The government collects taxes for two reasons: to provide public goods, like a criminal justice system and a national defense, and to redistribute income in the form of transfer payments. Now, up to a certain point, the provision of public goods and services makes private economic activity more productive-just imagine transporting goods without a highway system or incorporating a business without contract law.
Beyond a certain point, however, when taxes begin being used as transfer payments, incentives to work, save and invest are reduced, which affects the nation's economic progress. High marginal tax rates cause people to work fewer hours, take longer vacations, and shelter their income to evade tax collection. High taxes encourage individuals to divert resources from their most productive uses to those uses which will lower their tax burden.
In any economy, there is an optimal tax rate (the percentage of GDP that comes from taxes) which will ensure maximum economic growth; if the tax burden exceeds that level, economic growth will slow.
A study that examined data from 1950 to 1995 found that:1
The estimated growth-maximizing tax rate for the U.S. during that time period was 21 percent of GDP.
The corresponding rate of economic growth would be 4.6 percent.
In reality, taxes were 24.2 percent of GDP in 1950 and rose thereafter; the actual economic growth rate during that period was 3.4 percent.
Actual GDP in 1995 (measured in 1992 dollars) was $6.67 trillion, but if the optimal tax rate had been effect, GDP would have been $13.48 billion.
Under the optimal tax rate, workers would have been producing $107,900 in per capita output in 1995, much more than the actual figure of $54,100.
Historic Tax Cuts: JFK and Reagan
The 1960s and 1980s were periods of record sustained high growth, mainly due to the tax cuts and reforms enacted at the beginning of each decade by Kennedy and Reagan, respectively.
The JFK administration, against the advice of many economic advisers, began cutting taxes in 1962, starting with businesses. An investment tax credit encouraged investment and changes in depreciation costs lowered the cost of capital for businesses. The top corporate rate fell from 52 to 48 percent, and the top individual marginal tax rate fell from 90 to 70 percent. The empirical evidence shows that these tax cuts stimulated growth:2
Between 1962 and 1969, investment grew at an annual rate of 6.1 percent, far higher than the 3 percent annual rate for 1959-1962 and the 2.3 percent rate for 1969-1972, after the JFK tax reforms had been repealed.
Real GNP grew 4.5 percent during the 1960s, higher than the 2.4 percent growth rate seen from 1952-1960.
The JFK tax cuts also provided proof of a counter-intuitive idea, that cutting taxes will not raise deficits:3
From 1962-1969, government revenue increased 6.4 percent a year, compared with 1.2 percent a year between 1952-1959.
Indeed, after the '62 and '64 tax cuts, the deficit actually fell from $7.1 billion to $1.4 billion.
The 1980s was another decade marked by sustained economic growth, which was especially remarkable given the stagflation that was strangling the economy by the end of President Carter's term. From the trough of the recession in 1982 to the peak in 1990, it was the longest peacetime expansion in history.
Reagan's tax cuts spurred an investment boom, just like in the 1960s after the JFK tax cuts. The Economic Recovery Tax Act of 1981 featured a 25 percent across-the-board tax cut. The tax reforms increased incentives to save, work and invest, which increased the productive output of the economy to match the increase in demand:4
Real economic growth averaged 3.2 percent during the Reagan years, compared with 2.8 percent during the Fort-Carter years and 2.1 percent during the Bush-Clinton years.
Real median family income grew by $4,000 during the Reagan period after experiencing no growth in the pre-Reagan years; it experienced a loss of almost $1,500 in the post-Reagan years.
The amount of time the median worker stayed unemployed fell drastically.
The first law of government policy should be "first do no harm." The government should encourage long-term economic growth through low taxes, stable currency, and enforcing contracts. High taxes drain resources that would be most productive in the private sector. The experiences of the JFK and Reagan tax cuts show that a hands-off fiscal policy works best to stimulate economic growth.
The Growing Tax Gap?
The Internal Revenue Service's (IRS) most recent estimate of the difference between what taxpayers timely and accurately paid in taxes and what they owed was $345 billion. The tax gap arises when taxpayers fail to comply with the tax laws by underreporting tax liabilities on tax returns, underpaying taxes due from filed returns or non-filing.
Eventually, IRS will recover some this tax gap, but over the long term, we face a large and growing structural deficit that will stifle economic growth.
