I. The Theory: Laffer Curves, Supply Side Tax Cuts, and Demand Side Tax Cuts
We are hearing a lot these days about the lessons of the Reagan tax cuts. We are also being treated to a revival of the Laffer Curve. Which is... interesting.
There are two basic arguments for using tax cuts to stimulate the economy. One is the supply-side version: that's the argument that cutting taxes for high earners will cause them to invest more in the economy, which will ultimately produce more jobs. You may recall this as the "trickle down" theory, later rebranded as the "rising tide lifts all boats" ideal. This argument makes sense so long as two things are true: that the economy is being held back by a shortage of capital available for investment, and that high earners are being held back from investing because they do not have the money to do so. Given that we are currently in a situation in which corporations are sitting on record amounts of uninvested capital and have just recorded the most profitable quarter in all of American history, it's a little hard to see how those descriptions apply. The demand-side approach to tax cuts favors cuts for low and middle earners, in the hope that they will spend the extra money and thus stimulate the economy; this is essentially using tax cuts as a form of Keynesian stimulus. That argument makes sense so long as two things are true: that the economy is being held back by a lack of demand, and that there are lots of people who would buy more things if they had the money to do so. In the current economic climate, that seems like a fairly plausible pair of assumptions.
But! The Laffer Curve provides supply-siders with a different explanation for why tax cuts for high earners will stimulate the economy. Laffer's curve describes a theory about human motivation. It goes like this. Suppose you have someone earning $100 a year and paying 25 percent in taxes. That is, he gets to keep $75 out of that $100. Now suppose he has an opportunity to earn $120 next year, but the tax rate on that next $20 will be 35 percent. Laffer argued that a certain number of people would rather not earn that extra $20 if they only got to keep $13 of it -- they would rather earn $100 and take home $75 than earn $120 and take home $88, maybe because there is extra work or risk involved in earning that next $13. As tax rates get higher, the number of people who are unwilling to earn more money if they will have to pay higher rates on that additional income goes up. At a certain point -- the tipping point in the curve -- cutting tax rates at the top of the scale will persuade enough people to be willing to make more money who otherwise would have refused to do so that the total tax revenues received will go up. Laffer never claimed that tax cuts will always result in increased revenue -- it all depends on where you start on the curve. (To see the theory explained in Laffer's own words, go here.)
George H.W. Bush called this "voodoo economics," and it's not hard to see why (not that liberals talking about health care reform are above engaging in a bit of voodoo economics of their own.) On the one hand, it's hard to quibble with Laffer's contention that many people would decline to earn more money if it were going to be taxed at a rate of 100 percent -- it's what happens at other levels that becomes a matter for speculation, and perhaps some historical evidence.
II. What Are Actual Tax Rates?
There is something very strange about the way both Democrats and Republicans have been framing the conversation about tax cuts. The question a month ago was whether to retain all of the Bush tax cuts (the GOP's position), or only those affecting income below $250,00 for a household and $200,00 for an individual. Here's the strange part. Both sides were framing this in terms of distinguishing among persons, as in "we want a tax cut for the middle class but they want a tax cut for the rich."
But that is simply not true. We are talking about marginal tax rates here. That is, it is not the case that a household making more than $250,000 would pay the old, pre-tax cut rate on all their income, only on income above the $250,000 cap. On all their income up to that limit they would pay the same rate as everyone else. When we say that the top federal income tax rate is 37 percent, we don't mean that the taxpayers who are in that bracket pay 37 percent in taxes on all their income, only on the income that the earn above the cut-off. The effective tax rates are quite different.
Then, of course, there is the matter of the relentless focus on federal income taxes. Leaving aside state and local taxes (a significant omission given the importance of property taxes, state sales taxes, licensing fees, and so on). Focusing only on federal taxes, here are the effective rates as of 2005, according to the Congressional Budget Office. For each of several categories of households, I include the effective rates for all federal taxes, individual income taxes, payroll taxes, and corporate taxes. (I am not including federal excise taxes, which are not significant.) Note that these categories overlap, as the top 1 percent is included in the top 5% percent and so on.
