Chapter 9: The Myth of Tax Rates & Economic Growth

TAX RATES AND ECONOMIC GROWTH: MYTH AND FACT

Economic growth in a competitive world economy depends on America having (1) the most productive businesses and workers, (2) enough investment capital to finance a public and private economic infrastructure that will enable America’s businesses to operate more efficiently than their competitors, and (3) robust domestic consumption that encourages businesses to expand in America. Cuts in tax rates affect each of these factors but not always positively. A cut in tax rates that results in revenue loss can prevent America from educating its workforce and providing a world class infrastructure. And, if tax-rate cuts are targeted to the wrong groups, they can contribute to an imbalance between investment and consumption that can retard growth.

Economists have measured the effect of higher (in contrast to lower) individual personal income tax rates on economic growth and have debunked the myth that higher tax rates inherently retard economic growth and reduce revenue. No one disputes that taxes can be raised to a point that robs the best-off taxpayers of their incentive to earn the next dollar. However, there is plenty of room for dispute as to where that point is, and there is little, if any, evidence that marginal personal income tax rates have ever reached or exceeded that point.

In the practical world of personal income taxation, marginal tax rates have not exceeded 39.6% since 1987, and no credible player in the tax game is urging an increase much above that. Recent efforts to increase revenue by the Obama Administration concentrate on ending or curtailing tax preferences that especially benefit very high-income taxpayers, not by increasing marginal tax rates.

For a generation, a clique of evangelical economists have preached the gospel of the “Laffer Curve,” a gospel which ordains that cuts in marginal tax rates will increase both economic growth and tax revenue. Conventional economists have disputed this gospel.

Once a tax has been levied and all relevant data relating to its economic effects has been evaluated by experts, the facts eventually emerge. With respect to the twin beliefs that taxes can be cut without sacrificing any significant loss of revenue and high marginal tax rates are inherently bad for economic growth, the facts speak for themselves.

As for tax cuts not sacrificing revenue, the Reagan and Bush tax-rate cuts both reduced revenue as a percentage of GDP by about 1.5% while the Clinton tax-rate hikes increased revenue as a percentage of GDP by about 1.8%. As for the effect of these tax-rate cuts on spurring economic growth, in the eight years that followed the Clinton tax increases, GDP grew at an average annual rate of 3.65%; in the eight years that followed the Reagan tax cut, GDP grew at an average annual rate of 3.63%; and in the eight years that followed the Bush tax cuts, GDP grew at an average annual rate at 1.64%. So, contrary to the Laffer Curve gospel, the Reagan and Bush tax cuts did result in revenue loss while the Clinton tax increase did not prevent the economy from growing more than it did following the Reagan and Bush tax-rate cuts.

As for high marginal personal income tax rates discouraging economic growth relative to lower marginal rates, from 1946 through 2015, the top marginal rates ranged from 92% to 28% and annual GDP growth rates have ranged from -11.60% to 8.70%. Over this period, the top marginal rate was 50% or more for 40 years with the annual GDP growth rate averaging 3.20% while the top marginal tax rate was less than 50% for 30 years with the annual GDP growth rate averaging only 2.57%. So, there is no apparent correlation between economic growth rates and marginal personal income tax rates.

Facts, then, settled the argument (at least for most experts) in favor of the conventional economists (See the 2005 CBO Study published under the leadership of Douglas Holz-Eakin). As long as tax rates are not hiked above 50% (and maybe more) for the best-off, there is little (if any) credible evidence that economic growth would suffer. As a practical working principle for the personal income tax, tax-rate increases not exceeding 50% raise revenue and do not necessarily harm economic growth. For the time being, then, there is plenty of room for increasing personal income taxes on the best-off without quelling their thirst to make more money. The thirst to make money drives productivity.

The fancy of many tax cutters that tax-rate hikes almost always dampen economic growth and tax-rate cuts are almost always self-financing meshes nicely with the myth that Americans are over-taxed. All myths rest on some rationale that contains a seed of what seems to be an apparent truth. Even though the slightest scrutiny reveals that the apparent truth on which these myths rest is only a mirage, a mirage is good enough to support the belief of many. It is easy for many high-income taxpayers to believe these myths because they offer a compelling excuse to avoid paying higher taxes. For most, it is easier to believe that which is pleasant rather than that which is unpleasant, even if that which is unpleasant is true and that which is pleasant is false.

THE LAFFER CURVE

Although there is no factual evidence that tax-rate cuts cause increases in revenues and/or economic growth, there is factual evidence that they hardly ever cause any significant revenue loss either. However, correlation is not causation. So, it is worthwhile to examine the Laffer Curve and its rationale closely to see if there is a rational basis to believe that tax-rate cuts, in and of themselves, cause increases in both revenues and/or economic growth.

No one can explain the Laffer Curve better than its sire, Arthur Laffer, a leading conservative economist. In an article published by the Heritage Foundation in June 2004, Laffer described his offspring as follows:

“The Laffer Curve illustrates the basic idea that changes in tax rates have two effects on tax revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment—and thereby the tax base—by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.”

In the same article, Laffer depicted the Laffer Curve as follows in Figure VIII-1.

Figure VIII-1 The Laffer Curve

Source: Arthur Laffer; An additional notation has been made to indicate the “Tax Rate Ceiling.”

In the Laffer Curve, tax rates are the vertical axis; the tax base is the horizontal axis; and tax revenue is the amount shown where the curve traverses a perpendicular line extended from the horizontal axis. The extreme edge of the horizontal axis is the amount of tax revenue that would be realized absent at a given tax rate. The base of the curve begins at the intersection of the vertical and horizontal axes; it then arcs out to the edge of the horizontal axis; and finally, it arcs back to where the apex terminates on the vertical axis.

The tax-rate ceiling is where the outermost point on the curve meets the edge of the horizontal axis, and it marks the beginning of the prohibitive range which extends to the apex. According to the Laffer Curve, any tax rate below the tax-rate ceiling would cause tax revenues to rise arithmetically, and any tax rate above the tax-rate ceiling would causes tax revenues to fall as a result of the economic effect. With respect to his depiction of the Laffer Curve, Laffer made clear that it showed only a concept and did not predict the “exact levels of taxation corresponding to specific levels of revenues” as it relates to any particular tax or taxpayer. Since each tax and taxpayer have different characteristics, so too would the shape of the curve. The location of both the tax-rate ceiling and the apex of the curve will vary according to the characteristics of each tax and taxpayer.