Moreover, economic growth cannot even solve the problem; rather, a fundamental reexamination of major policies and priorities will be important to recapture our future fiscal flexibility:5
Underreporting of income by businesses and individuals accounted for most of the estimated $345 billion tax gap for 2001, with individual income tax underreporting alone accounting for $197 billion, or over half of the total gap.
Corporate income tax and employment tax underreporting accounted for an additional $84 billion of the gap.
Reducing the tax gap would help improve fiscal sustainability; given the tax gap's persistence and size, it will require considering not only options that have been previously proposed but also new administrative and legislative actions.
Even modest progress would yield significant revenue; each 1 percent reduction would likely yield nearly $3 billion annually.
Furthermore, progress will require attacking the gap with multiple strategies over a sustained period. These strategies could include efforts to regularly obtain data on the extent of, and reasons for, noncompliance, simplifying the tax code, providing quality service to taxpayers, enhancing enforcement of tax laws by utilizing enforcement tools such as tax withholding, information reporting, and penalties, leveraging technology and optimizing resource allocation.
The Flat Tax: A Progressive Idea
A flat tax, though, could boost economic growth and reduce political corruption.
The current tax system contains myriad special preferences that undermine economic performance by luring people into making inefficient decisions to reduce their tax liabilities. The economic damage is further magnified by the higher tax rates required to finance the plethora of deductions, exemptions, credits, and other loopholes.
The federal income tax deduction for state and local taxes is one of the largest loopholes in the tax code -- saving selected taxpayers more than $50 billion annually -- and also one of the most pernicious. This special tax break primarily benefits rich taxpayers while subsidizing bigger government. Eliminating the deduction would facilitate lower tax rates and help to control wasteful spending and high tax rates at the state and local levels.
Eliminating loopholes is an uphill battle, but there is an automatic constituency for getting rid of the state and local tax deduction. Only a small handful of states benefit significantly from current law:6
For instance, California, New York , and New Jersey account for 35 percent of the deduction.
By contrast, the vast majority of states have relatively few taxpayers who are net beneficiaries.
As many as 40 states would be net winners if the state and local tax deduction were repealed and the money used to lower tax rates.
Some critics oppose the flat tax because they think the "rich" will benefit. This is rather ironic since upper-income taxpayers benefit disproportionately from itemized deductions and receive an enormous portion of the state and local tax deduction:7
Only 35 percent of Americans itemize their deductions, and the number utilizing the deduction for state and local taxes is even smaller.
These taxpayers tend to be wealthy; IRS data confirm that more than 90 percent of taxpayers with incomes above $100,000 use the deduction, compared to less than 14 percent of taxpayers with incomes below $40,000.
This is why the Congressional Research Service noted that if state/local tax deductibility were eliminated, the federal tax burden would shift from all federal taxpayers toward itemizers who tend to have higher incomes, thus, federal income taxes may become more progressive if the state/local taxes paid deduction were eliminated.
But for the flat tax to work, it needs to be low, at around 14 percent. At this level, it will do more to help low-income people and should appeal to liberals as well as conservatives:8
What conservatives most want is an uncomplicated system that taxes income only once (when it is earned) at one low rate.
Liberals are more concerned about progressivity; they want the rich to bear more of a burden than the poor.
Under a 14 percent flat tax rate, the rich would bear more of the burden than they currently do.
In conclusion, a low-rate flat tax would help the economy and a rebate to the poor would enhance progressivity.
States Support Further Tax Cuts9
The nation's strong economic growth is creating a revenue boom for state and local governments.
At the local level, taxes have been rising rapidly for years; as property values have soared, cities and counties have received a windfall because they derive about three-quarters of their tax revenues from property taxes. At the state level, the economic downturn earlier this decade caused revenue growth to slow and briefly turn negative; but the revenue "crisis" is long gone and by 2005, tax revenue for the 50 states was up 18 percent.
Overall:
State and local tax revenues soared 8.1 percent in 2004 and an estimated 7.6 percent in 2005.
State taxes increased 8.7 percent in 2004 and an estimated 8.0 percent in 2005.
Local taxes increased 7.3 percent in 2004 and an estimated 7.1 percent in 2005.
With today's rising revenues, states that had increased taxes to fill budget gaps -- such as Virginia -- can return the money to taxpayers now that budgets are in surplus; unfortunately, some states are using the revenue boom to expand their budgets beyond sustainable levels -- like in California and Maryland.
