you fix this mess?

John

[1] If a hot dog cost $1.25 in 1998 and now costs $2.50, are you truly paying more? You only know the answer if you know how the buying power of the dollar has changed. If the dollar has dropped in value by 50% in the past decade, then the two hot dogs have the same price. If the dollar has dropped by 75%, then you are now getting a bargain – the hot dog would be $0.63 in 1998 dollars!
[2] This is a standard trick in the physical sciences; by normalizing, we look at scale-independent effects and so get to the root laws.
[3] Which means all of us complaining about the recent market downturn should shut up and think about things for awhile. The market has lost less than 12% of its value in the past year, and is up by nearly 60% for the past decade. Compare that to the 1930’s and market performance then!
[4] This also shows the effect of growing the GDP; war is no longer a large component of our GDP. (Something that I personally find very heartening.)
[5] When incomes go up and prices don’t, the relative wealth of a family increases, creating a larger middle class. When prices and incomes parallel each other, the middle class remains fairly constant in size. When prices outpace incomes, the middle class shrinks.
[6] In other words, this is yet another way that they screwed the rest of us!
[7] Here’s some math to show what I mean. Imagine that you spend $100 and that you made $86 this year and expect a 8% raise next year. How much can you raise your spending next year, given that this year’s gap was only $14? Next year, if you raise your spending as much as your income goes up, you will end up owing more. Your spending will grow to $108, and your funds will only be $93 – a gap of $15! If you get another 8% raise the year after and increase your spending again (what, don’t you learn?), then the gap will be larger still ($16) and you’ll go still further into debt ($45 total, including what you owe from previous years). In eight years, you’ll owe more than you make in a year. Keep it up too long, and you’ll go bankrupt [a].
[8] Calculation of the national debt at that time, and the length of time it will take to pay it off is left as an exercise for the student.
[9] I.e., the rates at which those earning the most are taxed is closer to the rate for those earning the least. This has the effect of increasing the tax burden on the middle and lower classes, strangling wealth creation in the US.
[10] This is more serious than it sounds, as every 1% reduction on the highest brackets must be matched by a much larger increase on the lowest brackets in order to stay revenue neutral. If I pay 35% and earn $100,000, then my tax is $35,000. If you pay 10% and earn $25,000, then your tax is $2,500; the total tax income is $37,500. If my tax rate decreases to 33%, so that I pay only $33,000, your will have to increase to 18% ($4,500) in order to make up the difference!
[11] Based on the figures in the FY2009 budget. Again, these are likely to understate the case; a 25% reduction ins pending is more likely to be needed.
[12] This part was added to address QoFB’s question (below).
[13] A side assumption is that money spent by individuals is more likely to generate wealth by circulating than money spent by the government. If I buy a loaf of bread, then part of the money goes to the store, part to the distributor, part to the baker, part to the wholesaler, part to the miller, part to the coop, part to the farmer, and so forth – all of whom pay taxes. If the government buys 10,000 loaves of bread, then many of the middle men are cut out and the net distribution of payments is severely reduced – as are the opportunities to build wealth and pay taxes on it. The same argument is made for decreasing taxes on the lower earners, as they more effectively spread the wealth by buying things (which are taxed at sale and when they generate income) instead of stock (which is only taxed when it is sold).

[a] The sad thing is that these figures are taken from the White House budget. There it is, in black and white, that the current President and Congress are spending us into bankruptcy. And yet, nobody seems to care.

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16 thoughts on “Do tax cuts help?

  1. John:

    This is a rigged game. The House Ways and Means Committee writes the tax code. This committee along with the Senate Finance Committee holds power over every penny, which you earn or ever hope to earn. The real bottom line is that people respond to incentives. Lower rates for individuals and corporations act as an incentive to be productive and take risks. American businesses need to remain competitive in the global economy and individuals need an incentive to advance them selves economically so that they may be able to become independent and avoid becoming dependent on public institutions. Our greatest national problem is the growing unfunded liabilities of government transfer programs, i.e., Social Security and Medicare. Progressive taxation just makes it worse.

  2. This is a rigged game. The House Ways and Means Committee writes the tax code.

    True, but the tax code is subject to veto by the president. And, as Reagan and Bush43 showed, a president can have considerable influence over how the tax code is structured.

    This committee along with the Senate Finance Committee holds power over every penny, which you earn or ever hope to earn.

    I'd love to see your evidence for this.The real bottom line is that people respond to incentives.

    Lower rates for individuals and corporations act as an incentive to be productive and take risks. Exactly!

    And the incentives should be placed where they do the most good for the country as a whole – at the bottom of the tax ladder, as that allows the people to develop wealth, earning more and eventually paying more in taxes.