In describing how the Laffer Curve functions, Laffer said the following:

“At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would be willing to work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base. The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too high—in the ‘prohibitive range’ shown above—then a tax-rate cut would result in increased tax revenues. [emphasis added] The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.”

Laffer, being no fool, confined his rendition of the Laffer Curve to an abstraction that failed to offer a real-world example of what the tax-rate ceiling would be for a specific tax and taxpayer. Speculating in the abstract freed Laffer from the delicate issue of quantifying exactly where the prohibitive range begins for a particular tax and what the effect would be as tax rates for that tax travel along the prohibitive range curve. The quandary over what the tax-rate ceiling of a given tax is amounts to a current version of the age-old question: what straw will break the camel’s back?

The Laffer Curve and the Personal Income Tax

The Laffer Curve attempts to explain the relationship between tax rates and tax revenues for all taxes, including sales taxes, property taxes, the corporate income tax, capital gains taxes, user fees, and, most importantly, the personal income tax. With respect to all of these taxes, the Laffer Curve makes the following two assertions:

• First, if tax rates are raised above the tax-rate ceiling, then revenue will fall.
• Second, if tax rates above the tax-rate ceiling are lowered, then revenues will rise.

These assertions are true but meaningless unless the tax-rate ceiling can be quantified with certainty. Without a precise tax-rate ceiling (which is verified by a consensus of experts) for the particular tax whose rates are being cut, the Laffer Curve contributes nothing to understanding how tax-rate changes affect tax revenue.

Concentrating on the personal income tax, the theory underlying the Laffer Curve contends that the more a taxpayer who works hard and smart is taxed the less the taxpayer will work which in turn will slow economic growth. So, if tax rates rise too high, taxpayers will not work as hard, and economic growth and tax revenues will suffer. To the extent that there is truth in this, Laffer Curve proponents bear the burden of explaining at what tax rate each income group of taxpayers will decide that chasing the next dollar just is not worth it and instead head for the hammock. Laffer Curve theory assumes that all taxpayers, rich and poor alike, make decisions about whether, and how hard, to work primarily based, if not exclusively, on if their tax rates are raised or lowered by a few percentage points which is a dubious assumption.

Common Sense and the Laffer Curve

It does not take a behavioral scientist or an economist to figure out that it is almost impossible to know what does and does not motivate workers to work harder and smarter and capitalists to invest more wisely than they are already doing. What motivates people to do more good things and fewer bad things affects many groups, including among others, employers who have to decide how best to motivate their employees, parents who have to decide how best to motivate their children, church leaders who have to decide how best to motivate their parishioners, teachers who have to decide how best to motivate their students, and doctors who have to decide how best to motivate their patients. If there were an easy answer about how best to motivate people of all classes to do better, then it would have been discovered long ago.

One commonsense generalization that can be made, however, is that although money (or put in classical terms, avarice) is a powerful motivator, it competes with other powerful motivators like the other six of Dante’s seven deadly vices: pride, envy, wrath, sloth, gluttony, and lust. While avarice works as the primary motivator for many people much of the time, for others one or more of the other vices can be more powerful, and for everyone any of the vices can overpower any of the others at any time. So, it should be obvious that no one can state with any certainty what the primary motivator is for any particular person to do any particular thing at any particular time. Independently of what motivates a particular individual, some individuals are so self-motivated that they need no external motivation while others are immune to motivation of any kind. Predicting with any precision what the effects of any particular motivational factor will be on any individual or group is at best problematic.

Focusing on workers, they fall into a wide number of disparate categories, such as the following: some are highly skilled and work more with their brains than muscles and others do not; some have extensive education and others do not; some are innovative and others are not; some are highly disciplined and other are not; some are extroverted and others are not; some are mature and others are not; some get along with others and others do not; and some are self-directed and others are not. Given the many differences among workers, the notion that there is a single magic formula (money) which will make all workers work harder and smarter is a cruel fantasy.

Disciples of the Laffer Curve say that cutting tax rates by a few points will coax workers to work harder and smarter and capitalists to invest more wisely, and, as a result, everyone will be richer. If this were true, then by merely cutting tax rates by a few percentage points, Warren Buffet would become a wiser investor, Kevin Durant would sink a few more baskets, Tom Brady’s passing percentage would go up, Al Pacino would pick up another Oscar or two, McDonalds’ burger flippers would make tastier burgers, Stephen Hawking would develop the theory of everything, research scientists would discover the cure to cancer, policemen would catch more crooks, criminal defense lawyers would spring more crooks, teachers would teach better, students would learn more, and so on into infinity.

According to the Lafferites, cutting tax rates would make everyone work harder, and it would not cost anyone anything because the resulting economic growth would recoup the lost revenues leaving everyone to live happily ever after. It is truly a shame that like other getting-something-for-nothing myths, this myth too is false.

Commonsense Examples

To the extent tax cutting does affect worker and capitalist effort, the following four scenarios (each of which assumes a different annual income for a taxpaying household and a personal tax rate of 35% from the first dollar to the last dollar with no deductions or exemptions) help everyone use their own common sense to decide what does and does not make workers and capitalists up their game.

In Scenario #1, both spouses work in low-wage service jobs, and their combined annual income is $50,000. At a 35% tax rate, this household would pay $17,500 in taxes. A Scenario #1 household’s income is barely above subsistence and cannot sustain itself without earning the next dollar even if it is taxed at 35%. The workers in this household have to work just to survive. There is no tax-rate ceiling at 35% for the Scenario #1 household.

In Scenario #2, both spouses work in professional jobs, and their combined annual income is $600 thousand. At a 35% tax rate, this household would pay $210 thousand in taxes. A Scenario #2 household maintains an upper middle-class standard of living, and depending on its willingness to reduce its standard of living, could choose to work less. The workers in this household live to work and do not want to reduce their standard of living even if their income is taxed at 35%. There is no tax-rate ceiling at 35% for the Scenario #2 household.

