Oliver Wendell Holmes, Jr. observed that taxes are what men pay to live in a civilized society. Of course, some may not wish to live in a civilized society. Even if we assume tax cuts increase economic growth, simple math makes clear that a tax cut will rarely pay for itself.
Simple math proves tax cuts rarely pay for themselves
Republicans often spout a faith based claim that tax cuts increase revenue so thata they pay for themselves. Many, many others claim that is baloney. A Republican friend once laughed and told me it’s a lie rich people tell dumb people. Bruce Barlett’s work Imposter contains a detailed look at the effect of tax cuts since the Reagan years, confirming that the cuts rarely pay for themselves.
Let’s look at the math. If we cut the tax rate, how much economic growth is needed to replace the government revenues?
For all examples we will assume:
• The tax cuts and revenue growth come immediately
• We will only look at one year’s projection
• We will assume that tax cuts actually cause economic growth.
Some comments: First, there is no solid proof that the tax cut actually increases economic activity. We’ve just made a faith based assumption it will. Second, these leave out timing-assuming all effects occur at the point in time when the tax cut takes effect. Normally, the tax rate change takes effect on revenue will take effect when it is first implemented. Assuming the tax cut stimulates growth, the growth likely won’t come immediately because it takes time for people to invest, time for the investments to bear fruit. Therefore, the increased revenues—if there are any—will come later. If the “growth” does not occur until year 2 or 3, for example, then the growth needs to make up for two or three years of lesser tax revenue. But let’s just keep our assumptions giving the faith based “growth” a huge benefit of the doubt.
Example No. 1--5% Tax Cut
Let’s start with the following assumptions:
• Gross Domestic Product is 100 units
• Tax rate is 40%
• Government revenue is 40 units
• Cutting the tax rate will increase economic growth.
• A tax cut lowering the rate from 40% to 35% is proposed.
This is a 13% tax reduction based on the rates; a 5% reduction based on the rates % to gross domestic product.
Question: How much GDP growth is necessary for Government Revenue to stay constant after the proposed tax cut?
Under the 40% tax scenario, the Government receives 40 units in income.
So 35% (GDP) must equal 40 for the Government to break even with the tax cut.
40/.35= $114.29 GDP
To pay for the 5% tax cut, GDP must grow by 14.29%, or approximately a 3 to 1 ratio.
Example No. 2--10% tax cut
Let’s change the assumption figures a bit:
• GDP 100
• Tax rate 30%
• Cutting tax rate will increase economic growth
• A tax cut is proposed from 30% to 20% (a 10% rate cut, or a 33 1/3% cut based on comparison to the existing tax rate).
Question: How much GDP growth is necessary for Government Revenue to stay constant after the proposed tax cut?
The Government receives 30 units in income prior to the proposed tax cut. If GDP stayed at 100, it would receive 20 units after the cut.
To achieve break even, .20(GDP) must equal 30. 30/.20= 150.
For government revenue to break even, the 10% rate cut requires a 50% growth rate in GDP (from 100 to 150). A 50% increase needed to pay for the 33% reduction proposed.
Example No. 3--35% tax cut
Assumptions:
• GDP 100
• Tax rate 70%
• Cutting tax rate will increase economic growth
A tax cut is proposed from 70% to 35% (a 35% rate cut, or a 50% cut from the existing tax rate).
Question: How much GDP growth is necessary for Government Revenue to stay constant after the proposed tax cut?
The Government receives 70 units in income prior to the proposed tax cut (.70X 100). If GDP stayed at 100, it would receive 35 units after the cut to 35% (.35 x 100).
To achieve break even, .35(GDP) must equal 70. 70/.35=200. GDP must grow from 100 to 200 to achieve break even in Government revenue, or a 100% GDP growth rate needed to pay for the 50% reduction proposed.
Example 4—Ryan Plan example on Highest earners
Mr. Ryan’s plan: http://budget.house.gov/... Mr. Ryan proposes reducing the highest earner tax rate to 25%. The capital gains tax would be eliminated entirely.
Mr. Romney and Mr. Ryan claim this cut will be balanced by unspecified other changes. They have both refused to name a single "loophole" they propose to close.
We no longer can use GDP as a firm baseline, since the taxes are paid on net income received by the highest earners. Substituting high earner “Income” for GDP growth, we can look at these assumptions. I’ll use the lower 35% tax rate figure.
Assumptions:
• Income for highest earners in their top tax bracket 100
• Tax rate 35%
• Cutting tax rate will increase economic growth
• Ryan proposes cutting the tax rate from 35% to 25% (a 10% rate cut, or a 29% cut from the existing tax rate).
We’ll just look at growth numbers and ignore the unspecified “loopholes” the plan mentions but does not specify.
Question: How much must High Earner Income (“Income”) grow to pay for the tax cut?
For example 4, the Government receives 35 units in revenue from the top earners prior to the proposed tax cut (.35x 100). If Income stayed at 100, Government revenue is 25 units after the cut to 25% (.25 x 100).
Conclusion: To achieve break even, .25(Income) must equal 35. 35/.25=140. The Highest Earner’s Income must grow from 100 to 140 to achieve break even in Government revenue, or a 40% Income growth rate needed to pay for the 30% reduction proposed.
