May 25, 2010

May 25, 2010 | Commentary on Taxes, Economy

Tax Hikes Won't Raise Revenue

Recently in the Wall Street Journal, David Ranson pointed out what tax economists have known for a long time: no matter what changes Congress makes to the existing tax code, it will continue to raise the same amount of revenue as a percentage of GDP year-after-year. Ranson writes: Despite big changes in marginal tax rates in both directions, "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19 percent of GDP.

The income tax is the predominant revenue raiser for the federal government, and fluctuations in the revenue it collects have the biggest effect on the total change in tax collections year-to-year. Over the course of its history the top rate has been as high as 91 percent and as low as 28 percent. Even with such large variations in top rates, the income tax has raised a remarkably consistent amount of revenue as the chart shows.

Revenue remains constant as the top rate changes because taxpayers change their behavior to account for changes in rates.

For example, when the top rate is high, workers faced with handing over a substantial portion of every additional dollar of income earned often chose not to work those extra hours. In addition, they will work harder to take advantage of every opportunity to the tax code affords them to reduce their tax liability.

Lastly, workers will shift how they receive their income to limit their tax exposure. Some will take their income in the form of capital gains and dividends instead of wage income because those forms are taxed at lower rates. Or they will take compensation in non-income form like tax-free employer-provided health insurance, a bigger expense allowance for decorating their offices, a company car, or season tickets for the local baseball team.

Each of these efforts reduces tax collections and creates a drag on the economy – especially reducing work effort. In contrast, when tax rates are lower, workers do not need to engage in these efforts to keep their taxes minimal. They are more willing to work longer hours because they get to keep more of what they earn, they don't need to expend their resources and time to squeeze every last deduction out of the tax code, and they are more willing to take their income in wages and salary than in other forms.

These behavioral changes explain why the income tax raises consistent amounts of revenue no matter what the top rate. They also show why substantial tax increases outside the federal income tax will remain a continual threat in the near future. As explained above, the tax code, even with all the changes to income tax rates, consistently raises no more than 19 percent of GDP.

In fact, it has averaged 18.2 percent of GDP in the post World War II era. Spending over that same period has averaged about 20 percent of GDP. That means the United States has averaged a budget deficit around 2 percent of GDP during that span. In the near future, once economic recovery picks up, federal tax revenues will rebound to their upper-bound historical average. But if Congress permanently pushes spending above 24 percent of GDP as President Obama called for in his budget, the deficit will consistently remain at unsustainable levels. The current tax code cannot raise the revenue necessary to support that level of spending.

That is why a concerted push from the left for a new broad-based tax, the value added tax (VAT), is revving into high gear. A VAT with a high enough rate could raise enough revenue to pay for the cradle-to-grave entitlements liberals have long desired. Without it they know they will have no choice but to give up their bigger government dreams and constrain spending to historical levels.

If Congress gives in to temptation and passes a VAT, it would forever expand the size of government and be an enormous tax increase that would raise the prices of everything we buy. Some have suggested a rate as high as 20 percent. At that level, the VAT would transfer about $1.5 trillion annually at the end of the decade from productive private hands to the wasteful hand of government.

A VAT in addition to the current tax code would also solidify in place the economic damage caused by the existing tax system and add on a new layer of inefficiency. The added economic drag created by the VAT and the massive amount of resources taken out of the economy by the VAT combined would significantly and permanently curtail economic growth.

That's why it is so important to stop the VAT. Despite the best efforts of some to make it appear the VAT is inevitable, Congress can reduce spending down to the historical average and the United States can remain VAT-free.

Curtis Dubay is a senior policy analyst at the Heritage Foundation

About the Author

Curtis S. Dubay Research Fellow, Tax and Economic Policy
Thomas A. Roe Institute for Economic Policy Studies

First appeared in The Orange County Register