Thursday, May 17, 2012

Do Tax Cuts Lead to Revenue Increases?

I know, I've dealt with this one before but for some reason the myth won't die no matter how many times it is doused with gasoline and hit by a flamethrower.  In a recent thread elsewhere I was told that 
"Every time federal income tax rates have been cut, federal revenue has increased!" 
Being the cynical skeptic that I am I just had to check this out.  Fortunately, the person making the claim provided a link to some tax data.  Unfortunately, it wasn't an analysis of the effect of tax cuts on revenue but just a White House Office of Management and Budget (OMB) table listing receipts, outlays, and deficits from 1940 through the present (with projections through 2017).  You can see the table here.

I responded by saying three things are necessary to 'prove' that tax cuts increase revenue:

  • It is not sufficient to show that revenue increased after a tax cut.  It must be demonstrated that revenue increased because of the tax cut.  This is far more difficult to do than merely saying that there was a tax cut in 1964 and that revenue was higher in 1968.  As we like to say in the social sciences, correlation is not causation.  
  • In order to demonstrate that a tax cut produced extra revenue we need to know how much revenue the government would have received without the tax cut.  This is very tricky to do, though we can use revenue projections based on standard growth projections, as I'll try to show below.  
  • Any claim of revenue increases must also use a constant measure of the dollar to control for inflation/deflation.  The OMB revenue table does this by using Fiscal Year 2005 as a baseline measure.  

Here's an oversimplified example of the above principles in action using the following assumptions:

  • Taxes are cut at the beginning of the five year period and;
  • Inflation is at 0% throughout the period and;
  • There is no recession (how can there be if tax cuts cause economic growth?).
Let's say we have an economy that has a Gross Domestic Product of $1 trillion annually.  Further, let us stipulate that the tax rate is 20%.  The economy has been growing at a rate of 3% per year and will continue to do so for the five year period.  Here's what we get with no tax cut:

Fiscal Year Gross Domestic Product (GDP)                 Revenue by Fiscal Year
FY01:  $1 trillion                                                              $200 billion
FY02:  $1.03 trillion                                                         $206 billion
FY03:  $1.06 trillion                                                         $212 billion
FY04:  $1.09 trillion                                                         $218 billion
FY05:  $1.13 trillion                                                         $226 billion

In this scenario we see a 13% growth in both GDP and revenue over the period.  Let us now compare that with a scenario in which taxes are reduced by 2 percentage points after the first year.  To be generous let us assume that a 2% tax rate cut will produce a 33% increase in economic growth.  This means GDP will grow by 4% per year instead of 3%.  The baseline remains the same so the first year revenue will be the same.

Fiscal Year Gross Domestic Product (GDP)                Revenue by Fiscal Year
FY01:  $1 trillion                                                             $200 billion
FY02:  $1.04 trillion                                                        $187.2 billion
FY03:  $1.08 trillion                                                        $194.4 billion
FY04:  $1.12 trillion                                                        $202.2 billion
FY05:  $1.17 trillion                                                        $210.6 billion

As we can see above, the government would have collected $1.062 trillion in revenue under the first scenario over the five year period.  After the tax cut, assuming the cut increased economic productivity by 33% (an unrealistic assumption but I'm being generous) government revenue for the five year period would be $994.4 billion, or $67.6 billion less than it would have been without the tax cut.  I also projected this scenario assuming 5% annual growth (a 67% increase as a result of the tax cut) and government revenue would still be more than $8 billion lower in FY05 than without the tax cut.

All of the above is calculated in a vacuum using perfect world scenarios.  We do not live in a perfect world. There are business cycle fluctuations resulting in recessionary periods and boom cycles resulting in extraordinary growth.  Tax cuts (and tax increases) in and of themselves do not cause these cycles.  Government policy needs to be flexible enough to deal with the ups and downs of the business cycle by reducing taxes during a downturn (but not reducing spending because this will negate the effect of the tax cut) and restoring tax cuts during boom cycles to pay off deficits accumulated earlier.  

For a far more complicated analysis look here.

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