Note this doesn’t mean GDP grows. It means the top tier income for the highest earners must grow 40% to achieve breakeven from this revenue source.
I previously predicted that if the RomneyRyan tax and budget proposals are enacted that the yearly deficit will hit $2 trillion per year.
Example No 5—The Ryan plans claim that the 3% rise in taxes will be a job killer
To get the tenor of Mr. Ryan’s faith, rather than point out President Obama’s budget projections assume the “Temporary” 2001 Republican tax cuts will expire (or any admission that Obama’s budget proposals include specifics on what the administration proposes would be spent) Ryan instead writes,
“The President has put forward a budget that calls for $1.9 trillion in higher taxes on American businesses and families. That’s bad enough. But what’s worse is that this new revenue comes, not from fundamental tax reform that lowers the rates and broadens the base, but from higher rates and added complexity in the tax code. The President’s budget would increase the top two income tax brackets from 33 percent to 36 percent and from 35 percent to 39.6 percent, respectively, starting next year.” (Emphasis added)
It is not accurate to claim that letting “temporary” tax cuts expire constitutes “raising” the rates. Personally, I find it confusing why Mr. Ryan believes changing the % paid from 36% to 39.6% “makes the tax code more complex.” Perhaps he is very dumb. If hitting the 9 key rather than the 6 key on a calculator is challenging for Mr.
Ryan, he has no business being in Congress, let alone a higher office. Those as challenged as Mr. Ryan can pay $40 for a computer program to assist them. Let’s assume tax preparers and accountants get over the horror.
Assumptions:
• Income for highest earners in their top tax bracket is 100
• Tax rate 35%
• Cutting tax rate will increase economic growth
• Raising the tax rate will decrease economic growth
• The temporary tax cuts expire, raising the rate from 36% to 39% (a 3% rate cut, or a 11% increase based on existing tax rate).
• Tax professionals are able to change the tax rate from 36% to 39.6% on the portion of income over $250,000.00 when making their tax calculations
Question: How much must High Earner Income on his earnings over $250,000 (“Top Income”) fall to make the government lose money on the tax cut?
For example 5, the Government receives 36 units in revenue from the top earners prior to the expiration of the temporary tax cut (.36x 100). If Income stayed at 100, Government revenue is 39 units the tax rate goes back to its regular level (.39 x 100).
For the Government to achieve break even, .39(Top Income) must equal 36. 36/.39=92.30.
The Highest Earner’s top Income can fall to 89.74 for the Government to break even on Government revenue, or an 11% Income drop would let the Government break even on the 3% tax increase proposed.
Growth Rates:
An economic growth rate exceeding 5% for GDP is quite rare, especially for established economies.
Due to the cyclical nature of any economy-- ours or the rest of the world’s-- sometimes it may seem that the economy grows quite quickly as the economy emerges from a slow period. I’m not sure you’d properly call that actual growth.
A growth rate exceeding 10%--or even 5%-- usually has some extreme drawbacks. When the growth rate gets too high, it creates inflationary pressures and inflation’s attendant problems. And it encourages too much risk taking which inevitably leads to a crash. A good micro-example is the 2000 Mortgage booms. A lot of people made a lot of money. Then came the bill.
A Lie Rich People Tell Dumb People: anecdote 1985
Back in the early 1980’s. when I was a college finance major, Professor Arthur Laffer visited our school to lecture. Mr. Laffer has made quite the career arguing that tax cuts pay for themselves. He coined the famous (or infamous for those who can do basic math) Laffer curve. This was in the early 1980’s. In his lecture, Mr. Laffer defended his ideas and his famous curve with anecdotes.
Now, this was a math based top ten business school. When asked for some mathematical proof—for instance, someone asked for a formula describing what shape his curve took--Mr. Laffer admitted he had no idea what shape the curve should be. He had no formula to describe the effects. He actually looked downcast as he admitted no fact based studies had ever supported his ideas.
Some Professors attended the lecture. They chortled in disbelief. One Israeli visiting professor commented that they could not believe such a man could gain professorship, let alone be someone the highest in government relied upon for advice.
Following the lecture, there was a hallway discussion about the lecture. I argued with a Republican defender of Mr. Laffer’s “Supply Side” precept that tax cuts paid for themselves through increased revenue. I was arguing the math didn’t work. My friend kept smiling and telling me I had to believe, that it was common sense, wouldn;t it be great if it worked. Comments like that.
Finally, my friend oared in laughter and explained that they (the rich people) all knew the idea cutting taxes paid for themselves through increased growth was BS. “Of course we know it’s BS,” he told me, “It’s just a lie we tell dumb people.”
Further Reading
David Stockman and Bruce Bartlett have each written several books explaining the fallacies of the so-called “Supply Side” fairy tale. Any critical reader is invited to read those works and compare their facts and arguments to the junk put out by the supply siders, including Mr. Laffer. While anecdotes are sometimes useful, and Mr. Laffer has many, they are no rational substitute for basic math.
Oliver Wendell Holmes, Jr. observed that taxes are what men pay to live in a civilized society. Of course, some may not wish to live in a civilized society.
Simple math makes clear that a tax cut will rarely pay for itself.