Do Tax Cuts Increase Revenue?
It is a widely held belief in the U.S. that cutting tax rates actually increases government tax revenues, as people work harder to make more money, and having more money (either from working longer hours or simply because they have more income after paying lower taxes), they spend more. This increased consumption stimulates growth in the business sector of the economy, increasing business profits, allowing businesses to hire more employees, etc. and the economy grows. Economic growth then leads to more tax revenues for the government, even though taxes have been reduced.
While this view has gained political currency, there is little evidence to support it. Indeed, as evident in the following graph, the evidence suggests that tax cuts do not increase revenues to the government in any meaningful way, but instead increase government deficits. Likewise, tax increases are often criticized as harmful to the economy and opponents argue that they do not actually increase government revenues. Again, the available evidence suggests that the opposite is true.
Regardless of the effect of changes in tax rates on the economy, it is important to recognize that the idea that tax cuts increase government revenues while tax increases decrease them is a myth. It is equally important to recognize that in the long run, taxes are equal to government spending. Every dollar the government spends is a tax dollar -- it has no other source of revenue. The question is when that dollar will be paid, and who will pay it.
The following graph, compiled by the Congressional Budget Office (but modified below to point out major pieces of tax legislation), illustrates the relationship between government tax revenues, budget deficits and changes in tax legislation over the past quarter-century. The graph is followed by a discussion summarizing the highlights of major tax legislation during this period.
Obviously, this table is slightly out of date, as it has not been updated for actual 2005 or 2006 figures. However, the projected figures are relatively accurate, so I have not updated the graph yet.
A brief summary of major tax legislation passed over this period:
The Economic Recovery Tax Act of 1981 reduced the maximum individual income tax rate from 70% to 50%. It reduced the maximum tax rate on capital gains from 28% to 20%. It also increased allowable depreciation deductions, especially on real estate, allowing taxpayers to depreciate real estate over 15 years using accelerated depreciation methods (150% declining balance vs. straight-line depreciation).
The Tax Equity and Fiscal Responsibility Act of 1982 backtracked on the tax cuts of 1981. Congress and the administration were concerned about the effect of the previous year's tax cuts on the deficit (illustrated in the above chart), and increased taxes, mostly by cutting back on benefits provided in the prior year's act. For example, the act added a number of preference items to the calculation of the alternative minimum tax and repealed the old "add-on" minimum tax. It also increased the floors on deductibility of medical expenses and casualty losses, increased the taxable portion of unemployment benefits (by reducing the AGI floor at which these benefits became taxable), and scaled back a number of corporate tax preferences (particularly those related to depreciation).
Because the 1982 tax increase did not alleviate the deficit, Congress passed the Deficit Reduction Act of 1984, which was signed into law by President Reagan in July 1984. This act was billed as the "largest tax increase in U.S. history" up to that time. The act increased the depreciable life over which real estate could be depreciated from 15 to 18 years, and expanded the definition of corporate "earnings & profits," thus increasing the taxability of corporate distributions to shareholders (a change affecting primarily closely held businesses). The act increased the reduction in certain corporate tax preferences to 20% (from 15%), disallowed the corporate deduction of construction period interest and taxes, and reduced the tax benefits available to business property used 50 percent or more for personal purposes.
As indicated in the above chart, while the 1982 and 1984 acts appear to have halted the growth of the deficit, they did not reverse it. Moreover, the tax law remained unpopular and was widely perceived as unfair and overly complex. In 1986, Congress and the administration passed the Tax Reform Act of 1986. This act significantly altered the tax code, reducing the maximum individual income tax rate from 50% to 28%, and reducing the maximum corporate income tax rate from 46% to 34%. These rates were effective as of mid-1987, so that the actual tax rates faced by individuals for 1987 ranged from 11% to 38.5%, before dropping to 15% and 28% in 1988.
To pay for these rate reductions, the act substantially broadened the tax base, focusing in particular on reducing the availability of tax shelters. For example the 1986 act implemented Section 469 of the Internal Revenue Code, significantly reducing the deductibility of "passive activity losses." The act also eliminated the preferential treatment of capital gains, though it established a maximum rate on long-term capital gains of 28%, suggesting the possibility that Congress would not leave the maximum tax rate on individuals at 28% for very long. This maximum rate was applicable only to capital gains reported by individuals. Corporate taxpayers paid the same rates on capital gains as they did on other types of income. Finally, the act also increased the holding period for assets to qualify for long-term capital gain treatment from six months to one year.