However, rather than expanding their budgets, states should use current surpluses to reform their tax codes in order to boost long-run economic growth; after all, competition for jobs and investment will only increase in the years ahead. By restraining spending and pursuing tax reforms, states will be better prepared for the next downturn and better able to sustain long-run growth.
The Next 25 Years
Between the 1960s and 1990s, we have seen sharply different opportunities in jobs, incomes, economic growth and inflation, but how did all this progress come to pass? It is because of tax reductions.
Consider:10
President Kennedy's tax cuts lowered the top marginal rate to 70 percent from 91 percent, and real economic growth jumped by more than 40 percent.
Reagan's cuts raised real economic growth by one-third and income tax receipts went up an average of 7 percent a year.
President Bush's 2003 tax cuts lowered the rate to 35 percent and created the economic growth that has increased tax revenues each year -- by 5.5 percent in 2004 and 14.5 percent--the largest in 25 years -- in 2005.
So what of the future? To keep on course, four policy choices are important:11
President Bush's lower tax rates on income, dividends and capital gains should be extended, because tax cuts create economic growth and individual opportunity.
We should move to a flat tax; estimates show that a flat tax would, in the first 10 years, generate $56 billion more in net government income tax receipts than the current tax code.
We must also bring the rapid growth of government to an end; in Bush's first term, domestic discretionary spending and education spending rose 7.1 percent and 139 percent, respectively.
Finally, we should move from static to dynamic economic calculations.
Since America 's economic thinking changed, the economy has grown, recessions are less frequent, job opportunities are increasing, inflation has not been a problem and individual income tax burdens have declined.
William A. Niskanen and Stephen Moore, "Supply Tax Cuts and the Truth About the Reagan Economic Record," Policy Analysis No. 261, Cato Institute, October 22, 1996. http://www.cato.org/pubs/pas/pa-261.html
"Tax Gap: Making Significant Progress in Improving Tax Compliance Rests on Enhancing Current IRS Techniques and Adopting New Legislative Actions," Government Accountability Office, February 15, 2006. http://www.gao.gov/highlights/d06453thigh.pdf
Daniel J. Mitchell, "Deduction for State and Local Taxes Undermines Tax Reform and Subsidizes High-Tax States ," Executive Memorandum #974 (Heritage Foundation), July 25, 2005. http://www.heritage.org/Research/Taxes/em974.cfm
Ibid.
John C. Goodman, "The Flat Tax: Improving on a Good Idea," NCPA Brief Analysis, no. 537, November 1, 2005. http://www.ncpa.org/pub/ba/ba537/
Do Taxes Affect Economic Growth?
Do Taxes Affect Economic Growth?
The government collects taxes for two reasons: to provide public goods, like a criminal justice system and a national defense, and to redistribute income in the form of transfer payments. Now, up to a certain point, the provision of public goods and services makes private economic activity more productive-just imagine transporting goods without a highway system or incorporating a business without contract law.
Beyond a certain point, however, when taxes begin being used as transfer payments, incentives to work, save and invest are reduced, which affects the nation's economic progress. High marginal tax rates cause people to work fewer hours, take longer vacations, and shelter their income to evade tax collection. High taxes encourage individuals to divert resources from their most productive uses to those uses which will lower their tax burden.
In any economy, there is an optimal tax rate (the percentage of GDP that comes from taxes) which will ensure maximum economic growth; if the tax burden exceeds that level, economic growth will slow.
A study that examined data from 1950 to 1995 found that:1
Historic Tax Cuts: JFK and Reagan
The 1960s and 1980s were periods of record sustained high growth, mainly due to the tax cuts and reforms enacted at the beginning of each decade by Kennedy and Reagan, respectively.
The JFK administration, against the advice of many economic advisers, began cutting taxes in 1962, starting with businesses. An investment tax credit encouraged investment and changes in depreciation costs lowered the cost of capital for businesses. The top corporate rate fell from 52 to 48 percent, and the top individual marginal tax rate fell from 90 to 70 percent. The empirical evidence shows that these tax cuts stimulated growth:2
The JFK tax cuts also provided proof of a counter-intuitive idea, that cutting taxes will not raise deficits:3
The 1980s was another decade marked by sustained economic growth, which was especially remarkable given the stagflation that was strangling the economy by the end of President Carter's term. From the trough of the recession in 1982 to the peak in 1990, it was the longest peacetime expansion in history.
