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April 21, 2011

GDP and Tax Revenue In One Easy Lesson
From the AoSHQ U Continuing Ed. Curriculum

One of the links in Monty's Daily Dose of DOOM!™ today contains a basic misunderstanding of cause and effect on the relationship of tax revenues to GDP that I've seen cropping up all over the place here lately:

A tax hike of 5-6% of GDP doesn't sound like much. But that's a big tax hike if your baseline is 19%--it means that everyone's taxes go up by about a third. If the equilibrium tax revenue at Clinton rates is more like 18-18.5% of GDP, then obviously, they have to go up even higher, from a lower baseline.

Megan McArdle got a lot right in that piece, but she does herself a real disservice in advancing the notion that there's some magic dial the feds can turn and move tax revenues from their historical average of around 19% of GDP up to a higher level on a permanent basis. If there is one, it's never been found.

The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth.


The time period in that graph encompasses three major revisions of the Internal Revenue Code (1939, 1954 and 1986) that have taken place since the 16th amendment was ratified. During the period, tax rates were all over the map, with top marginal rates as high as 90% at one point, and deductions, exemptions and credits were tinkered with constantly by Congress. But revenue was always constrained at 20% of GDP.

What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue.

Michael Barone appears to understand this (but Charles Krauthammer doesn't). Barone's piece is well-timed since the Campaigner-in-Chief is out on the trail right now lying through his teeth about solving our fiscal woes by simply taxing those evil millionaires and billionaires, even though he knows (or should know) that his plan to have a plan is merely a campaign gimmick that leaves us, well, doomed. Barone offered up this take on Obama's real motivation on taxes:

But perhaps Barack Obama understands [that higher tax rates result in less tax revenue]. In 2008, he told ABC’s Charlie Gibson that he wanted to raise capital-gains rates even if the government got less revenue because of “fairness.” Evidently he likes taking people’s money away. What he doesn’t explain is why this makes anyone better off.

Sure he knows we're spending more than we can hope to take in, but he'd rather just demonize Paul Ryan for a chance at four more years at the adults' table.

Another audience member gets a question, about the budget proposed by House Budget Committee Chairman Paul Ryan and the one put forth by Obama’s White House. “Is this a time for boldness, and is your plan bold?”

Obama begins: “I’d call the Ryan plan fairly radical, but not particularly courageous.” On the various cuts to social programs the Ryan plan espouses: “I guess you could call that bold. I would call it shortsighted.” “If you are an entrepreneur with a startup in a garage, good luck getting health insurance,” Obama said. “Nothing is easier than solving a problem on the backs of people who are poor, who don’t have lobbyists and don’t have power.”

So in addition to grandparents and kids with autism and Downs we now add both entrepreneurs and "the poor" generally to the list of people Paul Ryan has it in for. One thing's certain: Ryan's call for an adult conversation about our fiscal challenges, and his realistic take on tax revenues, fell on predictably deaf ears.

When the Democrats get around to offering an alternative to the House GOP's plan, it should be dead on arrival if it contemplates revenues in excess of the long-term historical average of 19% of GDP. Otherwise, everyone in the country, rich and poor alike, is boned in the name of "fairness."

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posted by Andy at 02:14 PM

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