In Scenario #3, one spouse works as an entertainer and the other is unemployed, and their annual income is $3 million. At a 35% tax rate, this household would pay $1.05 million in taxes. A Scenario #3 household maintains an upper-class standard of living, and depending on its willingness to reduce its standard of living, could choose to work much less. The entertainer in this household lives to work, and the couple does not want to reduce its standard of living even if its income is taxed at 35%. There is no tax-rate ceiling at 35% for the Scenario #3 household.

In Scenario #4, one spouse is a capitalist who owns an investment portfolio in excess of $3 billion and the other is unemployed, and their combined annual income is $275 million. At a 35% tax rate, this household would pay $96.25 million in taxes. A Scenario #4 household maintains a super-luxurious standard of living and invests what it does not spend. Except for overseeing his investments, the capitalist does not work for compensation and will not refuse to invest even if investment income is taxed at 35%. There is no tax-rate ceiling at 35% for the Scenario #4 household.

Notwithstanding the Laffer Curve, common sense says that adding or subtracting a few percentage points on the taxes of the workers and capitalist (as described in the four scenarios above) will not change much, if at all, the workers’ work effort or the capitalist’s investing wisdom. With respect to an increase in tax rates of a few percentage points, pity the worker whose work effort slackens; pity the employer who would tolerate an employee whose work effort slackens; pity the capitalist who refuses to invest as wisely as possible; and pity the economy whose workforce slackens their work effort and whose capitalists fail to invest as wisely as possible.

Facts vs. Economic Religion

Many Lafferites, probably excluding Laffer himself, are possessed of a religious-like faith in low tax rates as a panacea for whatever ails the economy, but the facts not only do not support their faith, rather they contradict it.

Table VIII-1 shows the highest marginal tax rates and annual GDP growth rates for the period 1946-2012.

Table VIII-1 Highest Marginal Personal Income Tax Rates and Annual GDP Growth Rates
Year	Highest Marginal Personal Income Tax Rate*	GDP Annual Growth Rate**	Year	Highest Marginal Personal Income Tax Rate*	GDP Annual Growth Rate**
1946	86.45%	-11.60%	1987	38.50%	3.50%
1947	86.45%	-1.10%	1988	28.00%	4.20%
1948	82.13%	4.10%	1989	28.00%	3.70%
1949	82.13%	-0.50%	1990	31.00%	1.90%
1950	91.00%	8.70%	1991	31.00%	-0.10%
1951	91.00%	8.10%	1992	31.00%	3.60%
1952	92.00%	4.10%	1993	39.60%	2.70%
1953	92.00%	4.70%	1994	39.60%	4.00%
1954	91.00%	-0.60%	1995	39.60%	2.70%
1955	91.00%	7.10%	1996	39.60%	3.80%
1956	91.00%	2.10%	1997	39.60%	4.50%
1957	91.00%	2.10%	1998	39.60%	4.50%
1958	91.00%	-0.70%	1999	39.60%	4.70%
1959	91.00%	6.90%	2000	39.60%	4.10%
1960	91.00%	2.60%	2001	38.60%	1.00%
1961	91.00%	2.60%	2002	38.60%	1.80%
1962	91.00%	6.10%	2003	35.00%	2.80%
1963	91.00%	4.40%	2004	35.00%	3.80%
1964	77.00%	5.80%	2005	35.00%	3.30%
1965	70.00%	6.50%	2006	35.00%	2.70%
1966	70.00%	6.60%	2007	35.00%	1.80%
1967	70.00%	2.70%	2008	35.00%	-0.30%
1968	75.25%	4.90%	2009	35.00%	-2.80%
1969	77.00%	3.10%	2010	35.00%	2.50%
1970	71.75%	0.20%	2011	35.00%	1.60%
1971	70.00%	3.30%	2012	35.00%	2.20%
1972	70.00%	5.20%	2013	39.60%	1.50%
1973	70.00%	5.60%	2014	39.60%	2.40%
1974	70.00%	-0.50%	2015	39.60%	2.40%
1975	70.00%	-0.20%
1976	70.00%	5.40%
1977	70.00%	4.60%
1978	70.00%	5.60%
1979	70.00%	3.20%
1980	70.00%	-0.20%
1981	69.13%	2.60%
1982	50.00%	-1.90%
1983	50.00%	4.60%
1984	50.00%	7.30%
1985	50.00%	4.20%
1986	50.00%	3.50%
Average GDP Annual Growth Rate		3.20%			2.57%
Source: Data extracted from the following:
* Eugene Steuerle, As The Urban Institute; Joseph Pechman, Federal Tax Policy; Joint Committee on Taxation, Summary of Conference Agreement on the Jobs and Growth Tax Relief Reconciliation Act of 2003, JCX-54-03, May 22, 2003.
** Bureau of Economic Analysis.

Table VIII-1 establishes the following:

• The annual GDP growth rate averaged 3.2% over a 40-year period from 1946-1986 when the highest marginal personal income tax was 50% or greater and ranged up to 91%.
• The annual GDP growth rate averaged 2.6% over a 25-year period from 1986-2011 when the highest marginal personal income tax was 39.6% or less and ranged from down to as low as 28%.
• When the highest marginal tax rate was 50% or greater, the annual GDP growth rate exceeded 5% thirteen times.
• When the highest marginal rate was less than 50%, the annual GDP growth rate never exceeded 4.8%.

While it would be foolish to conclude from these statistics that high marginal tax rates promote economic growth, it would be even more foolish to conclude that lowering marginal tax rates will always (or even usually) lead to increased economic growth. Tax rates are only one piece of a complicated puzzle that must be solved for growth to prosper.

The Laffer Curve and the Clinton Tax Increases

Facing a growing national debt in 1993, President Clinton convinced Congress to enact a tax increase. Increasing the top two tax rates from 31% to 36% and from 35% to 39.6% (which took effect in 1994) was the centerpiece of the Clinton tax increase. Hitting the top two tax rates only affected the highest income taxpayers, primarily those in the top one percent. According to the Lafferites, it is the economic efforts of the highest-income earners that in large measure drive economic growth, and if these efforts are over-taxed, economic growth would suffer, and everyone would be poorer for it. Slowed economic growth, moreover, would result in reduced, not increased, tax revenues.

