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Backgrounder #942 on Taxes

May 25, 1993

Why Higher Tax Rates on Income Will Slow Growth, Cost Jobs

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May 25,1993 WHY HIGHER TAX RATES ON INCOME WILL SLOW GROWTH, COST JOBS By Daniel J. Mitchell John M. Olin Fellow INTRODUCTION The Clinton Ad ministration has proposed the largest tax increase in American history as part of a budget package that the White House claims will reduce the federal budget deficit and restore fairness to the tax code. More than two-thirds of Clintons $316 bil lion hike comes from increases in tax rates on income and wealth generation. Most nota bly, Clinton proposes to increase tax rates for upper-income Americans from 3 l percent to as high as 42.5 percent. This 11.5 percentage point increase in tax rates represents a 3 7 percent increase in the tax burden for societys most economically productive citizens If approved, the Clinton budget will d Create a new 36 percent tax bracket for income above $1 15,000 for individual re d Impose a millionaires surtax of 10 percent of tax liability on income above d Eliminate the current $135,000 cap on the amount of income subject to the 2.9 d Increase the corporate income tax rate from 34 percent to 36 percent turns and 140,000 for joint returns 250,000 (equivalent to a 39.6 percent t ax bracket percent Medicare payroll tax 1 The House Ways and Means Committee, while approving the bulk of Clintons tax proposals on May 13, voted to raise the corporate income tax rate to 35 percent instead of 36 percent. As this study went to press, the f ull House had yet to act on the tax hikes. Nor has the Senate voted on Clintons proposals, so it is unclear which of Clintons tax d Increase, from 50 percent to 85 percent, the amount of Social Security benefits subject to the personal income tax for seni o r citizens earning more than 25,000 for individual returns and $32,000 for joint returns The Clinton tax hikes on income would have a devastating impact on long-term eco nomic growth. In particular, the increase in the tax burden would reduce savings and i n vestment, thus hampering the economys capacity to generate new jobs and higher wages. Specifically, higher tax rates on income would X Punish productive economic activity Reduce tax revenues X Lead to increased federal spending and higher budget deficit s Reduce job creation X Penalize small business Undermine U.S. competitiveness X Encourage greater use of tax shelters X Renege on the promise of the 1986 Tax Reform Act X Increase the marriage penalty Proponents of increased taxes dismiss such arguments a s trickle-down economics.

But perhaps they may wish to heed the words of the Democrat-controlled Joint Commit tee onTaxation, which in 1991 wrote When an economys rate of net investment increases, the economys stock of capital increases. A larger capital s tock permits a fixed amount of labor to produce more goods and services. The larger a countrys capital stock, the more productive its workers and, generally, the higher its real wages and salaries. Thus, increases in nvestment tend to cause future increas e s in a nations standard of living. i While Clintons tax-the-rich proposals are supposed to affect only the wealthy, those most harmed will be poor and middle-income Americans. Even for the few rich Ameri cans who will be unable to avoid higher taxes by us i ng tax shelters, the tax hike is un likely to mean a radical reduction in their quality of life. The poor and the middle class will not be so lucky. They are more vulnerable to economic downturns and most depen dent on economic growth to improve their liv i ng standards. And they have fewer oppor tunities to avoid new taxes. When savings and investment fall, as inevitably will happen with higher tax rates on income, the poor will be disproportionately affected by the economys inability to produce jobs and ri sing incomes hikes, if any, will be enacted into law.

Joint Committee on Taxation, Tax Policy and the Macroeconomy Stabilization, Growth, and Income Distribution report for the House Committee on Ways Means, Washington, D.C December 12,1991, p. 21 2 2 THEW ,YS TAX HIKES HURT THE ECONOMY I 1 tax rates have several damaging effects Higher tax rates on income may be attractive to class warfare politicians in Washington, D.C but their impact on the economy is unambiguously negative. Higher Effect #1: Higher ra t es punish productive economic activity Tajtes on income drive a wedge between the amount of income taxpayers earn and how much they are allowed to keep. The Administration's proposal to increase tax rates government would be confiscating approximately one - half of every dollar earned at cer tain income levels. Since many scholarly studies confirm that high tax rates depress in centives to work, save, and invest, adoption of the Clinton package would reduce income on income from 3 1 percent to 42.5 percent, c ombined with state taxes, means that and wealth generati~n High tax rates introduce a particularly strong disincentive for workers considering 1 whether to accept overtime and second job opportunities, spouses considering whether to work outside the home, and all individuals deciding whether to spend or invest. Ironical ly, the same Administration that openly considers imposing higher "sin" taxes on alcohol 1 and tobacco, in the knowledge that those taxes will discourage consumption, ignores the same eleme ntary economic analysis in the case of higher tax rates on income.