An interesting, and little understood, feature of the two-rate structure implemented in 1986 was the "phase-out" of the lower bracket for "high-income" taxpayers. The system was designed to act as a "flat" tax for the large majority of taxpayers. Those with incomes below certain levels paid a flat rate of 15% (because their incomes were not high enough to put them into the 28% bracket. However, as incomes reached a certain level, the benefit of the 15% bracket was eliminated, so that these taxpayers faced a flat rate of 28%. To accomplish this, the act put in place a 5% surtax to be paid on taxable incomes between $71,900 and $149,250 for married taxpayers. The result was that a marginal tax rate of 33% applied to incomes in this range before declining back to 28% as incomes exceeded $149,250. The result was that when a married couple's taxable income reached $149,250, their tax liability was equal to a flat 28% of their taxable income. Note that the 33% rate was triggered at lower levels of income for single taxpayers. Bracket amounts for all taxpayers were indexed for inflation.
Not surprisingly, this feature of the tax code was neither widely understood nor appreciated. Taxpayers with incomes between $71,900 and $149,250 ($43,150 and $89,560 for single taxpayers) complained loudly that their tax rates were higher than those faced by people making more money than them (whose marginal rates fell from 33% back to 28%). Although their average, or effective, tax rates were lower, their marginal rates (the rate paid on the next dollar of income) were higher than those faced by people making more money. This complaint was soon remedied by replacing the 5% surtax with a new 31% rate bracket, to be paid on all income above $82,150 ($49,300 for single taxpayers) beginning in 1991. Thus, five years after passage of a modified flat tax system in 1986, a third rate was added to the system.
In 1993, Congress passed the Omnibus Budget Reconciliation Act of 1993. This act added two additional tax brackets. A new rate of 36% applied to individual taxpayers reporting taxable incomes of $140,000 (married taxpayers) or $115,000 (single taxpayers). A new rate of 39.6% (structured as a 10% "surtax" on high income taxpayers: 36% times 1.1 = 39.6%) applied to incomes over $250,000. The maximum capital gains rate remained at 28%. The act also made permanent the phase-out of itemized deductions and personal exemptions for "high-income" taxpayers implemented under the first President Bush (and widely perceived to have cost him an opportunity for re-election in 1992). The act also modified the structure of the alternative minimum tax, converting it to a two-rate system (26% and 28%) from the old one-rate system, and implementing new "adjustments" in the calculation of the AMT base. For example, this act created the adjustments for state income taxes (no longer deductible for purposes of the AMT), medical expenses (increasing the floor for the deductibility of medical expenses to 10% for purposes of the AMT as compared to 7.5% for regular tax purposes). Other provisions reduced the deduction for meals and entertainment expenses to 50% of costs incurred (from 80%), modified the deduction for moving expenses, disallowed the deductibility of club dues (country clubs, hotel and airline clubs, etc.), and disallowed the deductibility of executive compensation in excess of $1 million (allowing an exception for "performance-based" compensation -- e.g. stock options). The act increased the taxable portion of social security benefits from 50% for retirees with earnings above $32,000 ($25,000 for single taxpayers) to 85% of such earnings, and eliminated the earnings ceiling previously applicable in calculating the Medicare payroll tax. Prior to repeal of the cap, earnings above $135,000 were not subject to this 1.45% payroll tax (2.9% for the self-employed). For tax years after 1993, all earnings are subject to the Medicare tax. All told, this act significantly increased taxes on individuals.
The Economic Growth and Tax Relief Reconciliation Act of 2001 enacted reductions in tax rates for individuals, reducing the maximum tax rate from 39.6 to 35%, phased in over a six-year period. The act reduced rates other than the top rate by 2 percentage points over this period. It also expanded the size of the lower tax brackets, allowing more income to be taxed at the 15% rate than under prior law, and implementing a new 10% tax bracket at the bottom of the rate structure. Additionally, the act implemented a new $1,000 child tax credit (phased out for "high-income" taxpayers).
The act also phased in substantial reductions to the estate tax over a 10-year period, with complete repeal of the estate tax (but not the gift tax) in 2010. In an unusual twist, all individual and estate tax rates were to revert to their 2000 levels in 2011. Thus, without further action by the Congress, the estate would be significantly reduced over the 2001-2009 period, falling to zero in 2010, before reverting back to 2000 levels the next year. Most practitioners discount the probability that the estate will be eliminated in 2010.
This act was followed by the Jobs and Growth Tax Relief Reconciliation Act of 2003 which reduced the maximum tax rate applicable to dividend and capital gain income 15%. Prior to this act, dividends were taxable at the taxpayer's marginal income tax rate, meaning that dividends for many taxpayers were taxed at 38.5%. Capital gains, on the other hand, had previously been taxable at a maximum rate of 20%. Again, these rates are scheduled to expire in 2010.
The above summaries discuss major tax legislation passed over the past 25 years. Many other years saw tax bills, but the landmark changes are captured in the above summary.