The Clinton tax increases presented an excellent case to test the Laffer Curve premise that tax increases (particularly on the most productive) harm both economic growth and tax revenue. Although Laffer himself had ten years of data to assess whether the Laffer Curve applied to the Clinton tax increases, he bypassed the opportunity in his 2004 article. If the Clinton tax increase had resulted in reducing both economic growth and tax revenues, then the application of the Laffer Curve would have been validated, but if economic growth and tax revenues increased, then it would be invalidated.

Table VIII-2 includes the tax and economic metrics as follows:

Table VIII-2 For the Years 1987-2001 Personal Income Tax Revenues as % of GDP, Share of Adjusted Gross Income Total of Top 1%, Share of Personal Income Tax Paid by Top 1%, Average Effective Tax Rate of Top 1%, Annual Increase (Year over Year) on Income Tax Paid by Top 1%, and Annual GDP Growth Rate.
Year	Personal Income Tax Revenue as % of GDP*	Share of Adjusted Gross Income Total of Top 1%**	Share of Personal Income Tax Paid by Top 1%**	Average Effective Tax Rate of Top 1%**	Annual Increase (Year over Year) on Income Tax Paid by Top 1%**	Annual GDP Growth Rate***
1989	8.3%	14.19%	25.24%	23.34%	-4.02%	3.5%
1990	8.1%	14.00%	25.13%	23.25%	2.82%	1.9%
1991	7.9%	12.99%	24.82%	24.37%	-.95%	-0.2%
1992	7.6%	14.23%	27.54%	25.05%	17.87%	3.3%
1993	7.7%	13.79%	29.01%	28.01%	11.19%	2.7%
1994	7.8%	13.80%	28.86%	28.23%	05.83%	4.0%
1995	8.0%	14.60%	30.26%	28.73%	15.36%	2.5%
1996	8.5%	16.04%	32.31%	28.87%	19.43%	3.7%
1997	9.0%	17.37%	33.17%	27.64%	13.46%	4.5%
1998	9.6%	18.47%	34.75%	27.12%	13.58%	4.2%
1999	9.6%	19.51%	36.18%	27.53%	15.84%	4.5%
2000	10.2%	20.81%	37.42%	27.45%	15.60%	3.7%
2001	9.7%	17.53%	33.89%	27.50%	-18.00%	0.8%
Source: Data extracted from the following:
* 2016 OMB Budget Historical Table 2.3 Receipts by Source of Revenue as Percentage of GDP.
** IRS Historical Tax Data, Table 5.–Returns with Positive Adjusted Gross Income (AGI):Number of Returns, Shares of AGI and Total Income Tax, AGI Floor on Percentiles in Current and Constant Dollars, and Average Tax Rates, by Selected Descending Cumulative Percentiles of Returns Based on Income Size Using the Definition of AGI for Each Year, Tax Years 1986-2009.
*** Bureau of Economic Analysis.

Comparing the economic and tax metrics for the five years preceding and following the 1994 effective date for the Clinton tax increase (as shown in Table VIII-2) reveals the following:

• Personal income tax revenue averaged 7.92% of GDP for the five-year period before the Clinton tax increase took effect and 8.58% for the five-year period afterward.
• The share of adjusted gross income for the top 1% averaged 13.84% of GDP for the five-year period before the Clinton tax increase took effect and 16.06% for the five-year period afterward.
• The share of personal income tax paid by the top 1% averaged 26.35% of GDP for the five-year period before the Clinton tax increase took effect and 31.87% for the five-year period afterward.
• The average effective tax rate of the personal income tax paid by the top 1% averaged 24.80% of GDP for the five-year period before the Clinton tax increase took effect and 28.12% for the five-year period afterward.
• The annual increase (year over year) of the personal income tax paid by the top 1% averaged 5.38% of GDP for the five-year period before the Clinton tax increase took effect and 13.53% for the five-year period afterward.
• The annual growth rate of GDP averaged 2.24% for the five-year period before the Clinton tax increase took effect and 3.78% for the five-year period afterward.

These comparisons of economic and tax metrics show that after increasing the marginal rates on those in the top 1% of personal income:

• personal income tax revenue increased,
• the share of adjusted gross income continued to concentrate in the top 1%,
• the share of personal income tax paid by the top 1% increased by an average of 5.52% percentage points,
• the average effective tax rate of the top 1% increased by 3.32% percentage points,
• the percentage of annual growth (year over year) in the income tax paid by the top 1% increased on average 8.15% percentage points, and
• The average annual GDP growth rate increased by an average of 1.54 percentage points.

Taken altogether, these metrics prove that the Clinton tax increase did not deter the top 1% from grubbing for the next dollar or increasing their share of total income. Despite the tax increase, the top 1% chose greed over more hammock time. Based on the data, there is no reason to suppose that the Laffer Curve had any relevance as a metric regarding the Clinton tax rate increase.

DYNAMIC SCORING

The real-world example of increased economic growth and revenue springing out of the Clinton tax increase of 1993 did not seem to discourage the faith of many of the Lafferites in tax cuts as the pathway to economic growth. Two Lafferites, D. Mark Wilson and William W. Beach, wrote an article in 2001 (published by the Heritage Foundation) evangelizing for the enactment of the tax cuts proposed by President George W. Bush in 2001. In their article, Wilson and Beach gave witness to their faith that the Bush tax cuts promised an almost cost-free, cure-all to promote a growing economy and healthy governmental budget. Wilson and Beach diss what they call “static” budget estimates relating to tax cuts and their effects on tax revenues in favor of a “dynamic” approach, and then they compare the two approaches as follows:

“Dynamic tax analysis attempts to capture the many ways that taxpayer behavior changes following a significant tax policy change. For example, dramatic decreases in the taxes on labor or capital will cause more labor or capital to be employed in productive activities. A business owner who knows that his or her own labor will be taxed less may work more; a non-employed spouse may seek work outside the home once the taxes on labor fall. Overall, additional labor or capital can spur the economy to higher levels of output, which causes a growth in tax revenues as a result of the expansion of the tax base. Those who employ static analysis, like the Center on Budget and Policy Priorities and Citizens for Tax Justice, assume that taxpayers will not alter their behavior in the face of significant tax policy changes. Thus, a major drop in taxes produces no additional labor or new uses of capital, just a drop in federal revenues.”