- top 1%: all taxes, 31.2%; income tax, 19.4%; payroll taxes, 1.7%; corporate tax, 9.9%
- top 5%: all taxes, 28.9%; income tax, 17.6%; payroll taxes, 3.5%; corporate tax, 7.4%
- top 10%: all taxes, 27.4%; income tax, 16.0%; payroll taxes, 4.8%; corporate tax, 6.1%
- top 20%: all taxes, 25.5%; income tax, 14.1%; payroll taxes, 6.0%; corporate tax, 4.9%
- everyone: all taxes, 20.5%; income tax, 9.0%; payroll tax, 7.6%; corporate tax, 3.1%
That's just the effective federal tax rates. A different question is what share of federal tax revenues, in each categories, come from each of these segments of the population? Again, these are 2005 data from the CBO:
- top 1%: all taxes, 27.6%; income tax, 38.8%; payroll taxes, 4.0%; corporate tax, 58.6%
- top 5%: all taxes, 43.8%; income tax, 60.7%; payroll tax, 14.4%; corporate tax, 74.9%
- top 10%: all taxes, 54.7%; income tax, 72.7%; payroll tax, 25.8%, corporate tax, 81.6%
- top 20%: all taxes, 68.7%; income tax, 86.3%; payroll tax, 43.6%; corporate tax, 87.8%
(Source: Historical Effective Federal Tax Rates, 1979 to 2005 (Congressional Budget Office, December 2007), here.
What about fairness? Don't the highest earners pay more than their share in taxes? The answer is, "yes, by a little bit," but not nearly as much as most people tend to think. Here is a look at the distribution of wealth, divided into all wealth, non-home wealth (known as "financial wealth"), and income. These data come from a study of 2007 Survey of Consumer Finance conducted by the Federal Reserve:
- top 1%: all wealth, 34.6%; non-home wealth, 42.7%; income, 21.3%
- top 5%: all wealth: 61.9%; non-home wealth, 71.4%; income, 36.9%
- top 10%: all wealth, 73.1%; non-home wealth, 81.5%; income, 46.8%
- top 20%: all wealth, 85.1%; non-home wealth, 91.6%; income, 61.4%
(Source: Edward N. Wolff, "Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze--an Update to 2007," Levy Economics Institute of Bard College working paper, March 2010.)
So, for example, in 2006 (located neatly between the two years of the data presented above), the top quintile of households earned 55.7 percent of pretax income and paid 69.3 percent of federal taxes, while the top 1 percent of households earned 18.8 percent of income and paid 28.3 percent of taxes. But note that these last numbers are distorted by the fact they compare income to all taxes, not just taxes on income -- If you look at the overall distribution of only federal taxes, the system is slightly progressive, and if you factor in the regressive effects of state and local property and consumption taxes, the entire system is even less progressive than that.
III. What Did the Reagan Tax Cuts Actually Do?
Historical discussions often lead into an impossible maze of information. For starters, there is the correlation-causation problem (if a tax cut is followed by growth, does that show that the tax cut caused the growth?) Nonetheless, we can at least look at some of the claims being made and try to focus more precisely on the areas of ambiguity. There are four major periods of tax cutting in modern history: the 1920s, the Kennedy administration, the Reagan administration, and the George W. Bush administration. I will focus primarily on the Reagan administration, with a few comments about the very large tax increases that were signed into law by Franklin Roosevelt.
We frequently forget that in addition to several tax cuts focusing on income taxes, Reagan also signed off on about a dozen tax increases, primarily on payroll and excise taxes. Measured in dollar value, the tax increases were about half as large as the tax cuts. In one way, this complicates the picture: What if there had been no tax increases? (Or, conversely, what if there had been no tax cuts?) If our question is "what is the effect of tax cuts on economic growth," this makes things complicated. On the other hand, if our focus is on the effects of tax rates on federal tax revenues -- the Laffer Curve claim -- we have a genuine experiment: by tracking the tax revenues that flowed in from the increased taxes and the decreased taxes, operating under the same economic conditions, we have an actual empirical test.
Another question is how we separate the effects of tax cuts or increases from changes in the overall economy. Again, the fact that these cuts and increases occurred simultaneously helps solve that problem. It is also the case, however, that economists measure the effects of tax rates on revenues in terms of a percentage of GDP rather than in gross dollar amounts. During periods of growth, this begs a very large question: what if economic growth would not have occurred but for the tax cuts in question? On the other hand, Reagan approved both tax cuts and tax increased during a recession. I'll come back to both of these points in a minute.