History shows that tax rates have a powerful impact on the economy. The 1920s 1960s, and 1980s were periods of extraordinary growth in the U.S. economy. Not coin cidentally these periods of growth followed steep reductions in tax rates on income. By contrast the economy stagnated during decades associated with higher tax rates, such as the 1930s and 1970s. Between the 1990 budget deal and Clinton's proposed tax hikes, it appears politicians have failed to learn the lessons of history Effect #2: Higher tax rates tend to mean lower tax revenues Since high tax rates discourage individuals from engaging in productive economic ac tivity the amount of reported taxable income shrinks. Therefore, ev e n though income is being taxed at a higher rate, the result may be lower tax revenues. Harvard economist Martin Feldstein points out, for instance, that if a couple with $180,000 of taxable in come were to reduce their taxable income by just 10 percent in response to Clinton's 3 Eric M. Engen and Jonathan Skinner Fiscal Policy and Economic Growth," National Bureau of Economic Research Working Paper No 4223, December 1992; Otto Eckstein Tax Policy and Core Inflation, A Study Prepared for the Use of the Join t Economic Committee" (Washington, D.C Government Printing Office, 1980 L. Godfrey Theoretical and Empirical Aspects of the Effects of Taxation on the Supply of Labour Paris: Organization for Economic Cooperation and Development, 1975 Michael Beenstock Tax ation and Incentives in the U.K Uoyds Bank Review, Number 134, October 1979, pp. 1-15; Dale W. Jorgenson Tax Policy and Investment Behavior,"

American Economic Review, 58:3, pp. 391-414; Keith Marsden, "Links Between Taxes and Economic Growth: Some Empiric al Evidence World Bank Staff Working Paper Number 605, Washington, 1983 William C. Dunkelberg and John Skorburg How Rising Tax Burdens Can Produce Recession Cat0 Institute Policy Analysis, No. 148 February 21,1991 3 higher tax rates, they would pay nearly 3,700 less in taxes than they did with 180,000 of income at current tax rates.

Making modest assump tions about behavioral changes, Feldstein con- cluded that"the proposed higher tax rates would collect only one-fourth of the additional revenue that the Administration 4 estimates.

The impact of higher tax rates on the upper-in come taxpayers-and on the amount of taxes they pay-is shown clearly by the reductions in tax rates on income that were enacted in 1981 and In 1990, Upperclncome Americans Paid a Lar ger Share of Income Taxes Than a Decade Earlier Share of All Income Taxes Paid (By Income GIDUD Highest 5 Highest 16 Highest 25 Highest 50% 92.6 6.2 U 7.4 Lowest 50 Lowest 25% I Om9% 0.8% i P...I...I...I...l 0 20% 40% 60% 80% 100 1990 U I980 owe: The Tax Foundation, Washington, D.C August I992 Herime haCharc 19

86. Even though the top tax rate was slashed from 70 percent down to 28 percent, the share of the income tax burden paid by the to ten percent of income-earners rose from 48.8 percent in 1980 to 53.9 percent in 1990.

Effect #3: Higher rates lead to increased federal spending and higher budget deficits 9 If history is any guide, higher taxes will trigger a surge of new spending by Congress.

According to historical budget figures, for every $1 that tax revenues grew in the 1970s federal spending climbed by $1.22.6 In the 1980s, government data show that federal spending grew by $1.29 for every new dollar of tax reven~e And since 1990, the ratio has grown even worse, with spending climbing by $1.88 for every new dollar of tax revenue. The government's own da t a are confirmed by scholarly research. According to the Joint Economic Committee, every dollar of higher taxes between 1947 and 1990 has been associated with an average of $1.59 in new spending9 8 4 5 6 7 Ibid 8 9 Martin Feldstein "Clinton's Revenue Mirag e The Wall Street Journal, April 6, 1993, p. A14 TopTenth of U.S. Taxpayers Pay Over Half of U.S. IncomeTaxes Tax Features, September 1992, p. 6.