“Dramatic,” as used by Wilson and Beach, makes all the difference. Stripped of the accompanying verbiage, dramatic is just another take on the Laffer Curve whose mantra teaches that the best way to raise tax revenue is to spur economic growth by liberating labor and capital from oppressive taxes. Like the Laffer Curve’s tax ceiling, exactly when taxes become so oppressive as to slow growth is a question Wilson and Beach do not answer.

For dynamic scoring to apply, it must be proven that the tax rate to be cut was so high that taxpayers had already chosen leisure over money-making. Otherwise, cutting tax rates only reduces tax revenue dollar for dollar. The prevailing tax rates prior to the Bush tax cuts ranged from a top rate of 39.6% to a low rate of 15%. The Bush tax cuts reduced existing rates across the board by lowering the top rate to 35% and the bottom rate to 10%. In their article, Wilson and Beach inferred that the tax rates that preceded the Bush tax cuts had so burdened labor and capital that by lifting that burden the Bush tax cuts would result in more growth and tax revenue.

If Wilson’s and Beach’s inference was correct that the pre-Bush tax rates were oppressing labor and capital, then the Bush tax cuts would in part be self-financing, but if the pre-Bush tax rates were not oppressive, then the tax cuts would increase the national debt dollar for dollar.

In predicting the effects of the Bush tax cuts, Wilson and Beach relied on an economic model concocted by Heritage Foundation economists that included assumptions reflecting “dynamic responses” to the Bush tax cuts. These dynamic responses—presumably the incentives for increased productivity—were not specified. Since models are no better than their assumptions, the accuracy of the Heritage Foundation dynamic model depended on the validity of the undisclosed assumptions. In their article, Wilson and Beach made a number of predictions of the economic and tax revenue effects of the Bush tax cuts, including specific estimates of GDP growth rates and tax revenues.

Table VIII-3 compares the estimates of the effects of the Bush tax cuts predicted by the Heritage Foundation model with what happened.

Table VIII-3 Comparison of Estimates of Total Tax Revenue (as a % of GDP) and Annual GDP Growth Rates (prepared by Heritage Foundation Center for Data Analysis) with Actual Data as Obtained from OMB in the 2013 Historical Tables and the BEA
Year	Estimated Total Tax Revenue (as a % of GDP)	Actual Total Tax Revenue (as a % of GDP)	Shortfall of Estimated Total Tax Revenues to Actual Total Tax Revenues	Estimated Annual GDP Growth Rate	Actual Annual GDP Growth Rate	Shortfall of Estimated Annual GDP Growth Rate
2001	20.8%	19.5%	1.3%	2.8%	1.1%	1.70%
2002	20.9%	17.6%	3.3%	3.3%	1.8%	1.50%
2003	20.7%	16.2%	4.5%	3.7%	2.5%	1.20%
2004	20.3%	16.1%	4.2%	3.4%	3.5%	-0.10%
2005	19.8%	17.3%	2.5%	3.3%	3.1%	0.20%
2006	19.4%	18.2%	1.2%	3.2%	2.7%	0.50%
2007	19.3%	18.5%	0.8%	3.1%	1.9%	1.20%
2008	19.6%	17.6%	2.0%	3.1%	-0.3%	3.40%
2009	21.3%	15.1%	6.2%	3.1%	-3.1%	6.20%
Source: Tax Estimates prepared by Heritage Foundation Center for Data Analysis as published in article prepared by Mark Wilson and William V. Beach, April 27, 2001; Tax Revenue Data extracted from 2016 OMB Budget Historical Table 2.3 Receipts by Source of Revenue as Percentage of GDP; and GDP data extracted from BEA.

Table VIII-3 shows, leaving aside 2001 before the Bush tax cuts took effect and 2008 and 2009 when the Great Recession skewed the data, the following:

• Actual annual total tax revenues lagged estimated annual total tax revenues by as much as 4.5% of GDP and as little as .8%.
• Actual annual GDP growth rates lagged estimated annual GDP growth rates significantly each year except for a small increase in 2004.

Theory is one thing and reality another. The estimates of the total annual tax revenues and annual GDP growth rates made by Wilson and Beach were not only off but out of the ballpark. The cost of their error was an increase in the national debt from 56.4% of GDP in 2001 to 69.7% of GDP in 2008—a 23.4% increase in just seven years.

Reality has rendered a verdict on the viability of the Heritage Foundation dynamic model as a metric for estimating tax revenue and economic growth in response to changes in tax rates; the verdict is GIGO, garbage in, garbage out.

Jobs and Taxes

Economic growth is an abstract idea to most wage earners, but jobs are real. With all the talk about the necessity of low tax rates for growth, wage earners are interested in the effect of tax rates and the level of taxes on jobs.

Table VIII-4 tracks the relationship between tax rates and unemployment percentages for the period 1948 through 2015.

