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 . 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 . 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 .
In order to obviate secondary effects, I plotted not the nominal amount , 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 . 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 . 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 . 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 .
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  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 !
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 . 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% . 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%  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?
 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!
 This is a standard trick in the physical sciences; by normalizing, we look at scale-independent effects and so get to the root laws.
 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!
 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.)
 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.
 In other words, this is yet another way that they screwed the rest of us!
 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].
 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.
 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.
 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!
 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.
 This part was added to address QoFB’s question (below).
 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.