Tax Cuts

Perhaps the hottest financial question today is whether in the recent tax cut will pay for itself.  Proponents of “trickle down economics”  and the Laffer Curve claim it always works while opponents assert it never works.  As you might expect, the truth lies somewhere in between.

Do tax cuts pay for them selves?  Of course, I’m not an economist, but if we look to history, the simple answer is probably not.  I can give examples.

The biggest tax cut that I am familiar with has to be the Bourbon tax reforms of the 18^th century Spanish Empire.  (Relax, I will get to American examples soon enough.)  As the last Hapsburg king, Charles II, died, the empire was near economic collapse.  When Philip V, a French Bourbon import, took over, he slowly dismantled the complicated tax system that was strangling his empire.   He loosened trade restrictions, encouraging economic growth in the New World colonies. 

While results were sluggish at first, eventually the economies of the colonies—especially Mexico—rebounded and tax revenues to the mother country actually increased...At least for a while.  The easing of restrictions also drove the colonies to independence, cutting off the major share of Spanish income.  Spain might have been able to stop those independence movements had she not been constantly bankrupt.

What?  If revenues increased, why was Spain bankrupt?  Simply put: as Spain’s income grew, so did her spending.  Spain tried futilely to reverse the Protestant Revolution that was then sweeping across Europe and also tried in vain to stop the French Revolution.   Spain seemed to believe that her income was unlimited, so her spending was also unlimited.  As a result, the empire collapsed, the country was invaded, and the world’s mightiest empire collapsed into a third-rate power.

Moving to American tax cuts, I have somewhat arbitrarily decided to deal with only the major tax cuts of the last century.  There were tax cuts in the 19^th century, but I believe that the fiscal policy of a pre-industrial America has little to teach us today.  (But, what do I know?  I’m just a poor, dumb ol’ country boy pretending that history teaches us something about today.)

The first meaningful tax cuts occurred during the 1920’s.  Called the Coolidge tax cuts, they were actually the brain child of Treasury Secretary Andrew Mellon, who had been appointed by President Harding.  After Harding’s untimely death in 1923, Mellon continued to hold office for President Coolidge.  The top income tax rate was 77% for all income over $1 million.  Arguing that this rate discouraged investment and hurt jobs, the rate was cut in 1921, 1924, and 1926, eventually dropping the top rate to 24%.  The cuts, like more recent ones, actually made the tax plan more progressive, as the top earners paid a larger share of the total tax collected, and dropped millions of people from the tax rolls altogether.

At first, revenue to the government dropped, in part due to a recession, but as the recession ended, government revenue increased.   For most of the Coolidge years, the government had a surplus, something that ended with the start of the Great Depression.  The net results?  They are somewhat mixed.  The tax cuts did not cause the depression, they did spur a growth in the economy which did cover part of the loss of revenue from the tax cuts, but the income from a rejuvenated economy did not cover the total cost of the tax cuts.

If the Great Depression had not occurred, would the government eventually have recovered the cost of the tax cuts?  We will never know.

The Kennedy tax cuts are actually misnamed.  Kennedy proposed cutting the top income tax rate from 91% to 65%, but he did not live long enough to see these cuts implemented.  Johnson was successful, in 1964, in reducing the top personal rate to 70% and the corporate rate to 48%.  With a static economy, they reduced government income by $12 billion a year. 

Note.  It is difficult to compare tax rates from the fifties to those of today without also referencing what deductions were allowed.  While the rates were much higher under Eisenhower, so were the deductions.

After the tax cuts, the economy greatly expanded, but there are still arguments whether this was due to the tax cuts or from the expanded government spending during the Vietnam War.  Regardless of the cause, new income from an expanded economy recovered at best only 75% of the revenue due to the tax cuts. 

It important to remember that while the overall income to the government might have dropped because of the tax cuts, there were other benefits.  More people were employed, and their wages were higher.  Standards of living increased.  If all we do is look at the total income of the government, it is easy to forget that the government exists to help people, not the reverse.

The Reagan tax cuts are difficult to analyze because, while Reagan did cut taxes in 1981, he also raised taxes eleven times.  These tax cuts also occurred just as the high inflationary period of the 1970’s ended.  When the first tax cut was being argued in Congress, no one argued that these cuts would produce enough economic activity to be revenue neutral, the bill’s sponsors said it would produce a drop in revenue of over $600 billion over five years.

While there was an initial drop in revenue, total government income over the next decade increased 28% adjusted for inflation.  

While the direct cause and effect can be argued, there are a few facts that can be stated unequivocally.  1.  The lowered taxes increased the incentive to invest and the economy expanded.  2.  Government spending increased faster than income, producing bigger deficits.  3.  The tax code was made more progressive, meaning that the top earners paid a larger share of the government budget.

So what is the bottom line?  First, tax cuts rarely pay for themselves even as they stimulate the economy.  Secondly, unless government spending is cut at the same time as the tax cuts, it is likely that deficits will  increase.  Indeed, even if the tax cuts do increase revenue, this usually encourages the government to spend more. 

Tax cuts do increase jobs.  The Kennedy tax cuts created over nine million new jobs while the Reagan tax cuts are credited with creating over 11 million jobs.  With all of the tax cuts, the economy expanded, more jobs were created, and the standard of living went up even as government income usually decreased.

Are tax cuts a good idea?  It’s up to you, but consider that until the presidency of John F. Kennedy, the Democratic Party was in favor of cutting income tax rates—it was actually the chief party plank that differentiated them from the Republican Party.  As we make these decisions, let’s be sure we are doing so on facts and not just to be contrary to the opposing party.