Defending Supply-Side Economics

Three years ago, I debunked a very sloppy report about tax policy.

The authors, David Hope and Julian Limberg, wanted readers to believe that lower marginal tax rates did not improve economic performance.

But there were major methodological flaws in the report, perhaps because the authors were political scientists rather than economists.

And I pointed out some of the most absurd findings.

• Are we really supposed to believe Thatcher’s tax-rate reductions played no role in the U.K.’s impressive recovery?
• Are we really supposed to believe the Reagan tax cuts played no role in America’s economic renaissance?
• Are we really supposed to believe that Ireland’s lower tax rates didn’t help turn the “Sick man of Europe” into the Celtic Tiger?
• Are we really supposed to believe that New Zealand’s tax cuts didn’t contribute to that nation’s remarkable turnaround?
• Are we really supposed to believe that countries such as Italy, Finland, Belgium, etc, are examples of supply-side reform?

Perhaps the strongest evidence against the Hope-Limberg report is that serious left-leaning economists didn’t give it any attention, presumably because they recognized it was based on cherry-picked data and laughable assumptions.

So after the initial burst of (predictable) media publicity, it quickly faded from the public discourse.

But, like a bad penny, it has reappeared. In her Washington Post column, Jennifer Rubin resuscitates the Hope-Limberg study as part of an attack on pro-growth tax policy.

…the claimed economic benefits of tax cuts for the rich don’t hold up under scrutiny. …A 2020 paper by David Hope of the London School of Economics and Julian Limberg of King’s College London examined “18 developed countries — from Australia to the United States — over a 50-year period from 1965 to 2015…” It turns out that “per capita gross domestic product and unemployment rates were nearly identical after five years in countries that slashed taxes on the rich and in those that didn’t, the study found.” …Hope and Limberg…confirmed there is “strong evidence that cutting taxes on the rich increases income inequality but has no effect on growth or unemployment.” …Sold as a prosperity booster, trickle-down tax cuts for the very rich do not increase prosperity, growth or employment for the average American.

The economists who wrote these studies obviously would disagree with Rubin’s regurgitated analysis.

And these economists also would disagree.

The bottom line is that most academic economists lean to the left, but they generally make more sensible arguments than Hope and Limberg (and Rubin).

• They will acknowledge that lower tax rates are good for growth, but they will argue that the positive effects are small.
• They will acknowledge that lower tax rates are good for growth, but they will argue that sacrificing some growth is acceptable to achieve other goals.
• They will acknowledge that lower tax rates are good for growth, but they will argue other policies can achieve the same results.

Those are all legitimate arguments, even if I have a different perspective. The same cannot be said for the Hope-Limberg study.

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In One Image, Everything You Need to Know about Supply-Side Economics

When trying to educate someone about the importance of low marginal tax rates, what’s the most-convincing visual?

• A supply-and-demand graph?
• A philoso-raptor meme?
• A cartoon with two doors?
• A Dan Mitchell hypothetical?

I’m partial to the image I created, of course, but let’s look at a real-world example that is very compelling.

In an article about Tory tax policy for the U.K.-based Telegraph, Charlotte Gifford included a graph showing that a family with two children can have more disposable income with an income of £99,000 rather than an income of £144,000.

In other words, there’s a de facto 100 percent tax rate on the additional £45,000.

At the risk of understatement, there’s not much incentive to earn more income if the government imposes a de facto 100 percent tax rate.

That’s the kind of policy you expect to see in France, not the United Kingdom.

So why is it happening? Ms. Gifford explains.

High-earning parents are better off only working four days a week as bizarre tax rules mean it no longer pays to work. …One of the biggest distortions in the tax system occurs once a parent earns more than £100,000. …One reader told The Telegraph they were considering shortening their working week from five days to four after realising they would keep more of their pay by earning £92,000 as opposed to £115,000. Reducing the working week makes perfect financial sense for many parents earning £100,000 or more. By working fewer days they would not only dodge the tax trap but also cut their childcare costs, which currently average at £285 per week full-time, or £13,695 a year.

If you want details, the de facto 100 percent-plus tax rate is the combined result of three factors.

1. A statutory tax rate of 40 percent.
2. The government’s clawback of the value of the personal allowance, pushing the effective marginal tax rate up to 60 percent. As stated in the article, “Once someone’s salary hits £100,000 they lose the personal allowance at a rate of £1 for every £2 until it disappears at £125,140.”
3. The loss of a government handout. As Ms. Gifford wrote, “…once a parent earns more than £100,000…they lose their entitlement to free childcare… This creates a perverse incentive for parents earning £99,000 to turn down a pay rise so they can hold on to the government benefit.”

The moral of the story is that people respond to incentives.

When the government makes it less attractive for people to be more productive and earn more income, they respond by…drum roll, please…being less productive and not earning more income.

Which means less taxable income for the government (hello, Laffer Curve).

That’s the simple lesson of supply-side economics.

P.S. American readers should know that there are also examples of implicit 100 percent-plus effective marginal tax rates in the United States.

P.P.S. The United Kingdom has bad tax policy because it has bad spending policy.

P.P.P.S. To avoid these problems, nations should have flat taxes and limited government.

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Not All Tax Cuts Are Created Equal

There are three reasons to be a knee-jerk supporter of tax cuts (or to be a knee-jerk opponent of tax increases).

1. The morality-driven libertarian argument that people should be able to keep the income they earn.
2. The starve-the-beast argument that less revenue at some point may translate into less spending.
3. The economic argument that lower taxes lead to better economic performance and more growth.

Today, let’s focus on the third argument.

To elaborate, lower taxes generally are good for growth, but not all tax cuts are created equal.

Some tax cuts (lower marginal tax rates on high earners, lower capital gains tax rates, lower corporate tax rates, etc) can be very powerful because affected taxpayers have a lot of control over the timing, level, and composition of their income. So if their tax rates change, they have the incentive and ability to increase their economic activity.

Other tax cuts (child credits, lower sales taxes, etc) may not have much economic impact because there is no significant change in incentives to work, save, invest, or be entrepreneurial. Or maybe taxpayers don’t simply don’t have much flexibility to respond. For instance, I’m a regular wage earner so I don’t have much ability or incentive to change my economic activity if my tax rate changes.

Understanding the economics of taxation is important because major parts of the Trump tax cuts will expire at the end of next year and it is very likely that politicians in Washington soon will decide that only some parts are worth keeping.

But which of the expiring tax cuts should be preserved? Here’s a chart showing how much “bang for the buck” the economy gets from different parts of the Trump tax cuts.

The chart comes from some new research by Erica York of the Tax Foundation. Here’s some of what she wrote.

…most of the 2017 tax reform law will expire after the end of next year. If lawmakers allow full expiration to occur, most Americans will see their personal tax bills rise and incentives for working and investing worsen. Extending the entire tax reform, however, would come with a $3.7 trillion price tag at a time when the country’s fiscal outlook is already bleak. Lawmakers should…prioritize policies that best boost work and investment incentives in a fiscally responsible manner. …The 11 tax cuts vary widely in how they would affect people’s decisions to work and invest. Some tax cuts create a larger economic boost than others. One indicator is to compare the estimated change in long-run GDP to the estimated change in annual tax revenue in the final year of the budget window. Using the last year of revenue is a proxy for the ongoing, long-run cost of a policy change. The most powerful provision under that metric is full expensing for business investment in equipment, followed by expensing for research and development costs. At the other end, some tax cuts counterintuitively reduce economic output because of their interactive effects with marginal tax rates. Other tax cuts have middling effects, improving incentives to work or invest but not as powerfully as full expensing.

None of this means that you have to agree with the exact details of the Tax Foundation’s model, or that economic bang for the buck should be the only consideration when deciding tax policy.

That being said, I think the Tax Foundation’s model is based on sound economic  principles and that pro-growth tax cuts are important if the goal is to maximize long-run income for average households.

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Lessons from Reaganomics for the 21st Century, Part II

In Part I of this series, I looked at Ronald Reagan’s reasonably successful track record on government spending (which could be characterized as fantastically successful when compared to other Republican presidents) and explained why we need Reaganomics 2.0 to deal with today’s federal leviathan that is far too big and projected to get even bigger.

In Part II, let’s look at Reagan’s track record on tax policy and ask whether we need another dose of “supply-side economics.”

When he took office, one of Reagan’s main goals was to lower marginal tax rates on American households. This was necessary for two reasons.

• First, tax rates were too high, including a staggering 70-percent top rate for the personal income tax.
• Second, more and more Americans were being hit by punitive tax rates because of “bracket creep.”

Since I’ve already written a lot about the problem of high tax rates, let’s address the second point.

During the 1970s, when inflation was high, there was understandable pressure to increase wages and salaries so that workers did not fall behind.

But when employees got pay raises to keep pace with inflation, that often meant they had to pay higher tax rates even though their inflation-adjusted incomes stayed constant.

This was not a trivial problem. Here’s a table from the study I recently wrote for the Club for Growth Foundation. As you can see, middle class households wound up paying much higher marginal tax rates as the 1970s came to a close.

President Reagan recognized this problem and he did two things to help American families.

• First, he lowered tax rates across board as part of his 1981 tax cut and his 1986 tax reform, with the top tax rate dropping from 70 percent in 1980 to 28 percent in 1988.
• Second, he “indexed” the personal income tax for inflation, meaning households no longer would be pushed into higher tax brackets because of bad monetary policy.

These reforms helped produce an economic boom.

Here’s some of what I wrote in the study.

In 1981, Reagan convinced Congress to enact the Economic Recovery Tax Act, which phased in lower income tax rates for all taxpayers. …Equally important, Reagan got Congress to adopt “indexing,” which meant that tax brackets were automatically adjusted for inflation. That reform ensured that government no longer profited from inflation. During his second term, Reagan then worked with Congress to approve the Tax Reform Act of 1986. That legislation further lowered tax rates for all taxpayers. …the Reagan tax cuts helped trigger an economic boom. The United States experienced a record economic expansion, with millions of jobs being created and family incomes rising to record levels after the malaise and stagnation of the Carter years. Households earned more money, and they got to keep a greater share of their earnings. Net worth also increased substantially, putting America’s middle class in a very strong position.

By the way, even though my left-leaning friends are viscerally opposed to lower tax rates for upper-income taxpayers, it’s worth noting that the IRS wound up collecting more money from the rich after Reagan slashed tax rates. A lot more money.

All things considered, the Reagan tax cuts were a smashing success (notwithstanding Paul Krugman’s protestations).

But is Reagan’s supply-side tax policy still relevant today?

Some people think tax policy is no longer a problem because individual income tax rates are lower than they were when Reagan took office and indexing is still protecting people from inflation (which has recently been a problem).

For what it’s worth, I think personal income tax rates are still far too high.

But the main reason that we need Reaganomics 2.0 is that the United States faces a major problem with double taxation. To be more specific, the IRS imposes very harsh tax rates on income that is saved and invested.

Here’s Figure 9 from the paper. You can see on the left that America’s personal income tax rate is only slightly higher than the average of other rich nations and the corporate tax rate is only somewhat higher.

But you can see on the right where America really lags, with significantly higher tax burdens on capital gains and dividend income.

Incidentally, the chart also shows that the United States would be wildly uncompetitive if Biden’s tax proposals were enacted.

So the obvious takeaway is that Biden’s class-warfare plan should never be resuscitated and that lawmakers instead should lower (or ideally eliminate) the capital gains tax and to reduce (or hopefully eliminate) the double tax on dividends.