    Our greatest national problem is the growing unfunded liabilities of government transfer programs, i.e., Social Security and Medicare. Progressive taxation just makes it worse.

    Can you prove your thesis? Or is this more of an ideological bias? (I.e., is there any evidence that you can point to to support your statement?)John

  3. Promises made on Social Security and Medicare place every taxpayer at risk to sharp parabolic tax hikes because as our population ages [I'm 56] fewer workers are going to be paying taxes to support Social Security and Medicare. Benefits are expanded and costs keep going up. The so-called Social Security Trust Fund is nothing more than paper promises to pay benefits, FICA taxes go to pay current benefits and all revenues go into the general fund. We have budget deficits and a growing national debt because politicians spend more than is taken in as revenue – the primary cause is because politicians continue to buy votes using spending programs to gain political support.

  4. Promises made on Social Security and Medicare place every taxpayer at risk to sharp parabolic tax hikes because as our population ages [I'm 56] fewer workers are going to be paying taxes to support Social Security and Medicare. Benefits are expanded and costs keep going up.

    So you are saying that the government shouldn't pay back people (including you and me) who have paid into Social Security?

    The so-called Social Security Trust Fund is nothing more than paper promises to pay benefits, FICA taxes go to pay current benefits and all revenues go into the general fund.

    Not quite true. Revenues go into a fund that is borrowed against using long-term government obligations. It is accrual accounting rather than cash accounting.

    We have budget deficits and a growing national debt because politicians spend more than is taken in as revenue – the primary cause is because politicians continue to buy votes using spending programs to gain political support.

    True – but not exactly on point here. You've given me philosophy – can you give me numbers to back up your statements?
    John

  5. You shouldn't presume what I mean in such accusatory tone ask for clarification. They are unfunded liabilities, which can only be funded by higher and higher payroll taxes. I don’t see turning America into a welfare state as positive.

  6. Call me math challenged, but I've never really seen how giving tax cuts can ever really increase tax revenue. If you decrease my tax bill by $100 and I go out to spend the entire $100 how can the government possibly receive more than $100 (or even all of my $100) back in increased revenue? Unless this money is magically multiplying in the dark of night there is only so much of it. Having the numbers go up in the pencil and paper calculations is one thing, having the hard cash to back it up is something else entirely. It has always seemed to me (even without your lovely calculations and easy to follow graphs) that the only way to fix the budget problem is to increase taxes and cut spending.

  7. You shouldn't presume what I mean in such accusatory tone ask for clarification. They are unfunded liabilities, which can only be funded by higher and higher payroll taxes.

    And you shouldn't use umbrage to avoid the question. Should we refuse to honor our obligations by canceling Social Security? It is a funded liability; we have already collected the funds for it (that's what that Social Security tax taken out of every paycheck is for; to pay for your social security annuity, not your parent's. That politicians have used the money and replaced it with IOUs is another matter entirely.)

    John

  8. Call me math challenged, but I've never really seen how giving tax cuts can ever really increase tax revenue. If you decrease my tax bill by $100 and I go out to spend the entire $100 how can the government possibly receive more than $100 (or even all of my $100) back in increased revenue? If the decreased taxes are used to stimulate the economy, then they can indeed have a multiplicative effect. Though the increase in the CPI is worrisome, it was done by the Fed deliberately; they chose to control inflation in order to encourage more spending which then created a larger GDP and greater wealth creation (and more tax revenues). Think of it as taking a smaller slice of a bigger pie. If given a choice between 70% of $100 or 30% of $1000, which would you take? The problem comes about when trying to decide between 40% of $1000 or 30% of $1200; unfortunately, this is the situation that we find ourselves in now.It has always seemed to me (even without your lovely calculations and easy to follow graphs) that the only way to fix the budget problem is to increase taxes and cut spending. Increase, yes – but not too much and mostly by reducing the loopholes. My nominal tax rate this year was 35%, but I only ended up paying at the 20% tax rate because of all of the special loopholes I was able to use. Other folks are even more clever than I am. Stockbrokers and financial advisers prefer to take their pay as dividends (15% tax rate) or other similar dodges to bring their effective rate lower still; many of the top earners and corporations pay no taxes at all!John

  9. Think of it as taking a smaller slice of a bigger pie. I understand the theory behind all of this. I always get hung up on the concept of the pie getting bigger. Minting of new coins is a concrete creation of new money. Everything else is just so many numbers on paper and relies on the trust and belief of the public to exist (IMO). 1929 gave us a pretty good example of what happens when people lose their faith in the system. Call me old fashioned, but I'd feel much more secure about the monetary system if all the assets were concrete.

