Wednesday, May 30, 2012

Lessons from The Laffer Curve in the 1920s

What happened to tax revenues collected in the 1920s following a "tax cut" in the top marginal income tax rate from 73% to 24%? They went up, not down.

Thomas Sowell discusses the relationship between tax rates and tax revenues.

"Democrats have been having a field day with the cry of "tax cuts for the rich" — for which Republicans seem to have no reply. This is especially surprising, because Democrats made the same arguments back in the 1920s, and the Republicans then not only had a reply, but one that eventually carried the day, when the top tax rate was brought down from 73 percent to 24 percent (see chart above).

Those who argue that "the rich" should pay a higher tax rate, and that the revenue this would bring in could be used to reduce the deficit, assume that higher tax rates equal higher tax revenues. But they do not.

After Secretary of the Treasury Andrew Mellon finally succeeded in getting Congress to lower the top tax rate from 73 percent to 24 percent, the government actually received more tax revenues at the lower rate than it had at the higher rate. Moreover, it received a higher proportion of all income taxes from the top income earners than before.

Something similar happened in later years, after tax rates were cut under Presidents Kennedy, Reagan and G.W. Bush. The record is clear. Barack Obama admitted during the 2008 election campaign that he understood that raising tax rates does not necessarily mean raising tax revenues.

Why then is he pushing so hard for higher tax rates on "the rich" this election year? Because class warfare politics can increase votes for his reelection, even if it raises no more tax revenues for the government."

MP: Part of the confusion about the relationship between tax rates and tax revenues comes about because we use the terms "raise taxes" to mean both "raise tax rates" and "raise tax revenues" interchangeably (e.g. "raise taxes on the rich"). In reality, "raising tax rates" could result in either "raising tax revenues" or "lowering tax revenues." Most of the discussion about "raising (or lowering) taxes" leaves out the most critical factor: the "tax base, i.e. the activity subject to be taxed," and its changes in the tax base that ultimately determine the relationship between "tax rates" and "tax revenues."

In the case of lowering the top marginal income tax rate from 73% to 24% in the 1920s, the "tax base" expanded so much in response to the lower tax rate that tax revenues actually increased, not decreased. In other words, history tells us that the way to impose a "tax hike on the rich" is to lower, not raise, the tax rate. Lower tax rates increase the incentives to engage in productive, taxable activities and increase the incentives to report instead of hide or shift, taxable income, and therefore raise tax revenues.

With marginal tax rates scheduled to increase next year, the lessons of history also tell us that the tax revenues collected next year will go down, not up. Reason? The tax base of activity subject to the higher tax rates will contract so much that the tax revenue collected will shrink, not expand. Next year's "tax hikes on the rich" will likely end up being a "tax cut" in revenues, and will make the budget deficit worse. 

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