P.S. The capital gains tax is not indexed for inflation, so people often are hit by that tax even when they lose money on an investment. That’s obviously another area where we need Reaganomics 2.0.

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More Evidence for Trump’s Corporate Tax Reform, Part II

Yesterday’s column reviewed a new academic study which found that Trump’s corporate tax reforms had a very positive impact on investment, which means more growth and higher wages for the American economy.

The study, which was written by Gabriel Chodorow-Reich from Harvard, Matthew Smith from the Treasury Department, Owen Zidar from Princeton, and Eric Zwick from the University of Chicago, echoes other findings on the benefits of better corporate tax policy.

Today, let’s investigate what the study says about the impact of Trump’s corporate tax reforms on tax revenue.

Here’s a chart from the study that looks at the revenue impact over a 20-year period.

And here’s the accompanying analysis from the study.

The total effect of the TCJA’s corporate provisions on tax revenue combines two forces: (i) the static revenue effect of the tax changes holding the capital stock fixed, and (ii) the revenue consequences of the dynamic changes in capital induced by the law. …). The solid red line in figure 9 shows the total change in corporate taxes as a result of the dynamic changes in capital, expressed as a ratio of pre-TCJA corporate tax revenue. …The dynamic response of capital reduces corporate tax revenue on impact and has a small positive long-run effect. The impact reduction occurs because capital does not jump at the time of the law change, but the immediate increase in investment incurs adjustment costs that depress taxable income and also increases depreciation deductions. Over time, rising domestic and foreign capital increase domestic corporate income. …However, because the negative revenue impact of higher depreciation deductions persists, total dynamic corporate revenue effects remain negative until year 12 and never exceed 5% of pre-TCJA revenue. …The solid blue line in figure 9 shows the effect of changes in labor taxes… Since the wage depends on the capital stock, it does not jump at the time of the law change but instead rises over time. By year 10, the increase in wages generates additional labor tax revenue of almost 15% of the pre-TCJA corporate tax revenue. Any overall long-run increase in tax revenue due to changes in capital therefore largely arises from higher labor rather than corporate tax payments

If you want a simpler explanation, here’s how the Tax Foundation summarizes the study’s findings regarding the revenue impact of Trump’s corporate tax reforms.

Regarding the TCJA’s impact on tax revenue, the study finds small dynamic effects within the 10-year budget window after accounting for increased economic activity. Tax revenues from labor increase due to the increased wage growth but are offset by a decline in corporate tax revenue particularly from bonus depreciation in the first few years after enactment. However, by year 10, dynamic corporate tax revenue gains begin to offset static corporate tax revenue losses while dynamic labor tax revenue reaches about 15 percent of baseline corporate tax revenue. This is sufficient to fully offset the static revenue losses from the corporate provisions by the end of the budget window.

Very similar to what I wrote in 2021 and 2022.

In other words, this new research is more evidence in favor of the Laffer Curve.

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More Evidence for Trump’s Corporate Tax Reform, Part I

I’m very critical of bad policies we got during the Trump years, most notably profligacy and protectionism.

But I shower praise on the good policies, such as the 2017 tax legislation (especially the lower corporate tax rate and the curtailing of the state and local tax deduction).

Today, we’re going to focus on the positive.

I’ve already written several columns about the benefits of Trump’s corporate tax reforms.

There’s now even more evidence to share, thanks to new academic research by Gabriel Chodorow-Reich from Harvard, Matthew Smith from the Treasury Department, Owen Zidar from Princeton, and Eric Zwick from the University of Chicago.

Here’s the most important finding.

The authors have a jargon filled explanation of their results.

This paper combines administrative tax data and a model of global investment behavior to evaluate the investment and firm valuation effects of the Tax Cuts and Jobs Act (TCJA) of 2017, the largest corporate tax reduction in the history of the United States. …the TCJA caused domestic investment of firms with the mean tax change to increase by roughly 20% relative to firms experiencing no tax change. …Figure 4 shows means of investment growth for different quantiles of the composite domestic tax term Γˆ−τˆ (“binned” scatter plots). For domestic-only firms plotted in Panel A, this composite tax term exactly comports with economic theory. The tight upward slope reveals a positive investment elasticity to taxation around TCJA. For multinational firms plotted in Panel B, our theory no longer dictates a single elasticity to Γˆ and τˆ. Nonetheless, the upward slope indicates a positive investment elasticity in this sample.

When citing academic research, I usually try to translate the jargon so that normal people can understand the findings.

Fortunately, I don’t have to do that because William McBride and Alex Durante of the Tax Foundation already stepped up to the plate. Here is their simplified explanation of the research.

A new detailed and thorough study from economists associated with the National Bureau of Economic Research and the Treasury Department finds the reforms substantially raised U.S. capital investment and boosted economic growth. …Their ultimate result is an estimate that the U.S. domestic corporate capital stock will grow 7.4 percent over the long run as a result of the law. Most of the growth in investment and the capital stock is predicted to occur within 10 years, and nearly all of it in 15 years. As the capital stock grows, so do worker productivity and wages. The study estimates a 0.9 percent increase in real wages over the long run. …The study’s estimated impacts on domestic investment are also largely consistent with a long history of empirical research, indicating corporate tax rate reductions and expensing boost domestic investment, wages, and economic growth.

None of this should come as a surprise to people who read this primer or watched this video.

Sadly, Biden wants to reverse this progress because of class-warfare ideology.

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Class-Warfare Tax Backfires in Los Angeles

The economic analysis of taxation has plenty of jargon, statistical analysis, and complicated graphs, which can make it seem very mysterious to ordinary people.

But the core principles are actually very easy to understand.

Simply stated, the more you tax of something, the less you get of it.

For instance, politicians often argue that there should be higher taxes on tobacco and alcohol in order to discourage smoking and drinking.

Given my libertarian proclivities, I obviously don’t like them trying to control our private lives, but they are right about higher taxes reducing cigarette and booze consumption.

To be sure, politicians don’t care about our health. They simply want more money in order to buy more votes. And they also don’t seem to care that punitive tax rates increase smuggling.

But I’m digressing. Let’s get back to the economics of tax policy.

Since my goal is to improve understanding, I prefer clear and simple analysis and explanation.

It also helps to have lots of real-world evidence.

For example, a report by Erica Werner in the Washington Post shows how taxes affect behavior.

A tax on mansion sales in Los Angeles was intended to raise millions to fight homelessness. It hasn’t quite worked out that way.Instead, wealthy Angelenos rebelled, putting the brakes on sales of homes priced at $5 million and above — those targeted by the initiative — with the result that the tax has raised far less money than expected since taking effect April 1. …The measure imposes a 4 percent tax on properties listed between $5 million and $10 million; at $10 million and above, the tax bumps up to 5.5 percent.

People are responding in predictable ways.

In the months before the tax took effect, high-end real estate sales exploded in L.A., as homeowners maneuvered to unload costly properties ahead of the new levy. The Los Angeles Times reported that celebrities including Brad Pitt and Mark Wahlberg were among those selling homes in the days leading up to April 1. …In the final days of March, some real estate agents even threw in free luxury cars to get clients to close sales before April 1. …Other tricks include separating properties into lots, or dividing a property between two spouses as “tenants in common” who can then sell their shares separately. …In the first quarter of the year, there were 248 sales of commercial and residential properties priced at $5 million and above in Los Angeles, according to Nathan Stark, an account executive at Chicago Title. Since April 1 through mid-June, there were only 34 sales.Stark and others argue the tax is counterproductive, since the city is losing out on transfer tax revenue it would be collecting if sellers weren’t holding back.

One realtor has a very sober-minded view of the issue.

Revelins has a home listed in the Venice Beach neighborhood of L.A. for $4,999,000 — a price tag she freely admits is aimed at avoiding the $5 million trigger for the new tax. …“That property is worth a little bit more,” Revelins said. “But if we listed it at $5.2, they would have to pay $200,000″ in taxes, money that Revelins says the city would squander.

We also see evidence of a Laffer Curve-type effect.

Proponents initially hoped the tax would raise some $900 million a year… But…the city administrative officer pegged first-year revenue closer to $670 million. …Mayor Karen Bass included just $150 million from the tax as part of…her first budget proposal. Through the end of May, the tax had raised a total of $15.5 million.

For what it’s worth, I’m sure the tax eventually will raise several hundred million dollars each year.

But I also feel confident that it will never raise as much as politicians expected.

That’s the main takeaway when you look at real-world incentives and real-world evidence.

P.S. The story includes this blurb about a referendum that might help reverse California’s economic decline.

California voters will vote on a 2024 ballot initiative that would give them greater say over taxation in the state, and require two-thirds support for local tax increases, retroactive to Jan. 1, 2022.

Since California voters supported Prop 30 back in 2012, I’m not overly optimistic about a return to common sense.

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The Feel-Good Map of 2023

Last year, I shared the “Feel-Good Map of 2022” that showed 18 states had lowered personal and/or corporate income tax since the start of 2021.

And that was after showing a map of 11 state lowering tax rates the previous year.

Courtesy of the Tax Foundation, we now have the 2023 version of that map. As you can see, more than half the states (27 if I can count correctly) have now joined the tax-cutting club.

This map does not even capture all the good news.

• Some states can’t lower tax rates because they wisely don’t have income taxes.
• Some states not only lowered tax rates, but also shifted to simpler and fairer flat taxes.

But there also is a bit of bad news.

A small handful of states have raised tax rates. That’s a very foolish approach when other states are making their systems more competitive.

But I guess we should not be surprised to see bad fiscal policy from California, the District of Columbia, and Massachusetts (and I believe the map is mistaken and New York also belongs to that ignoble group).

P.S. While the above map is good news, some of the progress is for a bad reason. States have been able to lower tax rates in part because Trump and Biden squandered so much money during the pandemic. Much of that new spending was transfers to state governments. In many cases, state politicians used the transfers to increase spending. But the silver lining to that dark cloud is that many states also lowered tax rates.

P.P.S. Another feel-good map, once it is updated, is what’s happening with school choice at the state level.

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Nebraska Joins the Tax-Cutting Wave

Other than doing very well in rankings of state pension debt (see here, here, and here), I’ve never had any reason to notice public policy in Nebraska.

That changes today because the Cornhusker State has – like about two dozen other states – lowered income tax rates.

The widespread shift to better state tax policy is a very positive development, second only to the really great news about school choice.

Let’s take a closer look about the good news from Nebraska.

The Wall Street Journal editorialized about the state’s new tax changes, including some special attention for the improvements in business taxation.

The gulf between high- and low-tax states keeps growing, and Nebraska is the latest to use budget surpluses to cut income and property taxes—and in a big way. …An income-tax cut will bring the top rate down to 3.99% from 6.64% by 2027, and a separate cut will slash the corporate tax to the same 3.99% rate from 7.25% today. …A two-year term limit for legislators has helped produce crops of increasingly market-friendly lawmakers. Interstate competition has also kept the tax pressure on. …neighboring Missouri cut its top rate on income to 4.95%, and Iowa followed up its recent flat-tax plan with additional cuts to property taxes. …More than half of all states have reduced their income-tax rates since 2021… Fewer states have cut corporate rates. In slashing its tax on businesses, Nebraska will leapfrog its neighbors to boast the lowest rate in the region after zero-tax South Dakota and Wyoming.

Kudos to Nebraska. They’ve moving from Column 4 to Column 3 in my state tax ranking.

The next step hopefully will be a flat tax.

P.S. Some state tax cuts are hardly worthy celebrating.