Budget Baselines, Historical Data, and Alternatives for the Future, Office of Management and Budget, Washington D.C January 1993 Budget of the United States Government, FY 1994, Office of Management and Budget, Washington, D.C April 8 1993.

Richard Vedder, Lowell Galloway, and Christopher Frenze Taxes and Deficits: New Evidence Joint Economic Committee, Washingto n, D.C October 30, 1991 4 While tax increases from all sources tend to trigger higher spending and larger deficits the higher tax rates on income proposed by Clinton would have an especially pronounced impact because such tax increases are likely to gener a te very little, if any new tax revenue. As such, the combination of Congress boosting spending in anticipa tion of new tax revenues and the fact that the bulk of those projected revenues will never materialize means that the deficit will expand even more t han it has following previous tax hikes EffecM4 igher.rates will reduce job creation Almost all jobs ultimately depend on the amount of savings and investment in the economy. Since high tax rates penalize savings and investment, high tax rates will under m ine job creation. Auto workers would not have jobs without individuals willing to in vest in the capital-plant and equipment-needed to produce cars. Employees in Silicon Valley could not produce computer software and hardware without the venture capitalis ts who put their money at risk starting the companies.

Soak-the-rich policies are especially damaging to savings and investment because the bulk of income for wealthy taxpayers is earned through investments instead of wages and salaries. Indeed 60 percent of family income above $200,000, and 75 percent of family income above 1 million, comes from such sources as dividends, interest, rents and royalties lo These families will tend to change their behavior when higher tax rates reduce the expected rate of re t urn for investment income. They will likely reduce the amount of money they are willing to put at risk, choosing instead to increase consump tion If the tax code were neutral, an individuals decision to consume income rather than devoting it to savings an d investing would not be changed by tax considerations. As the following example illustrates, however, tax policy is biased against savings and invest ment, and Clintons proposed increase in tax rates simply will exacerbate the problem.

Consider the case o f an individual who has lO,OOO, and must choose to use those funds for current consumption or to save and invest the money If the individual chooses to con sume, the tax burden will be fairly small, perhaps consisting of state sales taxes and per haps som e federal excise taxes In general, a taxpayer who chooses to consume will be able to consume almost the entire 10,000 free of taxes.

Like most individuals, however this taxpayer may be willing to forego current con sumption if the decision to save and inve st has a sufficient expected rate of return (that is, the individual trades consumption today for the expectation of greater consumption in the future). Assume, then, that this individual is willing to forego current consumption if the act of savings and i nvestment is expected to net a five percent rate of return. This is where taxes impose such a barrier to savings and investment. Assume the individual chooses to invest by purchasing shares in a start-up corporation. First of all, there is a danger that t h e venture will fail, thus leaving the investor with nothing. If this investor is fortunate, and the corporation earns a profit of 10 percent, this generates $1,000 of an 10 Lawrence A. Kudlow,Testimony to the Joint Economic Committee, U.S. Congress, Washi n gton, D.C February 12 1993 5 tion is subject to a 34 percent tax (36 percent if Clintons budget is approved The 1,000 of profit, representing a rate of return of 10 percent, falls to $660, dropping the rate of return down to 6.6 percent. This money the co rporation pays to the investor as a dividend. This 660, however, is then taxed as personal income at a rate of as high as 3 1 percent (as high as 42.5 percent if Clintons budget is approved thus leaving the in vestor with only 455.

40. Assuming there is no state income tax, the investors actual rate of return has fallen to less than 4.6 percent, below the level at which the tax ayer in this example is willing to forego current consumption and make the investment Effect #5: Higher taxes hurt small business Y l The increase in the corporate income tax rate certainly will hinder American business but the proposed tax increases on personal income will be even more burdensome. Ap proximately 80 percent of U.S. businesses-proprietorships, partnerships, and Subchap ter S Corporations- pay taxes through the personal income tax code. If the higher tax rates are approved, these small businesses will have their tax burden climb by as much as 37 percent.