  10. I understand the theory behind all of this. I always get hung up on the concept of the pie getting bigger. Minting of new coins is a concrete creation of new money.You are confusing the map (coins) with the territory (wealth). Having more coins is not the same as being wealthier – look at what happened to Spain after the conquistadors brought back all of that gold, for one example. Everybody in Spain had lots of gold, so it lost value; they were, in effect, poorer than they had been before plundering the New World [1].Everything else is just so many numbers on paper and relies on the trust and belief of the public to exist (IMO).True, but that is the case with gold as well as scrip. That's why different countries had different values for their gold coins – some were believed to be purer than others and so were stashed away while the less pure ones were traded away as quickly as possible. Understanding this led various economists to posit what is known as Gresham's Law: "Bad money drives out the good" [2].Even if you were to use nothing but gold (or some other concrete item) for exchange the actual relationship would remain abstract. It is just that many people feel that gold is more "real" as money than paper is. The way to think of it is that dollars are the eigenvectors for the eigenfunction relating work to wealth.1929 gave us a pretty good example of what happens when people lose their faith in the system. Call me old fashioned, but I'd feel much more secure about the monetary system if all the assets were concrete.Most economists agree that moving away from the gold standard was the best thing that could have happened to the US. When our money is based on an objective standard, then it is only worth what someone tells us it is worth, and is subject to strong outside influences.By maintaining a standard that is based on intangibles, the system is actually more stable than it would be otherwise. Let us suppose, by way of example, that the dollar were based on a â"diamond standard", where a 1 carat clear base cut white diamond was equal to the value of $1000. On that basis, last year's US tax receipts would have been the equivalent of 3,019,195 tons of diamonds [3]. Now let us suppose that DeBeer's decided to go out of the diamond hoarding business and to sell their backlog. Suddenly, the value of diamonds would plunge to about 1/10th of the current level and the US economy would go into the crapper.Compare that to the current currency, which is based on the reputation of the US government. As long as we pay our debts on time [4] and maintain a strong economy, our currency will be strong. When we start racking up debt, or when our economy shows sign of weakness relative to the other economies in the world, then our currency gets devalued [5].John[1] Serves them right, some would say.[2] Equally true with currencies: if you are paid in Kwanza, you trade them for dollars as soon as you can. But if you are paid in Euros, you keep them even when offered dollars.[3] If you had that many diamonds, you could form a cube roughly one half mile wide, long, and high.[4] This is why paying down (or off) the national debt is a good idea; it shows us as a responsible country, debt wise.[5] Indeed, that is what has been happening to the dollar. Since 2001, it has dropped in value by nearly 50% against the Euro simply because the Euro is used in countries with lower debt ratios that the US and because the European economy has not dropped as severely as the US economy has over the past few years.

  11. Even if you were to use nothing but gold (or some other concrete item)
    for exchange the actual relationship would remain abstract.Yes, I was thinking about that earlier today. [5] Indeed, that is what has been happening to the dollar. Since 2001, it has dropped in value by nearly 50% against the Euro simply
    because the Euro is used in countries with lower debt ratios that the
    US and because the European economy has not dropped as severely as the
    US economy has over the past few years.Even the drug dealers are switching to Euros.

  12. Sorry I am late to the tax cut party.The economy is kind of like global warming in that there are lot of variables that can influence the equation.One thing I did take away from your work was that overall there hasn't been much of a change around income vs. GDP over time. But our debt continues to grow.I concur with some of your thoughts Jon. And I think the only real way to get out of this debt mess is to reduce spending.The only one that will have to the guts to use that veto pen with a Democratic Congress is McCain — not Obama.

  13. The economy is kind of like global warming in that there are lot of variables that can influence the equation.

    Yes – like any interesting problem (science-speak for "difficult to solve"), it requires you to think deeply about what is happening and why.One thing I did take away from your work was that overall there hasn't been much of a change around income vs. GDP over time. But our debt continues to grow.

    There hasn't been much change in the rate of change; tax receipts grow about as fast as the GDP does (neglecting the drops where the tax cuts took effect). But the ratio of receipts to GDP gets much worse, because the GDP was higher to start with.I concur with some of your thoughts Jon. And I think the only real way to get out of this debt mess is to reduce spending.

    "When you find yourself in a hole, the first thing to do is to stop digging."The only one that will have to the guts to use that veto pen with a Democratic Congress is McCain — not Obama.Not so sure about that. My reading of the current political situation is that only a Republican will be able to get us out of Iraq (as Democrats are afraid of being labeled "weak on terrorism"), and only a Democrat will be able to control spending (as Republicans don't worry about being labeled as "tax and spend", despite their history).John

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