P.P.S. Massachusetts and Washington are among the few states moving in the wrong direction.

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Thatcher, Lawson, and Pro-Growth Tax Policy

As documented in Commanding Heights: The Battle of Ideas, Margaret Thatcher and Ronald Reagan saved their nations from economic malaise and decline.

Today, let’s focus on what happened in the United Kingdom.

Economic liberty greatly increased during the Thatcher years.

She deserves the lion’s share of the credit for the U.K.’s economic rebirth and renaissance, but she also had the wisdom to appoint some very principled and very capable people to her cabinet.

Such as Nigel Lawson, who served as her Chancellor of the Exchequer (akin to a combined Treasury Secretary/OMB Director in the U.S.).

Lawson died last week, leading to many tributes to his role is resuscitating the U.K. economy.

The Wall Street Journal‘s editorial summarized his achievements.

…our problems are solvable, as they were a half century ago. One of those crucial problem solvers was British politician Nigel Lawson, who died this week at age 91. …the 1970s…was even more miserable in the United Kingdom than it was in the U.S. By the time Margaret Thatcher led the Tories into office in May 1979, inflation was raging and the country had been wracked by strikes in its “winter of discontent”… Lawson entered Thatcher’s administration… He made his historic mark as Chancellor of the Exchequer starting in 1983. He’s best known for his tax reforms, which reduced the top personal income-tax rate to 40% from 60% and brought the top corporate rate to 35% from a 1970s high of 52%. He also was a steward of the Thatcher administration’s privatizations of large state-owned firms and the “Big Bang” financial reforms that would transform London into a global financial center.

In a column for CapX, Madsen Pirie examines Lawson’s work.

Nigel Lawson left a huge legacy. Under his stewardship Britain went from being the sick man of Europe into becoming an economic powerhouse and one of the world’s leading economies. He is regarded by many as the finest Chancellor of the 20th century… Lord Lawson held the firm conviction that lower taxes created space for enterprise and opportunity, and made it his policy that in every Budget he would lower the burden of taxation and abolish at least one tax. …During his tenure, Britain was transformed from being an economy in which most major businesses and services were owned and run by the state, into one in which they became private businesses, paying taxes instead of receiving taxpayer subsidies. Failing and outdated state enterprises became modern, successful private ones. …His 1988 Budget…announced that all taxes above 40% would be abolished, and that the basic rate would be cut to 25%, its lowest for 50 years… Within a very short time, more money was coming into the Treasury from the lower rates than it had been taking in from the higher ones. It was a vindication of the Laffer Curve. …The top 10% of earners had been paying 35% of the total income tax take. Under Lawson’s lower rate that went up to 48%. In rough terms this meant that the top 10% went from paying just over a third to just under a half of total income taxes.

In other words, the lower tax rates in the U.K. had the same positive impact as the lower tax rates in the U.S., both in terms of encouraging growth and confirming the Laffer Curve.

But let’s not forget that there also was spending restraint during the Thatcher years, particularly when Lawson was Chancellor of the Exchequer.

Just like we got spending restraint during the Reagan years.

The moral of the story is that it’s great to have good leaders, and it’s great when those leaders appoint good people.

P.S. If you want the U.S. equivalent of Nigel Lawson, the best historical example would be Andrew Mellon.

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Prosperity and Taxation: What Can We Learn from the 1960s?

Back in 2010, I shared a comparison of Obama and JFK on tax policy. For an update, here’s a comparison of Biden’s class-warfare agenda with JFK’s supply-side agenda.

I’m sharing this video for two reasons.

The first reason is that it shows that some Democrats in the past were very sensible about tax policy.

The second reason is that it gives me a good excuse to discuss what we can learn from tax policy in the 1960s, thus adding to our collection.

• Tax Lessons from the 1920s
• Tax Lessons from the 1930s
• Tax Lessons from the 1950s
• Tax Lessons from the 1980s

I’ll start with the caveat that tax policy does not necessarily overlap with 10-year periods. But we can learn by examining significant tax policy changes that occurred (or, in the case of the 1950s, did not occur) during various eras.

For the 1960s, the key change was the Revenue Act of 1964, generally known as the Kennedy tax cuts (proposed by President Kennedy in 1963 and then adopted in 1964 after his assassination).

Here’s what Kennedy proposed, as explained by the JFK library.

Declaring that the absence of recession is not tantamount to economic growth, the president proposed in 1963 to cut income taxes from a range of 20-91% to 14-65% He also proposed a cut in the corporate tax rate from 52% to 47%. …arguing that “a rising tide lifts all boats” and that strong economic growth would not continue without lower taxes.

And here’s what was enacted, as summarized by Wikipedia.

The act cut federal income taxes by approximately twenty percent across the board, and the top federal income tax rate fell from 91 percent to 70 percent. The act also reduced the corporate tax from 52 percent to 48 percent and created a minimum standard deduction.

The good news is that the Kennedy tax cuts were the right kind of tax cuts. Marginal tax rates were reduced on work, saving, investment, and entrepreneurship.

The bad news is that the top tax rate was still confiscatory, though 70 percent obviously was not as bad as 91 percent. And a 48 percent corporate rate was not much of an improvement compared to 52 percent.

That being said, moving in the right direction produced good outcomes.

People often talk about the booming economy in the 1960s. And there is some evidence to support that view since inflation-adjusted economic output grew rapidly as the tax cuts were implemented – by 6.5 percent in 1965 and 6.5 percent in 1966.

But I’m cautious about drawing sweeping conclusions from short-run data, especially since we know many other policies also have an impact on economic performance.

So let’s focus instead on some tax-related variables. Here’s a chart that I shared back in 2015, showing that upper-income taxpayers paid more when tax rates were reduced (the same thing happened in the 1980s).

That chart was taken from a report I wrote way back in 1996.

And here’s another chart from the same publication. This one shows that lower tax rates were associated with rising revenues. Especially as the changes were being implemented.

By the way, this does not mean that the tax cut was self-financing.

The core lesson of the Laffer Curve is not that tax cuts “pay for themselves.” That only happens in rare circumstances.

Instead, the lesson is that lower tax rates encourage more productive behavior, which means more taxable income. It then becomes an empirical question of how much of the revenue lost from lower rates is offset by the revenue gained from more taxable income.

And, in the 1960s, we know there was a big Laffer Curve response from upper-income taxpayers. Why? Because they have considerable control over the timing, level, and composition of this income.

Which brings us to the final lesson, which is that class-warfare tax policy was a bad idea in the 1960s and it is still a very bad idea today.

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Michigan Shows the Wrong Way to Cut Taxes

The economics of tax policy is largely the economics of incentives. When governments impose high tax rates on something, you get less of that thing.

My left-leaning friends acknowledge this is true, but only selectively. They openly agitate for higher taxes on things like tobacco (or sugar, or energy) and they correctly argue that higher tax rates will lead to less smoking.

As a libertarian, I don’t want to control other people’s lives, so I’m not a big fan of such taxes, but the underlying economic analysis is correct.

Unfortunately, my friends on the left often forget economic analysis when looking at tax rates on productive behaviors such as work, saving, investment, and entrepreneurship.

It is also important to realize that not all taxes are created equal. Whether politicians are cutting taxes or increasing taxes, the economic consequences will vary depending on the details.

For instance, even though I just stated that I don’t favor higher “sin taxes,” raising the tax burden on things like cigarettes will do less economic damage than increasing marginal tax rates on labor and capital.

There are also good and not-so-good ways of lowering taxes, and we have an example of this from Michigan.

As reported by Craig Mauger and Candice Williams of the Detroit News, there’s a big budget surplus in Michigan and politicians are debating whether to reduce the rate of the state’s flat tax or to give one-time tax rebates. Here are some excerpts from the story.

Michigan Gov. Gretchen Whitmer and the Democratic leaders of the Legislature are preparing a sweeping tax relief proposal they say will reduce tax bills by more than $1 billion and include rebate checks that could be issued directly to residents. The Friday agreement focuses on a plan to ease taxes on retirement income, boost a tax credit for low-wage workers and issue “inflation relief checks” in place of a potential cut in the state’s personal income tax, which was expected to be triggered by growing revenues, according to a source familiar with the plan. …as the state sits on a surplus of more than $9 billion, Republicans in the House and Senate have called for a broad tax cut for Michiganians and the preservation of the potential automatic drop in the personal income tax rate, which is being caused by language in a 2015 law. That policy tied the income tax, currently at 4.25%, to revenues for the state’s general fund. …based on preliminary fiscal year 2022 revenue figures, the revenue trigger would be activated and lower the income tax rate for the 2023 tax year from 4.25% to 4.05%. …“The Democrats’ proposal is a head fake intended to hide their attempt to rob Michigan taxpayers of an income tax cut in favor of funding a corporate welfare slush fund — prioritizing big corporations over Michigan families,” said Sarah Anderson, executive director of the Michigan Freedom Fund.

Michigan Democrats want more than rebates. They also favor “an exemption for public pensions” and “economic development subsidies for businesses.”

At the risk of stating the obvious, a lower rate for the flat tax will be far more beneficial to the state than one-time rebates and special favors for bureaucrats (who already enjoy higher compensation than workers in the private sector).

And a lower rate on the flat tax also would be far preferable to special handouts for businesses (which inevitably translates into corrupt cronyism).

I’ll close with a final point about overall fiscal policy. The Michigan tax fight is also a spending fight. Democrats are focusing on tax rebates in part because they are a one-off event. They’ll return some money to taxpayers this year, but there are no long-run savings.

By contrast, a cut in the state’s flat tax produces long-run savings for people. As the story noted, “Rebates are typically one-time spending bursts, while cuts in the income tax rate usually are kept in place for multiple years.”

Needless to say, politicians who want to spend more money prefer one-time rebates over permanent tax cuts.

P.S. Pursuing sub-optimal tax policy is not just a left-wing problem. Some folks on the right favor things such as child credits. That kind of tax cut will reduce tax liabilities for families, but those families quite likely would be better off in the long run with growth-oriented reductions in marginal tax rates on labor and capital.

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Evidence for Lower Corporate Tax Rates, Part III

To begin Part III of this series (here’s Part I and Part II), let’s dig into the archives for this video I narrated back in 2007.

At the risk of patting myself on the back, all of the points hold up very well. Indeed, the past 15 years have produced more evidence that my main arguments were correct.

• Lower corporate rates reduce double taxation
• Lower corporate rates reduce taxes on people
• Lower corporate rates boost worker income
• Lower corporate rates boost competitiveness
• Lower corporate rates generate revenue feedback

The good news is that all these arguments helped produce a tax bill that dropped America’s federal corporate tax rate by 14 percentage points, from 35 percent to 21 percent.

The bad news is that Biden and most Democrats in Congress want to raise the corporate rate.

In a column for CapX, Professor Tyler Goodspeed explains why higher corporate tax rates are a bad idea. He’s writing about what’s happening in the United Kingdom, but his arguments equally apply in the United States.

…the more you tax something, the less of it you get. …plans to raise Corporation Tax and end relief on new plant and machinery will result in less business investment – and steep costs for households. …Treasury’s current plans to raise the corporate income tax rate to 25% and end a temporary 130% ‘super-deduction’ for new investment in qualifying plant and machinery would lower UK investment by nearly 8%, and reduce the size of the UK economy by more than 2%, compared to making the current rules permanent. …because the economic costs of corporate taxation are ultimately borne both by shareholders and workers, raising the rate to 25% would permanently lower average household wages by £2,500. …the macroeconomic effects of raising the Corporation Tax rate to 25% would alone offset 40% of the static revenue gain over a 10-year period, and as much as 90% over the long run.