A. Tax Cuts and Tax Revenue: the Reagan Case
The main Reagan tax cut was the Economic Recovery Tax Act of 1981. That law had a number of elements that were phased in over time, reaching full implementation in 1983. By a nice coincidence, 1983 was also the year in which the most important tax increases took effect (the Tax Equity and Fiscal Responsibility of 1982, raising payroll taxes and certain excise taxes) took effect. Those and other Reagan tax increase were seriously regressive: In 1980, according to Congressional Budget Office estimates, middle-income families with children paid 8.2 percent of their income in income taxes, and 9.5 percent in payroll taxes. By 1988 the income tax share was down to 6.6 percent -- but the payroll tax share was up to 11.8 percent, and the combined burden was up, not down.
To test the effects of the two laws, I looked at the average for the four years following complete implementation (1983-1986), and compared that to the average for the preceding four years (1979-1982), using data compiled by the Tax Policy Center. The results:
- income tax revenues: 1979-82, 9.075% of GDP; 1983-86, 8.05% of GDP (down 11.29%)
- payroll tax revenues: 1979-82, 5.925% of GDP; 1983-86, 6.275% of GDP (up 5.5%)
- corporate tax revenues: 1979-82, 2.125% of GDP; 1983-86, 1.375% of GDP (down 35%)
But actually, the corporate tax cuts took effect in 1982. If we shift the years to that 1982 is included in the post-tax-cut category, the results are even more stark: the average corporate tax revenues from 1979-81 were 2.33% of GDP; from 1982-86 that average falls to 1.4%.
And just for comparison, for the four years from 2006-2009, the averages are:
- Income tax revenue: 7.65% of GDP
- Payroll tax revenue: 6.275% of GDP
- Corporate tax revenue: 2.125% of GDP
To repeat the point, during the very same years, in the very same economy, tax cuts resulted in a decrease in tax revenues measured as a portion of GDP while tax increases resulted in an increase in tax revenues measured in exactly the same way. Which, of course, leaves the question of the relationship between tax cuts and overall economic growth.
B. Tax Cuts and Growth
Here, we can range a bit more widely, recognizing that the larger the historical sweep of the discussion the more we are certainly omitting critical variables. Nonetheless, this exercise may be useful as an antidote to the kind of monocausal, ahistorical claims that are sometimes made on behalf of cutting taxes, such as this statement from the Heritage Foundation:
There is a distinct pattern throughout American history: When tax rates are reduced, the economy's growth rate improves and living standards increase...Conversely, periods of higher tax rates are associated with sub par economic performance and stagnant tax revenues...President Hoover dramatically increased tax rates in the 1930s and President Roosevelt compounded the damage by pushing marginal tax rates to more than 90 percent.
The preceding discussion was premised on the idea that we should look at tax revenues as a share of GDP. What if, instead, we look at the average annual change in tax collections? Here I do not have data breaking everything down by specifics, but on the other hand we have some long-term historical data which is potentially informative:
- FDR 121.3%
- Truman, 3.7%
- Eisenhower, 2.4%
- Kennedy, 4.8%
- Johnson, 6.9%
- Nixon, 0.3%
- Ford, 6.4%
- Carter, 3.0%
- Reagan, 2.4%
(Source: U.S. Office of Management and Budget, Historical Table 2.1, Budget for FY 1997.) That figure for FDR is not a misprint -- over 13 years, the total increase in tax revenues was 1,865%. FDR raised the top rate from 25 percent to 91 percent (that rate had been lowered in the 1920s from 75 percent).
What about general rates of economic growth? Here are the figures for increase in real GDP during the key years of FDR's administration, according to the Bureau of Economic Analysis:
- 1936, +13.0%;
- 1937, +5.1%;
- 1938, -3.4%;
What makes that 1938 figure so interesting is that in 1937, under pressure from conservatives in Congress, Roosevelt cut back on stimulus spending programs. Looking across a range of administrations, we get the following figures for overall economic growth: Kennedy-Johnson (49 percent over eight years), followed by Clinton (34 percent), followed by Reagan (32 percent), Nixon-Ford (24 percent) and Eisenhower (21 percent).
Actually, there are no clear affirmative conclusions to be drawn here except that we have overwhelming reasons to reject the claims being made by supply-side tax cut enthusiasts. The data certainly do not show that tax cuts never stimulate economic growth, nor even that they never stimulate economic growth enough to pay for themselves -- the data on the Kennedy tax cuts suggest that this is exactly what happened. But those were primarily demand-side tax cuts, similar to the tax cuts that were the largest element in Obama's stimulus package. The supply-sided, Laffer-curved theory of tax cuts as stimulus started out as voodoo economics 30 years ago. Today, Paul Krugman calls them "zombie" theories.
Which brings us to the question that has been plaguing Hollywood and cable television lately: Just what does it take to kill a zombie?