Reagan's tax cuts spurred an investment boom, just like in the 1960s after the JFK tax cuts. The Economic Recovery Tax Act of 1981 featured a 25 percent across-the-board tax cut. The tax reforms increased incentives to save, work and invest, which increased the productive output of the economy to match the increase in demand:4
The first law of government policy should be "first do no harm." The government should encourage long-term economic growth through low taxes, stable currency, and enforcing contracts. High taxes drain resources that would be most productive in the private sector. The experiences of the JFK and Reagan tax cuts show that a hands-off fiscal policy works best to stimulate economic growth.
The Growing Tax Gap?
The Internal Revenue Service's (IRS) most recent estimate of the difference between what taxpayers timely and accurately paid in taxes and what they owed was $345 billion. The tax gap arises when taxpayers fail to comply with the tax laws by underreporting tax liabilities on tax returns, underpaying taxes due from filed returns or non-filing.
Eventually, IRS will recover some this tax gap, but over the long term, we face a large and growing structural deficit that will stifle economic growth.
Moreover, economic growth cannot even solve the problem; rather, a fundamental reexamination of major policies and priorities will be important to recapture our future fiscal flexibility:5
Furthermore, progress will require attacking the gap with multiple strategies over a sustained period. These strategies could include efforts to regularly obtain data on the extent of, and reasons for, noncompliance, simplifying the tax code, providing quality service to taxpayers, enhancing enforcement of tax laws by utilizing enforcement tools such as tax withholding, information reporting, and penalties, leveraging technology and optimizing resource allocation.
The Flat Tax: A Progressive Idea
A flat tax, though, could boost economic growth and reduce political corruption.
The current tax system contains myriad special preferences that undermine economic performance by luring people into making inefficient decisions to reduce their tax liabilities. The economic damage is further magnified by the higher tax rates required to finance the plethora of deductions, exemptions, credits, and other loopholes.
The federal income tax deduction for state and local taxes is one of the largest loopholes in the tax code -- saving selected taxpayers more than $50 billion annually -- and also one of the most pernicious. This special tax break primarily benefits rich taxpayers while subsidizing bigger government. Eliminating the deduction would facilitate lower tax rates and help to control wasteful spending and high tax rates at the state and local levels.
Eliminating loopholes is an uphill battle, but there is an automatic constituency for getting rid of the state and local tax deduction. Only a small handful of states benefit significantly from current law:6
Some critics oppose the flat tax because they think the "rich" will benefit. This is rather ironic since upper-income taxpayers benefit disproportionately from itemized deductions and receive an enormous portion of the state and local tax deduction:7
But for the flat tax to work, it needs to be low, at around 14 percent. At this level, it will do more to help low-income people and should appeal to liberals as well as conservatives:8
In conclusion, a low-rate flat tax would help the economy and a rebate to the poor would enhance progressivity.
States Support Further Tax Cuts9
The nation's strong economic growth is creating a revenue boom for state and local governments.
At the local level, taxes have been rising rapidly for years; as property values have soared, cities and counties have received a windfall because they derive about three-quarters of their tax revenues from property taxes. At the state level, the economic downturn earlier this decade caused revenue growth to slow and briefly turn negative; but the revenue "crisis" is long gone and by 2005, tax revenue for the 50 states was up 18 percent.
Overall:
With today's rising revenues, states that had increased taxes to fill budget gaps -- such as Virginia -- can return the money to taxpayers now that budgets are in surplus; unfortunately, some states are using the revenue boom to expand their budgets beyond sustainable levels -- like in California and Maryland.
However, rather than expanding their budgets, states should use current surpluses to reform their tax codes in order to boost long-run economic growth; after all, competition for jobs and investment will only increase in the years ahead. By restraining spending and pursuing tax reforms, states will be better prepared for the next downturn and better able to sustain long-run growth.
The Next 25 Years
Between the 1960s and 1990s, we have seen sharply different opportunities in jobs, incomes, economic growth and inflation, but how did all this progress come to pass? It is because of tax reductions.
Consider:10
So what of the future? To keep on course, four policy choices are important:11
Since America 's economic thinking changed, the economy has grown, recessions are less frequent, job opportunities are increasing, inflation has not been a problem and individual income tax burdens have declined.