To bolster his argument for good policy on that side of the Atlantic Ocean, he then explains that America’s lower corporate tax rate has been a big success.

Critics of corporate tax reform should look to the recent experience of the United States… At the time, I predicted that these changes would raise business investment in new plant and equipment by 9%, and raise average household earnings by $4,000 in real, inflation-adjusted terms. …By the end of 2019, investment had risen to 9.4% above its pre-2017 level. Investment by corporate businesses specifically was up even more, rising to 14.2% above its pre-2017 trend in real, inflation-adjusted terms. Meanwhile, in 2018 and 2019 real median household income in the United States rose by $5,000 – a bigger increase in just two years than in the entire 20 preceding years combined. …What about corporate income tax revenues? …corporate tax revenue as a share of the US economy was substantially higher than projected, at 1.7% versus 1.4%.

If you want more evidence about what happened to corporate tax revenue in America after the Trump tax reform, click here.

Another victory for the Laffer Curve.

Not that we should be surprised. Even pro-tax bureaucracies such as the International Monetary Fund and Organization for Economic Cooperation and Development have found that lower corporate rates produce substantial revenue feedback.

So let’s hope neither the United States nor the United Kingdom make the mistake of undoing progress.

P.S. The specter of a higher corporate tax in the United Kingdom is especially bizarre. Voters chose Brexit in part to give the nation a chance to break free of the European Union’s dirigiste approach. But instead of adopting pro-growth policies (the Singapore-on-Thames approach), former Prime Minister Boris Johnson opted to increase the burden of taxes and spending. Hopefully the Conservative Party will return to Thatcherism with a new Prime Minister (and hopefully American Republicans will return to Reaganism!).

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Evidence for Lower Corporate Tax Rates, Part I

Here is the argument why corporate tax rates should be as low as possible.

• High corporate tax rates discourage investment.
• Less investment reduces worker productivity.
• Lower rates of productivity result in lower wages.

In an ideal world, there would be no corporate income tax (or any income tax).

But I’ll gladly accept any movement in the right direction, which is why the reduction in the corporate tax rate was the crown jewel of Trump’s 2017 tax plan.

The bad news is that Biden wants to undo much of that progress.

Today, let’s look at some new academic evidence on the issue. A new study from the National Bureau of Economic Research, authored by Professors James Cloyne, Joseba Martinez, Haroon Mumtaz, and Paolo Surico, finds that lower corporate rates are especially beneficial for long-run prosperity.

We use…post-WWII U.S. data on output, taxes, productivity and R&D spending to estimate the dynamic effects of income tax changes…and focus on personal and corporate income tax changes separately. …In Figure 1, we present our first set of main results. The figure contains two columns. On the left, we show the IRFs to a reduction in the average corporate tax rate. On the right, we show the results for a reduction in the average personal tax rate. …The first row in Figure 1 reveals that, following a shock to corporate and personal income taxes, the average tax rates decline temporarily. …The second row in Figure 1 shows the impulse response functions for the percentage response of real GDP. … Looking at the first column it is clear that, despite the transitory nature of the corporate tax reduction, there are very persistent effects on real GDP, whose short-run increase of 0.5% persists throughout the ten year period shown in the figure. In other words, the corporate income tax cut has disappeared after 5 years, but the effect on the level of economic activity is still sizable and significant after 8 years. …A similar picture emerges for productivity, as shown in the third row of Figure 1. Both tax rate cuts boost productivity on impact, with the size of the initial response to a personal income tax cut being much larger than for a cut to corporate taxes. On the other hand, the effects of corporate tax cuts grow over time and remain significant even after 10 years.

Here’s the aforementioned Figure 1 from their research.

I’ll conclude by noting that permanent tax cuts are much better than temporary tax cuts.

But if taxes are being cut, regardless of duration, the goal should be to get the most bang for the buck. And there’s plenty of evidence (from the United States, Australia, Canada, Germany, and the United Kingdom) that lowering corporate tax rates is a smart place to start.

P.S. It’s unfortunate that Biden wants a higher corporate tax burden in the United States. It’s even more disturbing that he wants a global tax cartel so the entire world has to follow in his footsteps. But he apparently does not understand the topic.

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The Laffer Curve and Trump’s 21 Percent Corporate Tax Rate

Reducing the corporate tax rate from 35 percent to 21 percent was the crown jewel of Trump’s 2017 Tax Cut and Jobs Act (TCJA).

• It was good for workers since a lower rate means more investment, which translates to increased productivity and higher wages.
• And it was good for U.S. competitiveness since the United States corporate tax rate no longer was the highest in the developed world.

Some critics downplayed those benefits and warned that a lower corporate tax rate would deprive the government of too much revenue.

Since I don’t want politicians to have more money, that was not a persuasive argument. Moreover, I argued during the debate in 2017 that a lower corporate tax rate would generate “revenue feedback.”

In other words, there would be a “Laffer Curve” effect as corporations responded to a lower tax rate by earning and reporting more income.

Based on the latest fiscal data from the Congressional Budget Office (CBO), I was right.

Corporate tax revenues for the 2021 fiscal year (which ended on September 30) were $370 billion. As shown in this chart, that’s only slightly below CBO’s estimate back in 2017 of how much revenue would be collected – $383 billion – if the rate stayed at 35 percent.

The chart also shows CBO’s 2018 estimate of what revenues would be in 2021 with a 21 percent rate (and if you want more data, the Joint Committee on Taxation estimated that the Trump tax reform would reduce corporate revenues in 2021 by $131 billion).

This leads me to ask two questions.

1. Is this a slam-dunk argument for the Laffer Curve?
2. Did the lower corporate tax revenue generate so much revenue feedback that it was almost self-financing?

The answer to the first question almost certainly is “yes” but “don’t exaggerate” is probably the prudent response to the second question.

Here are a few reasons to be cautious about making bold assertions.

• CBO’s pre-TCJA estimate in 2017 may have been wrong for reasons that have nothing to do with the tax rate.
• CBO’s post-TCJA estimate in 2018 may have been wrong for reasons that have nothing to do with the tax rate.
• The surge of 2021 revenues may have been a one-time blip that will disappear or fade in the next few years.
• The coronoavirus pandemic, or the policy response from Washington, may be distorting the numbers.

These are all legitimate caveats, so presumably it would be an exaggeration to simply look at the above chart and claim Trump’s reduction in the corporate tax rate almost “paid for itself.”

But we can look at the chart and state that there was a lot of revenue feedback, which shows that the lower corporate tax rate did produce good economic results.

Perhaps most important, we now have more evidence that Biden’s plan to increase the corporate tax rate is very misguided. Yes, it’s possible that the President’s plan may generate a bit of additional tax revenue, but at a very steep cost for workers, consumers, and shareholders.

P.S. If you want an example of tax cut that was self-financing, check out the IRS data on how much the rich paid before and after the Reagan tax cuts.

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States Lowering Income Tax Rates

The best news of 2021 almost surely is the big expansion of school choice in several states.

That’s a great development, especially for poor and minority families.

But there’s another positive trend at the state level. As indicated by this map from the Tax Foundation, tax rates have been reduced in several jurisdictions.

I’ve already written about Arizona’s very attractive tax reform, though I also acknowledged that the new law mostly stops the tax system from getting worse (because of a bad 2020 referendum result).

But stopping something bad is an achievement, regardless.

What about other states? The Tax Foundation’s article has all the details you could possibly want, including phase-in times and presence (in some states) of revenue triggers.

For purposes of today’s column, let’s simply focus on what’s happening to top tax rates. Here’s a table with the key results, ranked by the size of the rate reduction.

Kudos to Arizona, of course, but Iowa and Louisiana also deserve praise for significantly dropping their top tax rates.

As these states move in the right direction, keep in mind that some states are shifting (or trying to shift) in the wrong direction.

And bigger differences between sensible states and class-warfare states will increase interstate tax migration – with predictable political consequences.

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The Tradeoff Between Tax Progressivity and Economic Output

Almost everybody (even, apparently, Paul Krugman) agrees that you don’t want to be on the downward-sloping part of the Laffer Curve.

That’s where higher tax rates do so much economic damage that government collects even less revenue.

But I would argue that tax increases that produce more revenue also are a bad idea.

Sometimes they are even a terrible idea. For instance, there are tax increases that would destroy $5 of private income for every $1 of revenue they collect.

That would not be a good deal, at least for those of us who aren’t D.C. insiders.

Heck, according to research from economists at the University of Chicago and Federal Reserve, there are some tax increases that would destroy even greater levels of private income for every additional dollar that politicians got to spend.

The simple way of thinking about this is that you don’t want to be at the revenue-maximizing point of the Laffer Curve.

Because the closer you get to that point, the greater the damage to the private sector compared to any revenue collected.

To help understand this key point, let’s review a new study from Spain’s central bank. Authored by Nezih Guner, Javier López-Segovia and Roberto Ramos, it investigates the impact of higher tax rates.

They first look at what happens when progressivity (τ) is increased.

In the first experiment, we…change…the entire tax schedule, so that all households below the mean labor income face lower average taxes, while those above the mean income face higher average taxes. Since…richer individuals face higher taxes, all else equal, the government collects more taxes. All else, however, is not equal since more progressive taxes lower incentives to work and save. As a result, a higher τ might result in lower, not higher, revenue. The question is where the top of the Laffer curve is. We find that the tax revenue from labor income is maximized with τ = 0 .19. The increase in tax collection is, however, very small: the tax revenue from labor income increases only by 0.82% (or about 0.28% of the GDP). The tax revenue from labor income is, however, only one part of the total tax collection. There are also taxes on capital and consumption. With τ = 0 .19, while the tax collection from labor income is maximized, the total tax collection declines by 1.55%. This happens since with a higher τ, the aggregate labor, capital and output decline significantly. Indeed, the total tax collection falls for any increase in τ, and the level of τ that maximizes total tax revenue is much lower, τ = 0 .025, than its benchmark value.

The key takeaway is that more progressivity puts Spain on the wrong (downward-sloping) side of the Laffer Curve.

Here’s Table 6, which shows big declines in output, labor supply, and investment as progressivity increases.

Here’s some of the accompanying explanation.

The upper panel of Table 6 shows that capital, effective labor and output decline monotonically with τ. Hence, as the economy moves from τ = 0 .1581 to τ = 0 .19, the government is collecting higher taxes from labor, but the aggregate labor supply and output decline. For τ higher than 0.19, the decline in labor supply dominates and tax collection from labor income is lower. …The level of τ that maximizes the total tax collection is 0.025, which implies significantly less progressive taxes than in the benchmark economy. …In the economy with τ = 0 .025, the aggregate capital, labor and output increase significantly. The steady state output, for example, is almost 11 percentage points higher than the benchmark economy. As a result, the government is able to collect higher taxes despite lowering taxes on the top earners.

The authors also put together an estimate of Spain’s Laffer Curve, with the red-dashed line showing total tax revenue.

The authors also looked at what happens if politicians simply increase top tax rates.

They found that there are scenarios that would enable the Spanish government to collect more revenue.

We find that it is possible to generate higher total tax revenue by increasing taxes on the top earners. …The main message of our quantitative exercises is that…the extra revenue is not substantial. Higher progressivity has significant adverse effects on output and labor supply, which limits the room for collecting higher taxes. As a result, the only way to generate substantial revenue is with significant increases in marginal tax rates for a large group

But notice that those higher taxes would have “significant adverse effects on output and labor supply.”

