No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Fourteen: Decision-making in Democracy: Public Choice 350 One of the major problems is that under the current budget, spending is projected to stay significantly above its long-run average of ~21%, while the historical average revenue from all forms of taxation is only 18%! The budget assumes that revenue will climb above any previous year’s high, and then stay there. Yet even under that scenario, we still have a crushing deficit. Some politicians are suggesting that sharp rises in upper income tax rates are appropriate; those that are receiving the lion’s share of the national income should pay their fair share! There is one big problem with thinking that raising the tax rates on the rich is going to solve our debt problem; look at Figure 14.11 and see if it doesn’t jump right out at you! At the conclusion of World War II, the highest tax rate was over 90%, where it stayed until John F. Kennedy pushed for tax cuts and lowered the high rate to 70%. President Reagan lowered the rate to 50% and then 28%. The rate has gone up and down a bit with subsequent presidential administrations and is a source of much political debate. But the interesting conclusion is that tax revenue as a percentage of GDP does not vary much as the highest marginal tax rate is changed. Tax revenue is the product of the tax rate times the tax base (the underlying economic activity). The problem is that if you raise the tax rate to increase tax revenue, people change their behavior to avoid the tax hike and therefore reduce the tax base. So raising tax rates may increase tax revenue or decrease it. Periods of higher tax rates alse encourage socially unproductive rent seeking as special interest groups lobby for tax breaks for their favored activity. Historically, you can squeeze about 18% of the economy’s GDP out of the public in tax revenue. This is not promising to support the current spending rate of 22% of GDP. 1946 1949 1952 1955 1958 1961 1964 1967 1970 1976 1979 1973 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 100% Highest Marginal Tax Rate Vs. Revenue 80% 60% 20% 0% 40% High MTR Tax Rev %GDP Figure 14.11, Highest Marginal Tax Rate (MTR) Vs Tax Revenue. The highest MTR has varied dramatically since WWII, yet the revenue generated is always around the historical average of 18%. Source: Bureau of Economic Analysis. Tax Revenue = Tax Rate × Tax Base