Table VIII-4 Highest Marginal Personal Income Tax Rates and Annual Average Unemployment Percentages From 1948 – 2015
Year	Highest Marginal Personal Income Tax Rate*	Average Annual Unemployment Rate**	Year	Highest Marginal Personal Income Tax Rate*	Average Annual Unemployment Rate**
1948	82.13%	3.75%	1987	38.50%	6.18%
1949	82.13%	6.05%	1988	28.00%	5.49%
1950	91.00%	5.21%	1989	28.00%	5.26%
1951	91.00%	3.28%	1990	31.00%	5.62%
1952	92.00%	3.03%	1991	31.00%	6.85%
1953	92.00%	2.93%	1992	31.00%	7.49%
1954	91.00%	5.59%	1993	39.60%	6.91%
1955	91.00%	4.37%	1994	39.60%	6.10%
1956	91.00%	4.13%	1995	39.60%	5.59%
1957	91.00%	4.30%	1996	39.60%	5.41%
1958	91.00%	6.84%	1997	39.60%	4.94%
1959	91.00%	5.45%	1998	39.60%	4.50%
1960	91.00%	5.54%	1999	39.60%	4.22%
1961	91.00%	6.69%	2000	39.60%	3.97%
1962	91.00%	5.57%	2001	38.60%	4.74%
1963	91.00%	5.64%	2002	38.60%	5.78%
1964	77.00%	5.16%	2003	35.00%	5.99%
1965	70.00%	4.51%	2004	35.00%	5.54%
1966	70.00%	3.79%	2005	35.00%	5.08%
1967	70.00%	3.84%	2006	35.00%	4.61%
1968	75.25%	3.56%	2007	35.00%	4.62%
1969	77.00%	3.49%	2008	35.00%	5.80%
1970	71.75%	4.98%	2009	35.00%	9.28%
1971	70.00%	5.95%	2010	35.00%	9.61%
1972	70.00%	5.60%	2011	35.00%	8.93%
1973	70.00%	4.86%	2012	35.00%	8.08%
1974	70.00%	5.64%	2013	39.60%	7.37%
1975	70.00%	8.48%	2014	39.60%	6.17%
1976	70.00%	7.70%	2015	39.60%	5.26%
1977	70.00%	7.05%
1978	70.00%	6.07%
1979	70.00%	5.85%
1980	70.00%	7.18%
1981	69.13%	7.62%
1982	50.00%	9.71%
1983	50.00%	9.60%
1984	50.00%	7.51%
1985	50.00%	7.19%
1986	50.00%	7.00%
Average		5.66%			6.05%
Source: * Data extracted from Table VIII-1. ** Data extracted from BLS Unemployment Rate Report, dated February 8. 2017.

Table VIII-4 establishes the following:

• in the 38 years from 1948 through 1986 (when the highest tax rate was 50% or more) the average unemployment rate was 5.66%, and
• in the 28 years from 1987 through 2015 (when the highest tax rate was 39.6% or less) the average unemployment rate was 6.05%.

While correlation does not prove causation, it seems likely that unemployment percentages would have been lower during the 28 low tax years than during the 38 high tax years if low tax rates were the key to keeping unemployment low. Surprisingly, at least to the Lafferites, the average annual unemployment percentage was noticeably lower for the high tax years than the low tax years.

As further evidence that taxes and tax rates are not the only factors that determine the number of jobs in the economy, the number of jobs increased dramatically after both the Clinton tax increase in 1993 and the Obama tax increase in 2012. In the case of Clinton, the number of jobs created after the tax increase was 23.6 million, and in the case of Obama, the number of jobs created after the increase was 10 million. Further indicating that tax cuts are not the be all and end all to job creation, only about 2.5 million jobs were created after the Bush tax cuts of 2003.

What leads to economic growth and job creation is far more complex than whether tax rates and taxes go up or down. Common sense says that a well-educated and well-motivated workforce is more likely to have less unemployment than a poorly-educated and poorly-motivated workforce even if taxes are high. Since the market income of almost all wage earners is not enough to enable them to provide for their own retirement and health care and the post-secondary education of their children, then taxes must be raised to pay for both the social insurance necessary to maintain high morale in the workforce and the post-secondary education necessary to keep a high-skilled workforce.

History of Personal Income Tax Revenues

Facts can only be overcome by faith, and Table VIII-5 lays out the facts regarding personal income tax revenues from 1946-2011.

Table VIII-5 Personal Income Tax Revenue as a % of GDP: 1946-2011
Year	Personal Income Tax % of GDP	Year	Personal Income Tax % of GDP	Year	Personal Income Tax % of GDP
1946	7.2%	1969	9.2%	1991	7.9%
1947	7.7%	1970	8.9%	1992	7.6%
1948	7.5%	1971	8.0%	1993	7.7%
1949	5.7%	1972	8.1%	1994	7.8%
1950	5.8%	1973	7.9%	1995	8.0%
1951	6.8%	1974	8.3%	1996	8.5%
1952	8.0%	1975	7.8%	1997	9.0%
1953	8.0%	1976	7.6%	1998	9.6%
1954	7.8%	TQ	8.4%	1999	9.6%
1955	7.3%	1977	8.0%	2000	10.2%
1956	7.5%	1978	8.2%	2001	9.7%
1957	7.9%	1979	8.7%	2002	8.1%
1958	7.5%	1980	9.0%	2003	7.2%
1959	7.5%	1981	9.4%	2004	6.9%
1960	7.8%	1982	9.2%	2005	7.5%
1961	7.8%	1983	8.4%	2006	7.9%
1962	8.0%	1984	7.8%	2007	8.4%
1963	7.9%	1985	8.1%	2008	8.0%
1964	7.6%	1986	7.9%	2009	6.6%
1965	7.1%	1987	8.4%	2010	6.3%
1966	7.3%	1988	8.0%	2011	7.3%
1967	7.6%	1989	8.3%
1968	7.9%	1990	8.1%
Source: Data extracted from 2016 OMB Budget Historical Table 2.3 Receipts by Source of Revenue as Percentage of GDP

There were major tax cuts in 1981, 2001, and 2003, and there were significant tax increases in 1982 and 1983, and a major tax increase in 1994. For those believers in dynamic scoring, Table VIII-5 shows that (1) tax revenues fell after taxes were cut in 1981 (except for 1985 which reflected minor tax increases in 1982 and 1983) until taxes were raised in 1994, (2) tax revenues rose after taxes were raised in 1993 until when taxes were cut in 2002 and 2003, and (3) tax revenues fell after taxes were cut in 2001 and 2003. Neither the Reagan nor the Bush tax cuts were self-financing, and both were financed by increasing the national debt. Lessons: In the real world of tax-rate changes, tax cuts reduce revenue, and tax increases raise revenue.

A Non-Partisan View on Low Tax Rates

Congress created the CBO in 1974 for the purpose of providing it with expert, non-partisan advice on economic and tax policy. Over the years, CBO has earned a reputation with both political parties for acting as both a competent and honest broker on policy no matter which party controls Congress. As such, CBO reports carry great credibility in the sphere of public finance.

In 2005, the CBO published a study titled, “Analyzing the Economic and Budgetary Effects of a 10 percent Cut in Income Tax Rates,” under the leadership of its director, Douglas Holtz-Eakin, a conservative Republican. The purpose of the study was to analyze the economic growth and tax revenue effects of a ten-year, ten percent across-the-board cut in all personal income tax rates without any other changes in taxing or spending.