Which brings us back to the earlier discussion about the desirability of causing a lot of damage to the private economy in order to give politicians a bit more money to spend.

The authors have a neutral tone, but the rest of should be able to draw the logical conclusion that higher taxes would be a big mistake for Spain.

And since the underlying economic principles apply in all nations, we also should conclude that higher taxes would be a big mistake for the United States.

P.S. We conducted a very successful experiment in the 1980s involving lower tax rates. Biden now wants to see what happens if we try the opposite approach.

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A Primer on Marginal Tax Rates, Part II: The Importance of Low Rates

When studying the economics of taxation, one of the most important lessons is that there should be low marginal tax rates on work, saving, investment, and entrepreneurship.

That’s also the core message of this video from Prof. John Cochrane.

I wrote a primer on marginal tax rates back in 2018. I wanted to help people understand that the incentive to engage in additional productive behavior is impacted by how much people get to keep if they earn additional income.

So what matters isn’t the tax on income that’s already been generated. The key variable is the marginal tax on the additional increment of income. As illustrated by the accompanying visual.

I’ve shared real-life examples of how the American tax system can result in very high marginal tax rates, especially when you include the extra layers of tax on income that is saved and invested (producing extremely high effective marginal tax rates).

For today’s column, let’s look at a real-world example from the other side of the Atlantic Ocean.

The U.K.-based Telegraph has a story illustrating how marginal tax rates often can be much higher than the official statutory tax rate.

More than a third of a million people now face paying income tax at a rate of 60pc because of government stealth tax policies… 336,000 people earned between £100,000 and £125,000 in 2018-19, the last year for which data was available. …This group is meant to pay income tax at a rate of 40pc, but risks falling foul of a costly trap which results in their earnings being subject to effective income tax rates that are far higher. The trap is sprung once someone starts to earn more than £100,000, as this is the point at which the Government begins to withdraw the £12,570 tax-free personal allowance. For every £1 earned over £100,000, the state reduces the allowance by 50p. The result is that each additional £1 of income effectively incurs 60p of income tax… Once National Insurance is factored in, the true rate is even higher.

Here’s a chart that was part of the article.

It shows that anyone earning £50,000 or above is losing at least 40 percent to the tax authorities. That statutory rate is both punitive and excessive.

But you also can see how the marginal tax rate jumps to 60 percent once taxpayers hit £100,000 on income.

At the risk of understatement, high marginal tax rates are bad news for the economy.

That’s true in the United Kingdom, the United States, and everyplace else in the world.

To use economic jargon, “deadweight losses” grow exponentially as tax rates are increased.

In regular English, this simply means that class-warfare tax policy (ever-higher tax rates on the so-called rich) causes the most economic damage. Even the left-leaning OECD agrees with this analysis.

You may be wondering why a supposedly conservative government in the United Kingdom allows such a destructive policy.

Sadly, there is no good answer. As you can see from this excerpt, Boris Johnson’s government sounds a lot like what the U.K. would have experienced if Jeremy Corbyn won the last election.

The Government said it was aware of the effect of the 60pc tax trap but said it had to take a “balanced approach”. “We want to keep taxes low to support working people to keep more of what they earn, but it’s only fair that those with the broadest shoulders bear the biggest burden as we rebuild the public finances and fund public services,” a spokesman said.

P.S. If President Biden’s tax plan is any indication, our friends on the left seem to be motivated by spite and envy, so they don’t care that high tax rates have negative consequences.

P.P.S. A wealth tax could easily result in marginal tax rates of more than 100 percent.

P.P.P.S. The politicians in Washington also believe in very high implicit tax rates on low-income people.

P.P.P.P.S. The various plans for per-child handouts would create another big spike in marginal tax rates for a large cohort of American taxpayers.

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Prosperity and Taxation: What Can We Learn from the 1930s

The United States conducted an experiment in the 1980s. Reagan dramatically lowered the top tax rate on households, dropping it from 70 percent to 28 percent.

Folks on the left bitterly resisted Reagan’s “supply-side” agenda, arguing that “the rich won’t pay enough” and “the government will be starved of revenue.”

Fortunately, we can look at IRS data to see what happened to tax payments from those making more than $200,000 per year.

Lo and behold, it turns out that Reaganomics was a big success. Uncle Sam collected five times as much money when the rate was slashed.

As I’ve previously written, this was the Laffer Curve on steroids. Even when you consider other factors (population growth, inflation, other reforms, etc), there’s little doubt that we got a big “supply-side effect” from Reagan’s tax reforms.

Now Biden wants to run this experiment in reverse.

Based on basic economics, his approach won’t succeed. But let’s augment theory by examining what actually happened when Hoover and Roosevelt raised tax rates in the 1930s.

Alan Reynolds reviewed tax policy in the 1920s and 1930s, but let’s focus on what he wrote about the latter decade. He starts with some general observations.

Large increases in marginal tax rates on incomes above $50,000 in the 1930s were almost always matched by large reductions in the amount of high income reported and taxed… An earlier generation of economists found that raising tax rates on incomes, profits, and sales in the 1930s was inexcusably destructive. In 1956, MIT economist E. Cary Brown pointed to the “highly deflationary impact” of the Revenue Act of 1932, which pushed up rates virtually across the board, but notably on the lower‐​and middle‐​income groups.

He then gets to the all-important issue of higher tax rates leading to big reductions in taxable income.

In Figure 1, the average marginal tax rate is an unweighted average of statutory tax brackets applying to all income groups reporting more than $50,000 of income. After President Hoover’s June 1932 tax increase (retroactive to January) the number of tax brackets above $50,000 quadrupled from 8 to 32, ranging from 31 percent to 63 percent. The average of many marginal tax rates facing incomes higher than $50,000 increased from 21.5 percent in 1931 to 47 percent in 1932, and 61.9 percent in 1936. One of the most striking facts in Figure 1 is that the amount of reported income above $50,000 was almost cut in half in a single year—from $1.31 billion in 1931 to $776.7 million in 1932.

Here’s the aforementioned Figure 1. You can see that taxable income soared when tax rates were slashed in the 1920s.

But when tax rates were increased in the 1930s, taxable income collapsed and never recovered.

What’s the lesson from this chart? As Alan explained, the lesson is that high tax rates lead to rich people earning and declaring less taxable income (they still have that ability today).

In the eight years from 1932 to 1939, the economy was in cyclical contraction for only 28 months. Even in 1940, after two huge increases in income tax rates, individual income tax receipts remained lower ($1,014 million) than they had been in the 1930 slump ($1,045 million) when the top tax rate was 25 percent rather than 79 percent. Eight years of prolonged weakness in high incomes and personal tax revenue after tax rates were hugely increased in 1932 cannot be easily brushed away as merely cyclical, rather than a behavioral response to much higher tax rates on additional (marginal) income. Just as income (and tax revenue) from high‐​income taxpayers rose spectacularly after top tax rates fell from 1921 to 1928, high incomes and revenue fell just as spectacularly in 1932 when top tax rates rose.

One big takeaway is that Hoover and FDR were two peas in a pod.

Both imposed bad tax policy.

From 1930 to 1937, unlike 1923–25, virtually all federal and state tax rates on incomes and sales were repeatedly increased, and many new taxes were added, such as the Smoot‐​Hawley tariffs in 1930, taxes on alcoholic beverages in December 1933, and a Social Security payroll tax in 1937. Annual growth of per capita GDP from 1929 to 1939 was essentially zero. …To summarize: all the repeated increases in tax rates and reductions of exemptions enacted by presidents Hoover and Roosevelt in 1932–36 did not even manage to keep individual income tax collections as high in 1939–40 (in dollars or as a percent of GDP) as they had been in 1929–30. The experience of 1930 to 1940 decisively repudiated any pretense that doubling or tripling marginal tax rates on a much broader base proved to be a revenue‐​maximizing plan.

Alan closes with an observation that should raise alarm bells.

It turns out that the higher tax rates on the rich were simply the camel’s nose under the tent. The real agenda was extending the income tax to those with more modest incomes.

The most effective and sustained changes in personal taxes after 1931 were not the symbolic attempts to “soak the rich,” but rather the changes deliberately designed to convert the income tax from a class tax to a mass tax. The exemption for married couples was reduced from $3,500 to $2,500 in 1932, $2,000 in 1940, and $1,500 in 1941. Making more low incomes taxable quadrupled the number of tax returns from 3.7 million in 1930 to 14.7 million in 1940… The lowest tax rate was also raised from 1.1 percent to 4 percent in 1932, 4.4 percent in 1940, and 10 percent in 1941.

The same thing will happen today if Biden succeeds in raising taxes on the rich. Those tax hikes won’t collect much revenue, but politicians will increase spending anyhow. They’ll then use high deficits as an excuse for higher taxes on lower-income and middle-class taxpayers (some of the options include financial taxes, carbon taxes, and value-added taxes).

Lather, rinse, repeat. Until the United States is Europe. And that will definitely be bad news for ordinary people.

P.S. Here’s what we can learn about tax policy in the 1920s. And the 1950s.

P.P.S. The 1920s and 1930s also can teach us an important lesson about growth and inequality.

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Big Government vs. “Trickle-Down Economics”

If nothing else, Biden’s big-government agenda is triggering a debate about fundamental issues, such as whether it’s a good idea to make America’s economy more like Singapore or more like Italy.

In making the case for the Italian approach of higher taxes and bigger government during his speech to Congress, President Biden exclaimed that “trickle-down economics has never worked.”

But we need to realize that Biden is using a straw-man definition. In his mind, “trickle-down economics” is giving a tax cut to rich people under the assumption that some of that cash eventually will wind up in other people’s pockets.

However, if you actually ask proponents of pro-growth tax policy what they support, they will explain that they want lower tax rates for everyone in order to reduce penalties on productive behaviors such as work, saving, investment, and entrepreneurship.

And they will be especially interested in getting rid of the tax code’s bias against saving and investment.

Why? Because every economic theory – even socialism, even Marxism – agrees that saving and investment are a key to long-run growth and rising living standards.

Which is why there’s such a strong relationship in the data between the amount of capital and workers’ wages.

Indeed, it’s almost a tautology to say that this form of “trickle-down taxation” leads to higher productivity, which leads to higher wages for workers.

As Stanford Professor John Shoven observed several decades ago:

The mechanism of raising real wages by stimulating investment is sometimes derisively referred to as “trickle-down” economics. But regardless of the label used, no one doubts that the primary mechanism for raising the return to work is providing each worker with better and more numerous tools. One can wonder about the length of time it takes for such a policy of increasing saving and investments to have a pronounced effect on wages, but I know of no one who doubts the correctness of the underlying mechanism. In fact, most economists would state the only way to increase real wages in the long run is through extra investments per worker.

In other words, everyone agrees with the “trickle-down economics” as a concept, but people disagree on other things.

• Such as socialists who say government should be in charge of allocating major investments.
• Such as “supply-siders” who supposedly say lower tax rates are all that is needed for growth.
• Such as honest redistributionists who say we should forgo some growth to have more equality.

So I guess it depends on how the term is defined. If it simply means tax cuts while ignoring other policies (or making those other policies worse, like we saw during the Bush years or Trump years), then you can make an argument that trickle-down economics has a mediocre track record.

But if the term is simply shorthand for a broader agenda of encouraging more saving and investment with an agenda of small government and free markets, then trickle-down economics has a great track record.

For instance, here’s a chart from the most-recent edition of Economic Freedom of the World. Nations with market-oriented economies are far more prosperous than countries with state-controlled economies.

