When Tax Cuts Increased Revenue

History of top marginal income tax rates in the United States (Photo credit: Wikipedia)

One of more popular / infamous posts here on Almost Classical is "The 90% Tax Rate Myth." It explores the differences between marginal and effective rates and explains that when the marginal rate was 90% or higher, the effective rate remained relatively consistent, between 40 and 50% throughout the twentieth century. Even in most of Europe, effective rates stay close to that same range, indicating something of a natural ceiling for effective tax rates.

No serious economist would propose a tax rate of five or ten percent for the highest income earners. The actual debate among economists is where tax rates produce the greatest revenues with the least detriment to risk taking and entrepreneurship. In current academic papers, the debate on the highest marginal individual tax rate ranges from 35% to 60%, with most studies finding 45% works well as an effective tax rate on the top ten percent of earners.

Here's a quick summary of the so-called "Chicago" school of thought in economics, as of 2017.

• Tax revenues seem to be "stuck" between 16 and 20 percent of GDP, a relatively narrow range. Determining who pays those taxes and and what rates is the subject of current debate.
• Effective tax rates for the top 10 percent of earners over the last century stays within a narrow range, as well, from 40 to 50 percent most years, with  mean of 44 percent. 
• Taxing only "earned income" at the top marginal rate distorts earnings from investments and shelters some wealth.

Basically, the "left" and "right" debate among economists and economic historians is over the range and breadth of marginal tax rates. The debate is not nearly as extreme as politicians and the press might suggest.

The "conservatives" agree that tax cuts below the 35 percent top marginal rate produce no corresponding increase in economic activity nor federal revenues. In fact, each dollar of cuts below the 35 to 40 percent range seems to produce only 35 cents of private economic activity. (Lots of 35s in this, I realize). So, you cut taxes three dollars for one dollar in activity? That's not logical and most conservative economists state this opening: tax cuts that reduce rates below 40 percent do not pay for themselves through increased economic growth.

But... when you lower high effective and marginal rates, say from 60 percent to 50 percent, we have experienced economic growth and greater federal tax revenues. The data suggest $1.25 to $1.50 in new economic activity when high marginal tax rates were brought closer to 50 percent.

So, there's a "ideal range" -- a "Goldilocks" range -- for effective tax rates.

State taxes in high tax-states like California are deductible from federal income taxes. Also, most wealthy don't have the high "incomes" people imagine... and only income is taxed directly. There are still many, many ways for the wealthy to reduce their effective federal tax rates. In other words, a high marginal rate doesn't translate into reality. It never has.

Thomas Sowell's meta-analysis "Trickle Down" Theory and "Tax Cuts for the Rich" explores this historical data. https://www.youtube.com/watch?v=RMhI-AQgYPU

The problem is, whenever tax cuts are suggested, the progressives march out the "Trickle Down" moniker, yet there is no such theory, no such set of economists as "Trickle Down" theorists. There are supply-side and fiscal-centered economists (versus monetary policy advocates). Most economists are pragmatic and know policy is more nuanced. Then, you have the political economists who embrace rhetorical flourishes.

…the reasons for proposing such tax cuts are often verbally transformed from those of the advocates — namely, changing economic behavior in ways that generate more output, income and resulting higher tax revenues — to a very different theory attributed to the advocates by the opponents, namely "the trickle-down theory."

No such theory has been found in even the most voluminous and learned histories of economic theories, including J.A. Schumpeter's monumental 1,260-page History of Economic Analysis. Yet this non-existent theory* has become the object of denunciations from the pages of the New York Times and the Washington Post to the political arena. It has been attacked by Professor Paul Krugman of Princeton and Professor Peter Corning of Stanford, among others, and similar attacks have been repeated as far away as India.

It is a classic example of arguing against a caricature instead of confronting the argument actually made.

Data are more important than emotional appeals to fairness or some mythical equality of taxation. In reality, moderate taxation rates collect more revenues. The debate is what constitutes a moderately progressive top marginal rate.

Sowell reminds us of the history of tax cuts for the highest earners.

The facts are unmistakably plain, for those who bother to check the facts. In 1921, when the tax rate on people making over $100,000 a year was 73 percent, the federal government collected a little over $700 million in income taxes, of which 30 percent was paid by those making over $100,000. By 1929, after a series of tax rate reductions had cut the tax rate to 24 percent on those making over $100,000, the federal government collected more than a billion dollars in income taxes, of which 65 percent was collected from those making over $100,000.

There is nothing mysterious about this. Under the sharply rising tax rates during the Woodrow Wilson administration, to pay for the First World War, fewer and fewer people reported high taxable incomes, whether by putting their money into tax-exempt securities or by any of the other ways of rearranging their financial affairs to minimize their tax liability. Under these escalating wartime income tax rates, the number of people reporting taxable—incomes of more than $300,000 — a huge sum in the money of that era — declined from well over a thousand in 1916 to fewer than three hundred in 1921. The total amount of taxable income earned by people making over $300,000 declined by more than four-fifths during those years.

Since these were years of generally rising incomes, as Mellon pointed out, there was no reason to believe that the wealthy were suddenly suffering drastic reductions in their own incomes,12 but considerable reason to believe that they were receiving tax-exempt incomes that did not have to be reported under existing laws at that time.

Can tax rates be too high? Keynes thought so.

It was none other than John Maynard Keynes who said, in 1933, that "taxation may be so high as to defeat its object," that "given sufficient time to gather the fruits, a reduction of taxation will run a better chance, than an increase, of balancing the Budget."

But, politicians and pundits don't argue about facts. They argue the emotions of "inequality" and suggest that high taxes (which have tended to slow growth and economic progress for everyone) is at least morally the right course of action.

Again, the question is what is the best balance between collecting revenues and stimulating economic activity. That is at least what the debate should be.

As Sowell reminds us, tax revenues actually did increase up through 2009 under George W. Bush. Then, we had the ultimate Black Swan combination: terrorism and the housing bubble. But, those are unrelated to the revenues where were being collected. Even the New York Times, in 2009, reported on the increased federal revenues.

Even when empirical evidence substantiates the arguments made for cuts in tax rates, such facts are not treated as evidence relevant to testing a disputed hypothesis, but as isolated curiosities. Thus, when tax revenues rose in the wake of the tax rate cuts made during the George W. Bush administration, the New York Times reported: "An unexpectedly steep rise in tax revenues from corporations and the wealthy is driving down the projected budget deficit this year." Expectations, of course, are in the eye of the beholder.

We should discuss taxation through the lens of historical data and current economic theory. We don't. We discuss taxes in terms of what will make us feel good: someone else paying more.

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