With respect to an unpaid-for tax cut, the study sought to answer two questions:

• Would it cause an increase in economic growth?
• Would it cause an increase in tax revenues that would wholly or partially offset revenue losses?

As background, the CBO pointed out various factors that affect economic and tax policy as follows:

“Changes in marginal tax rates and changes in after-tax incomes affect people’s choices about how they divide their time between work and leisure and how they divide their income between consumption and saving. Those choices in turn affect the amount of labor and productive capital available to generate economic output. Tax policy also influences overall demand for goods and services, which affects output in the short run. Finally, tax policy affects the composition and level of output by changing the relative returns to different economic activities. All those economic effects in turn influence the federal budget.”

Identifying relevant factors leads to nothing unless they are quantified, and quantifying them means that assumptions must be made. For purpose of its analysis, CBO first established a tax revenue loss and economic growth baseline by using (1) the estimate made by the JCT that the tax cut would cause a loss of $1.241 trillion in tax revenues over ten years and (2) existing estimates of Gross National Product, aka GNP, growth rates (CBO used GNP as opposed to the more commonly used GDP for technical reasons relating to the flow of capital across national borders). Having established a baseline, CBO then compared the estimated tax revenue and economic growth effects of the tax cut to the baseline.

In making its estimates, CBO described the assumptions that it used as follows:

“CBO’s analysis depends upon assumptions about how people and firms respond to changes in tax policy. Those assumptions are embodied in systems of equations referred to as ‘economic models.’ The estimated effects of the tax cut vary depending on which particular set of assumptions is used. Because there is insufficient evidence to conclusively identify which set of assumptions provides the most accurate estimates, CBO employed a number of such sets, which generated a range of results. However, that range does not span the possible effects of the tax cuts because people’s behavior may differ from CBO’s assumptions.

One important assumption concerns the degree of foresight and planning that households employ in making their economic decisions. Empirical evidence on that issue is mixed, so CBO employed three different assumptions regarding foresight. In the first (‘no foresight’), households do not plan ahead and therefore respond only to current tax policy. Lower tax rates on labor encourage more labor supply, which tends to increase output. However, the tax cut also leads to higher consumption, which tends to reduce investment and the stock of productive capital and therefore decrease output. On net, this approach indicates that the tax cut, if implemented, would raise the level of output by 0.2 percent over the first five years on average and reduce it by 0.1 percent over the second five years.

Under the second assumption about foresight (‘lifetime foresight’), households look forward and plan for what they expect to happen during their lifetimes. The final assumption (‘unlimited foresight’) assumes that households plan for the welfare of their descendants as well as their own. That means all future events, no matter how distant, can affect current behavior.

When people plan ahead in making their decisions, they must implicitly evaluate how the budget will be stabilized in the long run despite the lower tax receipts. Many different types of spending cuts and tax increases are possible. CBO used two simple assumptions to give some sense of the outcomes: in some simulations, the tax cut was ultimately followed by decreases in government spending on goods and services; in others, the tax cut was ultimately reversed through an increase in marginal tax rates. In each case, the balancing policies were phased in beginning 10 years after the initial tax cut.

In general, the analysis suggests that people would tend to work and save more during the first 10 years if they expected that tax rates would ultimately rise. The expectation of an eventual tax increase encourages people to work and save more in the meantime to prepare. In addition, people may shift some of their hours of work into the period with lower tax rates to take advantage of the higher after-tax wages. By contrast, under the assumptions used in this analysis, lower government spending on goods and services leaves more resources available for private consumption, so those who expect spending to fall in the future feel less need to work and save in the meantime.

Once the financing policy is implemented, however, the economic implications are reversed: an increase in tax rates will discourage work and saving once it occurs, implying relatively less output in the long run, whereas a cut in government spending on goods and services frees resources for both consumption and investment, implying relatively more output in the long run.

CBO also tested how the estimates are affected by the degree to which the U.S. economy is assumed to be open to flows of goods and finance from other countries: some simulations assumed capital could flow freely into and out of the country, whereas others assumed capital was immobile.

Under the different assumptions about foresight and the openness of the country to capital flows, the tax cuts are projected to increase output from 0.5 percent to 0.8 percent on average over the first five years and from 0.2 percent to 1.1 percent over the second five years. The estimates are most positive when the tax cut is expected to lead to future increases in tax rates and when people form their plans with maximum foresight.”

Those assumptions imply that people fully anticipate a permanent future rise in taxes and thus increase saving and work effort accordingly.

In the no foresight scenario, CBO estimated that (1) tax revenue losses would be $33 billion more than the $1.241 trillion estimated by the JCT and (2) GNP would grow .1% faster than otherwise. So, without assuming that taxpayers would behave during the ten-year tax cut period as if they knew what tax and spending policy would follow thereafter, an additional $33 billion in tax revenues would be lost and the GNP growth rate would not be materially affected.

Only by assuming that taxpayers would work and invest on the basis of their presuming that certain tax and spending policies would follow the ten-year tax cut could CBO tease out any offsetting revenues. Using the unlimited foresight scenario with a tax increase to follow the ten-year tax cut, CBO estimated that there would be $245 billion in revenues to partially offset the $1.241 trillion revenue loss. All other foresight scenarios used by CBO resulted in less offsetting revenues than the $245 billion estimate.

Importantly, CBO omitted pointing out that if tax rates were increased in the period following the ten-year tax cut then economic growth would suffer when that tax increase went into effect. So, the $245 billion of offsetting revenues due to the ten-year tax cut would have been bought at the price of borrowing against the future. A slight boost in tax revenues during the ten-year tax cut would be paid for by the next generation of taxpayers—just another intergenerational transfer of wealth. The foresight assumption scenarios defy common sense. It is no more reasonable to assume that taxpayers will make today’s economic decisions based on what they believe tax and spending policy will be ten years out than that they would make vacation plans ten years out based on a ten-year weather forecast. Stripped of unrealistic assumptions, CBO answered the two questions by finding that the unpaid, ten-year tax cut failed to produce either any offsetting tax revenues or any material increase to economic growth.