By the way, Biden is not an honest redistributionist.

Instead of admitting that higher taxes and bigger government will lead to less economic output (and justifying that outcome by saying incomes will be more equal), Biden actually wants people to believe that bigger government somehow will lead to more prosperity.

To be fair, he’s not the only one to make this argument. Bureaucracies such as the International Monetary Fund, the United Nations, and the Organization for Economic Cooperation and Development also have claimed that there will be more prosperity if governments get more control over the economy.

I call this the “magic beans” theory of economic development.

Which is why I always ask people making this argument to cite a single example – anywhere in the world, at any point in history – of a nation that has prospered by expanding the burden of government.

In other words, I want a response to my never-answered question.

The response is always deafening silence.

To be sure, I don’t expect Joe Biden to answer the question. Or to understand economics. Heck, I don’t even expect him to care. He’s just trying to buy votes, using other people’s money.

But there are plenty of smart folks on the left, and none of them have a response to the never-answered question, either. Heck, none of them have ever given me a good reason why we should copy Europe when incomes are so much lower on that side of the Atlantic Ocean.

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Milton Friedman on Taxation

Yesterday’s column featured some of Milton Friedman’s wisdom from 50 years ago on how a high level of societal capital (work ethic, spirit of self-reliance, etc) is needed if we want to limit government.

Today, let’s look at what he said back then about that era’s high tax rates.

His core argument is that high marginal tax rates are self-defeating because the affected taxpayers (like Trump and Biden) will change their behavior to protect themselves from being pillaged.

This was in the pre-Reagan era, when the top federal tax rate was 70 percent, and notice that Friedman made a Laffer Curve-type prediction that a flat tax of 19 percent would collect more revenue than the so-called progressive system.

We actually don’t know if that specific prediction would have been accurate, but we do know that Reagan successfully lowered the top tax rate on the rich from 70 percent in 1980 to 28 percent in 1988.

So, by looking at what happened to tax revenues from these taxpayers, we can get a pretty good idea whether Friedman’s prediction was correct.

Well, here’s the IRS data from 1980 and 1988 for taxpayers impacted by the highest tax rate. I’ve circled (in red) the relevant data showing how we got more rich people, more taxable income, and more tax revenue.

The bottom line is that Friedman was right.

Good tax policy (i.e., lower rates on productive behavior) can be a win-win situation. Taxpayers earn more and keep more, while politicians also wind up with more because the economic pie expands.

Something to keep in mind since some politicians in Washington want a return to confiscatory taxes on work, saving, investment, and entrepreneurship.

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OECD Data: Higher Tax Rates Don’t Necessarily Mean Higher Tax Revenue

I participated in a debate yesterday on “tax havens” for the BBC World Service. If you read last month’s two-part series on the topic (here and here), you already know I’m a big defender of low-tax jurisdictions.

But it’s always interesting to interact with people with a different perspective (in this case, former Obama appointee David Carden and U.K. Professor Rita de la Feria).

As you might imagine, critics generally argue that tax havens should be eliminated so politicians have greater leeway to increase tax rates and finance bigger government. And if you listen to the entire interview, that’s an even bigger part of their argument now that there’s lots of coronavirus-related spending.

But for purposes of today’s column, I want to focus on what I said beginning at 49:10 of the interview.

I opined that it’s reasonably to issue debt to finance a temporary emergency and then gradually reduce the debt burden afterwards (similar to what happened during and after World War II, as well as during other points in history).

The most important part of my answer, however, was the discussion about how revenues didn’t decline when tax rates were slashed beginning in 1980.

Let’s first take a look at what happened to top tax rates for 24 industrialized nations from North America, Western Europe, and the Pacific Rim. As you can see, there’s been a big reduction in tax rates since 1980.

In the interview, I mentioned OECD data about taxes on income and profits, which can be found here (specifically data series 1000). So let’s see what happened to revenues during the period of falling tax rates.

Lo and behold, it turns out that revenue went up. Not just nominal revenues. Not just inflation-adjusted revenues. Tax revenues even increased as a share of gross domestic product.

In part, this is the Laffer Curve in action. Lower tax rates meant better incentives to engage in productive behavior. That meant higher levels of taxable income (the variable that should matter most).

For what it’s worth, I suspect that the lower tax rates – by themselves – did not cause tax revenue to rise. After all, there are many policies that determine the overall vitality of an economy.

But there’s no question that there’s a lot of “revenue feedback” when tax rates are changed.

The bottom line is that the folks advocating higher tax rates shouldn’t expect a windfall of tax revenue if they succeed in imposing class-warfare tax policy.

P.S. For the folks on the left who are motivated by spite rather than greed, it doesn’t matter if higher tax rates generate more money.

P.P.S. Interestingly, both the IMF and OECD have admitted, at least by inference, that lower corporate tax rates don’t result in lower tax revenues.

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The Adverse Economic Consequences of Higher Tax Rates

The good news is that Joe Biden has not embraced many of Bernie Sanders’ worst tax ideas, such as imposing a wealth tax or hiking the top income tax rate to 52 percent..

The bad news is that he nonetheless is supporting a wide range of punitive tax increases.

• Increasing the top income tax rate to 39.6 percent.
• Imposing a 12.4 percent payroll tax on wages above $400,000.
• Increasing the double taxation of dividends and capital gains from 23.8 percent to 43.4 percent.
• Hiking the corporate tax rate to 28 percent.
• Increasing taxes on American companies competing in foreign markets.

The worst news is that Nancy Pelosi, et al, may wind up enacting all these tax increases and then also add some of Crazy Bernie‘s proposals.

This won’t be good for the U.S. economy and national competitiveness.

Simply stated, some people will choose to reduce their levels of work, saving, and investment when the tax penalties on productive behavior increase. These changes give economists the information needed to calculate the “elasticity of taxable income”.

And this, in the jargon of economists, is a measure of “deadweight loss.”

But now there’s a new study published by the Federal Reserve which suggests that these losses are greater than traditionally believed.

Authored by Brendan Epstein, Ryan Nunn, Musa Orak and Elena Patel, the study looks at how best to measure the economic damage associated with higher tax rates. Here’s some of the background analysis.

The personal income tax is one of the most important instruments for raising government revenue. As a consequence, this tax is the focus of a large body of public finance research that seeks a theoretical and empirical understanding of the associated deadweight loss (DWL). …Feldstein (1999) demonstrated that, under very general conditions, the elasticity of taxable income (ETI) is a sufficient statistic for evaluating DWL. …It is well understood that, apart from rarely employed lump-sum taxes and…Pigouvian taxes, revenue-raising tax systems impose efficiency costs by distorting economic outcomes relative to those that would be obtained in the absence of taxation… ETI can potentially serve as a perfect proxy for DWL…this result is consistent with the ETI reflecting all taxpayer responses to changes in marginal tax rates, including behavioral changes (e.g., reductions in hours worked) and tax avoidance (e.g., shifting consumption toward tax-preferred goods). …a large empirical literature has provided estimates of the individual ETI, identified based on variation in tax rates and bunching at kinks in the marginal tax schedule.

And here are the new contributions from the authors.

… researchers have fairly recently come to recognize an important limitation of the finding that the ETI is a sufficient statistic for deadweight loss… we embed labor search frictions into the canonical macroeconomic model…and we show that within this framework, a host of additional information beyond the ETI is needed to infer DWL …once these empirically observable factors are controlled for, DWL can be calculated easily and in a straightforward fashion as the sum of the ETI and additional terms involving these factors. … We find that…once search frictions are introduced, …DWL can be between 7 and 38 percent higher than the ETI under a reasonable calibration.

To give you an idea of what this means, here are some of their estimates of the economic damage associated with a 1 percent increase in tax rates.

As you peruse these estimates, keep in mind that Biden wants to increase the top income tax rate by 2.6 percentage points and the payroll tax by 12.4 percentage points (and don’t forget he wants to nearly double tax rates on dividends, capital gains, and other forms of saving and investment).

Those are all bad choices with traditional estimates of deadweight loss, and they are even worse choices with the new estimates from the Fed’s study.

So what’s the bottom line?

The political impact will be that “the rich” pay more. The economic impact will be less capital formation and entrepreneurship, and those are the changes that hurt the vast majority of us who aren’t rich.

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Taxes and Growth

I’ve explained the economics of taxation, which is based on the common-sense notion that you get less productive economic activity when taxes drive a bigger wedge between pre-tax income and post-tax consumption.

Simply stated, the more you tax of something, the less you get of it, and this applies to taxes on labor and taxes on capital.

Today, let’s examine some empirical evidence. I’ve done that before (see here, here, here, here, here, here, here, here, and here), but it’s always good to expand the collection.

Three Italian professors, in a new working paper for the Centre for Economic and International Studies, investigated the relationship between taxes and growth.

We’ll start with a description of the methodology.

In this paper, we revisit a traditional issue in the empirics of growth and economic policy: whether taxation has long-lasting effects on real GDP dynamics. …we focus on the impact that taxes may have on the rates of physical and human capital accumulation. …our main departure from the existing literature is the use of a semi-parametric technique, which allows for countries’ unobserved heterogeneity in the input effects on per capita GDP. …we test our model, using a sample of 21 OECD countries over the period 1965-2010.

Here are the key findings.

Our main finding is that taxation negatively affect per capita GDP growth rates, both directly and indirectly, via physical and human capital saving rates. …Our cross-country analysis makes a clear point on this, at least for our sample of OECD countries: on average, tax cuts produce a beneficial impact on GDP dynamics but of modest size. In our baseline specification, a cut by 10% in personal income tax rate generates an change in the real per capita GDP growth rate of +1% while a cut by 10% in corporate income tax rate increases the rate of growth of real per capita GDP by 0.9%. …The main message of our empirical exercise is that, across various samples and specifications, taxes are harmful for growth.

These are very strong results.

Though I find it very interesting that the authors say they are “of modest size.”

I guess that depends on expectations and perspective. I’ll simply repeat the point I made two years ago about the importance of even small increases in the long-run growth rate.

The bottom line is that future Americans would enjoy significantly greater prosperity with better tax policy.

That’s a desirable outcome at any point in time, and it’s even more important today as we consider how to recover from the economic wreckage caused by the coronavirus.

Interestingly, the study ends with some interesting estimates on the impact of lower tax rates on labor and capital.

Table 10 reports the results of a “what if”exercise, in which we compute the change in GDP growth rate generated by a ceteris paribus cut by 10 % in τw and τk.

And here is the aforementioned Table 10 (“τw” is the tax rate on labor and “τk” is the tax rate on capital).

There are two big takeaways from this research.

First, it’s further evidence that Trump’s tax reform, which lowered the corporate tax rate from 35 percent to 21 percent, was a very good step for the American economy.

Second, it’s further evidence that it’s a big mistake for Biden and other folks on the left to push for higher tax rates, including big increases in tax rates on personal income.

P.S. Just in case those last two sentences sound overly favorable to Trump, I’ll remind people that reckless spending increases – sooner or later – will lead to punitive tax increases. In other words, if Biden wins and there are big tax hikes, Trump will deserve some of the blame (just as Bush’s irresponsible policies set the stage for some of Obama’s irresponsible policies).

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Mirror, Mirror, on the Wall, What Nation Punishes Success Worst of All?

In some cases, politicians actually understand the economics of tax policy.

It’s quite common, for instance, to hear them urging higher taxes on tobacco because they want to discourage smoking.

I don’t think it’s their job to tell people how to live their lives, but I agree with their economic analysis. The more you tax something, the less you get of it.

One of my many frustrations is that those politicians then conveniently forget that lesson when it comes to taxing things that are good, such as work, saving, production, and investment.

And some countries are more punitive than others. There’s some new research from the European Policy Information Center, Timbro, and the Tax Foundation, that estimates the “effective marginal tax rate” for successful taxpayers for 41 major countries.

And they don’t simply look at the top income tax rates. They quite properly include other taxes that contribute to “deadweight loss” by driving a wedge between pre-tax income and post-tax consumption.

The political discussion around taxing high-earners usually revolves around the income tax, but in order to get a complete picture of the tax burden high-income earners face, it is important to consider effective marginal tax rates. The effective marginal tax rate answers the question, “If a worker gets a raise such that the total cost to the employer increases by one dollar, how much of that is appropriated by the government in the form of income tax, social security contributions, and consumption taxes?” …all taxes that affect the return to work should be taken into account. …Combining data mainly from international accounting firms, the OECD, and the European Commission, we are able to calculate marginal tax rates in the 41 members of the OECD and/or EU.

The main message of this research is that you don’t want to live in Sweden, where you only keep 24 percent of any additional income you produce.

And you should also avoid Slovenia, Belgium, Portugal, Finland, France, etc.

Congratulations to Bulgaria for being the anti-class warfare nation. That’s a smart strategy for a nation trying to recover from decades of communist deprivation.

American readers will be happy to see that the United States looks reasonably good, though New Zealand is the best of the rich nations, followed by Switzerland.

Speaking of which, we need a caveat for nations with federalist systems, such as the U.S., Switzerland, and Canada. In these cases, the top income tax rate is calculated by adding the central government’s top rate with the average top rate for sub-national governments.

So successful entrepreneurs in those countries actually have the ability to reduce their tax burdens if they make wise decisions on where to live (such as Texas or Florida in the case of the United States).

Let’s now shift to some economic analysis. The report makes (what should be) an obvious point that high tax rates have negative economic effects.

Countries should be cautious about placing excessive tax burdens on high-income earners, for several reasons. In the short run, high marginal tax rates induce tax avoidance and tax evasion, and can cause high-income earners to reduce their work effort or hours.

I would add another adverse consequence. Successful taxpayers can move.

That’s especially true in Europe, where cross-border tax migration is much easier than it is in the United States.

But even though there are odious exit taxes for people leaving the United States, we’ll see an exodus if we wind up with some of the crazy tax policies being advocated by Bernie Sanders and Elizabeth Warren.

P.S. Today’s column looks at how nations rank based on the taxation of labor income. For taxation of capital income, the rankings look quite different. For instance, because of pervasive double taxation, the United States gets poor scores for over-taxing dividends, capital gains, and businesses.

P.P.S. If you want to see tax rates on middle-income workers (though it omits value-added taxes), here is some OECD data.

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Adverse Consequences of California’s Class-Warfare Tax Policy

California is suffering a slow but steady decline.

Bad economic policy has made the Golden State less attractive for entrepreneurs, investors, and business owners.

Punitive tax laws deserve much of the blame, particularly the 2012 decision to impose a top tax rate of 13.3 percent.

I’ve already shared some anecdotal evidence that this tax increase backfired.

But now we have some scholarly evidence from two Stanford Professors. Here’s what they investigated.

In this paper we study the question of the elasticity of the tax base with respect to taxation using microdata from the California Franchise Tax Board on the universe of California taxpayers around the implementation of Proposition 30 in 2012. This ballot initiative increased marginal income tax rates… These increases came on top of the 9.3% rate that applied to income over $48,942 for singles and $97,884 for married couples, and also in addition to the 1% mental health tax that since 2004 had applied to incomes of over $1 million. The reform therefore brought the top marginal tax rate in California to 13.3% for incomes of over $1 million.

For those not familiar with economic jargon, “elasticity” is simply a term to describe how sensitive taxpayers are when there are changes in tax policy.

A high measure of elasticity means a large “deadweight loss” since taxpayers are choosing to earn and/or report less income.

And that’s what the two scholars discovered.

Some high-income taxpayers responded to the big tax increase by moving.

We first study the extensive margin response to taxation, and document a substantial one-time outflow of high-earning taxpayers from California in response to Proposition 30. Defining a departure as a taxpayer who went from resident to non-resident filing status, the rate of departures in 2013 over 2012 spiked from 1.5% after the 2011 tax year to 2.125% for those primary taxpayers earning over $5 million in 2012, with a similar effect among taxpayers earning $2-5 million in 2012.

By the way, you won’t be surprised to learn that California taxpayers increasingly opted to move to states with no income tax, such as Florida, Nevada, and Texas.

Other taxpayers stayed in California but they chose to earn and/or report less income.

We combine these results on the extensive margin behavioral response with conclusions of analysis of the intensive margin response to Proposition 30. …we use a differences-in-differences design in which we compare upper-income California resident taxpayers to a matched sample of non-resident California filers, for which there is relatively rich data… Our estimates show a substantial intensive margin response to Proposition 30, which appears in 2012 and persists… We find that California top-earners on average report $522,000 less in taxable income than their counterfactuals in 2012, $357,000 less in 2013, and $599,000 less in 2014; this is relative to a baseline mean income of $4.15 million amongst our defined group of California top-earners in 2011. …the estimates imply an elasticity of taxable income with respect to the marginal net of tax rate of 2.5-3.3.

In the world of public finance, that’s a very high measure of elasticity.

Wonky readers may be interested in these charts showing changes in income.

By the way, guess what happens when taxpayers move, or when they decide to earn less income?

The obvious answer is that politicians don’t collect as much revenue. Which is exactly what the study discovered.

A back of the envelope calculation based on our econometric estimates finds that the intensive and extensive margin responses to taxation combined to undo 45.2% of the revenue gains from taxation that otherwise would have accrued to California in the absence of behavioral responses. The intensive margin accounts for the majority of this effect, but the extensive margin comprises a non-trivial 9.5% of this total response.

We can call this the revenge of the Laffer Curve.

By the way, it’s quite likely that there has been a resurgence of both the “extensive” and “intensive” responses to California’s punitive tax regime because the 2017 tax reform restricted the deductibility of state and local taxes. This means that the federal government – for all intents and purposes – is no longer subsidizing California’s backwards fiscal system.

P.S. Makes me wonder if California politicians will turn Walter Williams’ joke into reality.

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The Real Motive for Class-Warfare Taxation

In addition to being a contest over expanding the burden of government spending, the Democratic primary also is a contest to see who wants the biggest tax increases.

Bernie Sanders and Elizabeth Warren have made class-warfare taxation an integral part of their campaigns, but even some of the supposedly reasonable Democrats are pushing big increases in tax rates.

James Pethokoukis of the American Enterprise Institute opines about the anti-growth effect of these proposed tax hikes, particularly with regard to entrepreneurship and successful new firms.

The Democratic presidential candidates have plenty of ideas about taxes. Wealth taxes. Wall Street taxes. Inequality taxes. And probably more to come. So lots of creative thinking about wealth redistribution. Wealth creation? Not so much. …one way to look at boosting GDP growth is thinking about specific policies to boost labor force and productivity growth. But there’s another way of approaching the issue: How many fast-growing growing new firms would need to be generated each year to lift the economy-wide growth rate each year by one percent? …a rough calculation by analyst Robert Litan figures there about 15 billion-dollar (in sales) companies formed every year. But what if the American entrepreneurial ecosystem were so vibrant that it produced 60 such companies annually? …The big point here is that the American private sector is key to growth. No other large economy is as proficient as the US in creating high-impact startups. But it doesn’t appear that the Democratic enthusiasm for big and bold tax plans is matched by concern about unwanted trade-offs.

If you want a substantive economic critique of class-warfare tax policy, Alan Reynolds has a must-read article on the topic.

He starts by explaining why it’s important to measure how sensitive taxpayers are (the “elasticity of taxable income”) to changes in tax rates.

Elasticity of taxable income estimates are simply a relatively new summary statistic used to illustrate observed behavioral responses to past variations in marginal tax rates. They do so by examining what happened to the amount of income reported on individual tax returns, in total and at different levels of income, before and after major tax changes. …For example, if a reduced marginal tax rate produces a substantial increase in the amount of taxable income reported to the IRS, the elasticity of taxable income is high. If not, the elasticity is low. ETI incorporates effects of tax avoidance as well as effects on incentives for productive activity such as work effort, research, new business start-ups, and investment in physical and human capital.

Alan then looks at some of the ETI estimates and what they imply for tax rates, though he notes that the revenue-maximizing rate is not the optimal rate.

Diamond and Saez claim that, if the relevant ETI is 0.25, then the revenue-maximizing top tax rate is 73 percent. Such estimates, however, do not refer to the top federal income tax rate, …but to the combined marginal rate on income, payrolls, and sales at the federal, state, and local level. …with empirically credible changes in parameters, the Diamond-Saez formula can more easily be used to show that top U.S. federal, state, and local tax rates are already too high rather than too low. By also incorporating dynamic effects — such as incentives to invest in human capital and new ideas — more recent models estimate that the long-term revenue-maximizing top tax rate is between 22 and 49 percent… Elasticity of taxable, or perhaps gross income…can be “a sufficient statistic to approximate the deadweight loss” from tax disincentives and distortions. Although recent studies define revenue-maximization as “optimal,” Goolsbee…rightly emphasizes, “The fact that efficiency costs rise with the square of the tax rate are likely to make the optimal rate well below the revenue-maximizing rate.”

These excerpts only scratch the surface.

Alan’s article extensively discusses how high-income taxpayers are especially sensitive to high tax rates, in part because they have considerable control over the timing, level, and composition of their income.

He also reviews the empirical evidence from major shifts in tax rates last century.

All told, his article is a devastating take-down of the left-of-center economists who have tried to justify extortionary tax rates. Simply stated, high tax rates hinder the economy, create deadweight loss, and don’t produce revenue windfalls.

That being said, I wonder whether his article will have any impact. As Kevin Williamson points out is a column for National Review, the left isn’t primarily motivated by a desire for more tax money.

Perhaps the strangest utterance of Barack Obama’s career in public office…was his 2008 claim that raising taxes on the wealthy is a moral imperative, even if the tax increase in question ended up reducing overall federal revenue. Which is to say, Obama argued that it did not matter whether a tax increase hurt the Treasury, so long as it also hurt, at least in theory and on paper, certain wealthy people. …ideally, you want a tax system with low transaction costs (meaning a low cost of compliance) and one that doesn’t distort a lot of economic activity. You want to get enough money to fund your government programs with as little disruption to life as possible. …Punitive taxes aren’t about the taxes — they’re about the punishment. That taxation should have been converted from a technical question into a moral crusade speaks to the basic failure of the progressive enterprise in the United States…the progressive demand for a Scandinavian welfare state at no cost to anybody they care about…ends up being a very difficult equation to balance, probably an impossible one. And when the numbers don’t work, there’s always cheap moralistic histrionics.

So what leads our friends on the left to pursue such misguided policies? What drives their support for punitive taxation?

Is is that they’re overflowing with compassion and concern for the poor?

Hardly.

Writing for the Federalist, Emily Ekins shares some in-depth polling data that discovers that envy is the real motive.