Final verdict on dynamic scoring: It is a fraud.

TAX CUTS: THEORY AND REALITY

The Congressional Research Service, aka CRS, is an agency of the Library of Congress that was created for the purpose of conducting research and analysis on all issues of national policy for members of Congress and congressional committees. As with the CBO, the CRS has a reputation for providing accurate and non-partisan reports and is well respected by both parties. The CRS does not make legislative or policy decisions but confines its role to providing information for the benefit of policymakers.

In 2012, the CRS prepared a study of the inter-relationship of tax rates, economic growth, and income concentration. The CRS described the purpose of the study as follows:

“Advocates of lower tax rates argue that reduced rates would increase economic growth, increase saving and investment, and boost productivity (increase the economic pie). Proponents of higher tax rates argue that higher tax revenues are necessary for debt reduction, that tax rates on the rich are too low […] and that higher tax rates on the rich would moderate increasing income inequality (change how the economic pie is distributed). This report attempts to clarify whether or not there is an association between the tax rates of the highest income taxpayers and economic growth.”

The study reached the following conclusions:

“Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today it is 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the 1970s; today it is 15%. The real GDP growth rate averaged 4.2% and real per capita GDP increased annually by 2.4% in the 1950s. In the 2000s, the average real GDP growth rate was 1.7% and real per capita GDP increased annually by less than 1%. There is not conclusive evidence, however, to substantiate a clear relationship between the 65-year steady reduction in the top tax rates and economic growth. Analysis of such data suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth. However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. The share of income accruing to the top 0.1% of U.S. families increased from 4.2% in 1945 to 12.3% by 2007 before falling to 9.2% due to the 2007-2009 recession. The evidence does not suggest necessarily a relationship between tax policy with regard to the top tax rates and the size of the economic pie, but there may be a relationship to how the economic pie is sliced [emphasis added].”

CBO and CRS, as non-partisan experts, have disappointed many of faith by concluding that neither dynamic scoring nor low tax rates can pay down the national debt and ignite economic growth. No magic will get these things done; only tough policy choices followed up with sustained effort will pay down the national debt and spark economic growth. Although many of faith will be disappointed by these conclusions, it is unlikely that their faith will be shaken. After all, the Easter Bunny, Santa Claus, and the Tooth Fairy have survived just fine in the age of science.

Final verdict on low tax rates as the key to economic growth: It is a fraud.

JUNKING IDEOLOGY IN FAVOR OF COMMON SENSE IN TAX POLICY

Since the Reagan tax cuts of 1981, a number of politicians (who are always influential and sometimes controlling in the playing of the tax game) have pushed policies based on the premise that most of the rich will get off their butts and work harder best if the government offers them carrots, and most of the poor will get off their butts and work harder only if they are beaten with sticks. The carrots for the rich include tax cuts, and the sticks for the poor include cutting, or better yet, taking away all their food stamps, unemployment benefits, subsidized school lunches, child-care subsidies, and other income support programs. For the most part, these politicians rely on (1) the Laffer Curve and Dynamic Scoring theories as the basis for keeping taxes low as an incentive for the rich and (2) the belief that income support programs encourage the poor to wallow in governmental dependency in order to avoid work as the basis for cutting income support programs for the poor.

Paul Ryan, former Speaker of the House and conservative economic spokesman, personifies the carrots for the rich and sticks for the poor theory of taxing and spending. As a rationale for this policy, Ryan cites Ayn Rand’s objectivist economic theory, libertarianism on steroids. Ayn Rand’s theories, in short, preach that if you are smart and play the money-making game well you should get to keep ALL of your winnings, and if you are a loser at money-making, you can starve; this approach, Rand’s disciples argue, improves the stock of money-makers by getting rid of the weak and frail so that the strong can thrive. For much of the last generation, Ryan’s theories, as embodied by his budgetary handiwork, the “Pathway to Prosperity,” prevailed among many politically conservative politicians.  Ryan’s theories provided the rationale for many of the politicians who consistently voted to cut taxes that disproportionately benefitted the best-off and cutting income support programs that disproportionately benefitted the worst-off.

Distilled to its essence, this carrot and stick belief boils down to economic rewards best induce the rich to work harder and economic punishment best induces the poor to work harder. For this belief to be true, the believers should be able to prove that there is a difference in the DNA of the rich and poor that accounts for why rewards motivate the rich but not the poor and punishment motivates the poor but not the rich when it comes to grubbing for the next dollar. To date, however, no such convincing proof has been offered, and common sense refutes it.

From a commonsense point of view, human beings, rich and poor alike, share the same human traits in that some of each are industrious and some lazy, some are successful and some unsuccessful, some are moral and some immoral, some are attractive and some ugly, some are healthy and some unhealthy, some are lucky and some unlucky, and so forth. Siblings in the same families are often quite different even though they carry many of the same genes. In the absence of proof to the contrary, the working premise should be that all of us are motivated to work harder by a number of personal traits with some of us responding to some stimuli while others of us responding to different ones. As for the universe of personal traits that influence behavior, Dante’s Seven Deadly Vices (pride, envy, wrath, sloth, avarice, gluttony, and lust) run the gamut. To suggest that greed, in the form of economic rewards and punishments, overrides the rest is at best presumptuous.

The tools available in tax policy to make people work harder are complicated to figure out. No doubt greed (in the form of monetary rewards and punishments) induces some rich and poor alike to work harder, but other traits also induce rich and poor alike to work harder. Some work harder out of pride to show that they are better than others; some work harder out of envy to make sure that they have as much or more than others; some work harder or do not work at all as a means of venting their anger; some are lazy and will not work regardless of the incentives; and some work harder to support their appetites. The problem is that no one knows for sure what, in any particular instance and for any particular individual, does and does not make a person work harder. Given this uncertainty about what makes a person work harder, those who set policy in the playing of the tax game should be careful not to let their ideological biases dictate policy.

So, in the playing of the tax game, little weight should be accorded to either carrots for the rich or sticks for the poor. All taxing and spending policies should be based on an analysis of what effect each such policy will have on America’s economic growth and social equity. Facts as applied by reason, not beliefs based on blind faith, should control.