Supporters often contend their motivation is compassion for the dispossessed… In a new study, I examine…competing explanations and ask whether envy and resentment of the successful or compassion for the needy better explain support for socialism, raising taxes on the rich, redistribution, and the like. …Statistical tests reveal resentment of the successful has about twice the effect of compassion in predicting support for increasing top marginal tax rates, wealth redistribution, hostility to capitalism, and believing billionaires should not exist. …people who agree that “very successful people sometimes need to be brought down a peg or two even if they’ve done nothing wrong” were more likely to want to raise taxes on the rich than people who agree that “I suffer from others’ sorrows.” …I ran another series of statistical tests to investigate the motivations behind the following beliefs: 1) It’s immoral for our system to allow the creation of billionaires, 2) billionaires threaten democracy, and 3) the distribution of wealth in the United States is “unjust.” Again, the statistical tests find that resentment against successful people is more influential than compassion in predicting each of these three beliefs. In fact, not only is resentment more impactful, but compassionate people are significantly less likely to agree that it’s immoral for our system to allow people to become billionaires.

Here’s one of her charts, showing that resentment is far and away the biggest driver of support for class-warfare proposals.

These numbers are quite depressing.

They suggest that no amount of factual analysis or hard data will have any effect on the debate.

And there is polling data to back up Emily’s statistical analysis. Heck, some folks on the left openly assert that envy should be the basis for tax policy.

In other words, Deroy Murdock and Margaret Thatcher weren’t creating imaginary enemies.

P.S. If you think Kevin Williamson was somehow mischaracterizing or exaggerating Obama’s spiteful position on tax policy, just watch this video.

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More Sloppy Analysis from the New York Times

The New York Times is going overboard with disingenuous columns.

A few days ago, I pointed out the many errors in David Leonhardt’s column extolling the wealth tax.

I also explained back in August how Steven Greenhouse butchered the data when he condemned the American economy.

And Paul Krugman is infamous for his creative writing.

But Mr. Leonhardt is on a roll. He has a new column promoting class warfare tax policy.

Almost a decade ago, Warren Buffett made a claim that would become famous. He said that he paid a lower tax rate than his secretary, thanks to the many loopholes and deductions that benefit the wealthy. …“Is it the norm?” the fact-checking outfit Politifact asked. “No.” Time for an update: It’s the norm now. …the 400 wealthiest Americans last year paid a lower total tax rate — spanning federal, state and local taxes — than any other income group, according to newly released data. …That’s a sharp change from the 1950s and 1960s, when the wealthy paid vastly higher tax rates than the middle class or poor.

Here’s the supposed proof for Leonhardt’s claim, which is based on a new book from two professors at the University of California at Berkeley, Emmanuel Saez and Gabriel Zucman.

Here are the tax rates from 1950.

And here are the tax rates from last year, showing the combined effect of the Kennedy tax cut, the Reagan tax cuts, the Bush tax cuts, and the Trump tax cut (as well as the Nixon tax increase, the Clinton tax increase, and the Obama tax increase).

So is Leonhardt (channeling Saez and Zucman) correct?

Are these charts evidence of a horrid and unfair system?

Nope, not in the slightest.

But this data is evidence of dodgy analysis by Leonhardt and the people he cites.

First and foremost, the charts conveniently omit the fact that dividends and capital gains earned by high-income taxpayers also are subject to the corporate income tax.

Even the left-leaning Organization for Economic Cooperation and Development acknowledges that both layers of tax should be included when measuring the effective tax rate on households.

Indeed, this is why Warren Buffett was grossly wrong when claiming he paid a lower tax rate than his secretary.

But there’s also another big problem. There’s a huge difference between high tax rates and high tax revenues.

Simply stated, the rich didn’t pay a lot of tax when rates were extortionary because they can choose not to earn and declare much income.

Indeed, there were only eight taxpayers in 1960 who paid the top tax rates of 91 percent.

Today, by contrast, upper-income taxpayers are paying an overwhelming share of the tax burden.

It’s especially worth noting that tax collections from the rich skyrocketed when Reagan slashed the top tax rate in the 1980s.

Let’s close by pointing out that Saez and Zucman are promoting a very radical tax agenda.

Saez and Zucman sketch out a modern progressive tax code. The overall tax rate on the richest 1 percent would roughly double, to about 60 percent. The tax increases would bring in about $750 billion a year, or 4 percent of G.D.P…. One crucial part of the agenda is a minimum global corporate tax of at least 25 percent. …Saez and Zucman also favor a wealth tax

Punitive income tax rates, higher corporate tax rates, and a confiscatory wealth tax.

Does anybody think copying France is a recipe for success?

P.S. I pointed out that Zucman and Saez make some untenable assumptions when trying to justify how a wealth tax won’t hurt the economy.

P.P.S. It’s also worth remembering that the income of rich taxpayers will be subject to the death tax as well, which means Leonhardt’s charts are doubly misleading.

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Spain and Lessons on Supply-Side Tax Policy

At the risk of over-simplifying, the difference between “supply-side economics” and “demand-side economics” is that the former is based on microeconomics (incentives, price theory) while the latter is based on macroeconomics (aggregate demand, Keynesianism).

When discussing the incentive-driven supply-side approach, I often focus on two key points.

• Marginal tax rates matter more than average tax rates because the incentive to earn additional income (rather than enjoying leisure) is determined by whether the government grabs a small, medium, or large share of any extra earnings.
• Some taxpayers such as investors, entrepreneurs, and business owners are especially sensitive to changes in marginal tax rates because they have considerable control over the timing, level, and composition of their income.

Today, let’s review some new research from Spain’s central bank confirms these supply-side insights.

Here’s what the authors investigated.

The impact of personal income taxes on the economic decisions of individuals is a key empirical question with important implications for the optimal design of tax policy. …the modern public finance literature has devoted significant efforts to study behavioral responses to changes in taxes on reported taxable income… Most of this work focuses on the elasticity of taxable income (ETI), which captures a broad set of real and reporting behavioral responses to taxation. Indeed, reported taxable income reflects not only individuals’ decisions on hours worked, but also work effort and career choices as well as the results of investment and entrepreneurship activities. Besides these real responses, the ETI also captures tax evasion and avoidance decisions of individuals to reduce their tax bill.

By the way, “elasticity” is econ-speak for sensitivity. In other words, if there’s high elasticity, it means taxpayers are very responsive to a change in tax rates.

Anyhow, here’s how authors designed their study.

In this paper, we estimate the elasticity of taxable income in Spain, an interesting country to study because during the last two decades it has implemented several major personal income tax reforms… In the empirical analysis, we use an administrative panel dataset of income tax returns… We calculate the MTR as a weighted average of the MTR applicable to each income source (labor, financial capital, real-estate capital, business income and capital gains).

You can see in Figure 1 that the 2003 reform was good for taxpayers and the 2012 reform was bad for taxpayers.

If nothing else, though, these changes created the opportunity for scholars to measure how taxpayers respond.

And here are the results.

We obtain estimates of the ETI around 0.35 using the Gruberand Saez (2002) estimation method, 0.54 using Kleven and Schultz (2014)’s method and 0.64 using Weber (2014)’s method. …In addition to the average estimates of the ETI, we analyze heterogeneous responses across groups of taxpayers and sources of income. …As expected, stronger responses are documented for groups of taxpayers with higher ability to respond. In particular, self-employed taxpayers have a higher ETI than wage employees, while real-estate capital and business income respond more strongly than labor income. …we find large responses on the tax deductions margin, especially private pension contributions.

In other words, taxpayers do respond to changes in tax policy.

And some taxpayers are very sensitive (high elasticity) to those changes.

Here’s Table 6 from the study. Much of it will be incomprehensible if you’re not familiar with econometrics. But all that matters is that I circled (in red) the measures of how elasticities vary based on the type of income (larger numbers mean more sensitive).

I’ll close with a very relevant observation about American fiscal policy.

Currently, upper-income taxpayers finance the vast majority of America’s medium-sized welfare state.

But what if the United States had a large-sized welfare state, like the ones that burden many European nations?

If you review the data, those large-sized welfare states are financed with stifling tax burdens on lower-income and middle-class taxpayers. Politicians in Europe learned that they couldn’t squeeze enough money out of the rich (in large part because of high elasticities).

Indeed, I wrote early this year about how taxes are confiscating the lion’s share of the income earned by ordinary workers in Spain.

And if we adopt the expanded welfare state envisioned by Bernie Sanders, Alexandria Ocasio-Cortez, and Kamala Harris, the same thing will happen to American workers.

P.S. I admire how Spanish taxpayers have figured out ways of escaping the tax net.

P.P.S. There’s also evidence about the impact of Spain’s corporate tax.

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More Real-World Evidence for “Supply-Side Economics”

Assuming the goal is faster growth and higher living standards, there are three core principles of good tax policy.

• Low marginal tax rates on productive activity such as work and entrepreneurship.
• No tax bias (i.e., extra layers of tax) against saving and investment.
• No preferences and loopholes that encourage inefficient economic choices.

You could call this list the Holy Trinity of supply-side economics. Simply stated, incentives matter, so it makes no sense for government to discourage the things that make a nation more prosperous.

Regarding low marginal tax rates, my left-leaning friends sometimes dismiss the importance of this principle by pointing out that they don’t pay much attention to their marginal tax rates.

I can sympathize with their skepticism. When I was first learning about public finance and studying supply-and-demand curves showing deadweight loss, I also wondered about the supply-side claim that marginal tax rates mattered. Even after I started working, I had doubts. Would I somehow work harder if my tax rate fell? Or goof off if my tax rate went up? It didn’t make much sense.

What I didn’t recognize, however, is that I was looking at the issue from the perspective of someone working a standard, 9-to-5 job with a modest income. And it is true that such workers are not very responsive (especially in the short run) to changes in tax rates.

In the real world, though, there are lots of people who don’t fit that profile. They have jobs that give them substantial control over the timing, level, and composition of their income.

And these people – such as business owners, professionals, second earners, investors, and entrepreneurs – often are very responsive to changes in marginal tax rates.

We have a new example of this phenomenon. Check out these excerpts from a story in the U.K.-based Times.

About three quarters of GPs and hospital consultants have cut or are planning to cut their hours… About 42 per cent of family doctors and 30 per cent of consultants have reduced their working times already, claiming that they are being financially penalised the more they work. A further 34 per cent and 40 per cent respectively have confirmed that they plan to reduce their hours in the coming months… The government has launched an urgent consultation over the issue, which is the result of changes to pension rules limiting the amount that those earning £110,000 or more can pay into their pensions before they are hit with a large tax bill.

In other words, high tax rates have made leisure more attractive than work. Why work long hours, after all, if the tax authority is the biggest beneficiary?

There are also indirect victims of these high tax rates.

Last month figures from NHS Providers, which represents hospitals, showed that waiting lists had climbed by up to 50 per cent since April as doctors stopped taking on extra shifts to avoid the financial penalties. Richard Vautrey, chairman of the BMA GPs’ committee, said: “These results show the extent to which GPs are being forced to reduce their hours or indeed leave the profession altogether because of pension taxes. …swift and decisive action is needed from the government to end this shambolic situation and to limit the damage that a punitive pensions taxation system is inflicting on doctors, their patients and across the NHS as a whole.”

The U.K.’s government-run health system already has plenty of problems, including long wait times and denial of care. The last thing it needs is for doctors and other professionals to cut back their hours because politicians are too greedy.

The moral of the story is that tax rates matter. Depending on the type of person, they can matter a lot.

This doesn’t mean tax rates need to be zero (though I like that idea).

It simply means that taxes impose costs, and those costs become increasingly apparent as tax rates climb.

P.S. If you want a horror story about marginal tax rates, check out what happened to Cam Newton, the quarterback of the Carolina Panthers.

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