The Clinton plan will make it very difficult for small businesses t o expand, since an nual earnings often are the main source of capital for many growing firms. As such, the more profit the government confiscates, the less money the entrepreneur will have available to plow back into the business. And since small business is the primary source of job creation in the American economy, this reduction in investment will have a partic ularly harmful impact on job creation Effect #6: Higher rates undermine U.S. competitiveness Increasing tax rates on income will impede the abil i ty of individuals and businesses in the United States to compete in the global economy. As the following table indicates country after country around the world followed the lead of the United States in the 1980s by reducing their tax rates. The main reaso n : investors are not restrained by na tional boundaries. So when the United States, the worlds largest economy, reduced its tax rates, other countries were effectively forced to reduce their rates to compete for investors capital. If the United States now a dopts higher tax rates, this will reduce the ex pected profitability of investments and investors will seek out more attractive business climates in other countries. 12 Effect #7: Higher rates will encourage greater use of tax shelters If tax rates on inc o me are increased by as much as 37 percent, as the Clinton Adminis tration proposes, higher-income individuals and small business owners will not stand by and watch the government confiscate the. fruits of their labor. They will instead do what taxpayers h a ve done throughout time-make financial decisions that protect as much of 11 This analysis does not include the effect of capital gins taxes, depreciations, and other features of the tax code that impose additional barriers to savings and investment 12 For an excellent discussion of this phenomenon, see Richard B. McKenzie and Dwight R. Lee, Quicksilver Capital How the Rapid Movement of Wealth has Changed the World (New York: The Free Press, 1991 6 taxpayers have done throughout time-make financial decision s that protect as much of their earnings as they can from excessive taxation. The higher the tax rate, the more the taxpayer is prepared to invest in avoiding taxes. Many taxpayers already have shifted investments into municipal bonds, which pay lower inte r est but are not subject to the fed eral income tax. The impact on the economy of this shift to municipal bonds is signifi cant, since investors are taking funds out of productive private sector investments and putting money in state and local government d e bt instruments which, at best, do little to produce jobs and increase living standards. In general, of course, any switch to tax shel ters means that money is being used less productively than it would be if the taxpayer was investing for economic reasons rather than tax avoidance purposes. It also should be remembered that the very existence of higher tax rates encourages lobbyists to pressure the tax-writing committees to re-establish old tax shelters or create new ones I MAXIMUM TAX RATES ON INDIVIDUAL I NCOME I Global Economic Freedom (Vancouver 7 Proponents of "soak-the-rich" tax policies seem to forget, moreover, that many upper income taxpayers have considerable discretion over what form their income takes and when they receive it. As mentioned earlie r , the majority of income received by such tax payers is not in the form of wages and salaries. These individuals can take steps not avail able to most workers, yet all perfectly legal, to minimize their tax liability. Last year, for instance, many profess i onal athletes, corporate executives, and even law firm partner Hil lary Rodham Clinton arranged to receive earnings before the 1993 tax year began. The reason, of course, was their expectation that income received in 1993 would be subject to higher tax ra t es Effect #8: Higher rates renege on the promise of the 1986 Tax Reform Act The 1986 Tax Reform Act was based in part on the uncontestable premise that the economy would perform better if tax rates were lowered. The government was not ex pected to lose re venue because, even though tax rates were lowered, the elimination of many credits, deductions, and exemptions meant that the tax base (that is, taxable in come) was expanded.

Many taxpayers expressed concern at the time that politicians, having expanded t he amount of income subject to tax, would come back later and raise tax rates. Although I policy makers assured voters that this was not the case, the higher tax rates enacted as part of the disastrous 1990 budget deal, combined with the massive increase i n tax rates proposed by Clinton, suggest that these concerns were justified. This will make it far more difficult in the future to win support for lower rates by widening the tax base Effect #9: Higher rates will increase the marriage penalty 13 The tax c o de already punishes families by imposing an extra tax burden on married Consider a couple, a school administrator making 65,000 and a rising executive in a couples. The Clinton plan will exacerbate this counterproductive policy local company earning lOO,O OO. Married, they will pay $1,250 more in taxes on their combined income of 165,000 under Clinton's proposal than they would if they remained single and paid lower tax rates on their separate incomes.

One effect of the marriage penalty is to impose a harsh tax burden on the spouse with the lower income, usually the woman. This is because the income of the lowerlearning spouse, when added to joint income for tax purposes, is taxed at the highest applicable marginal rate. Adding in the effect of payroll taxe s , the lower-earning spouse could receive less than 50 cents in take-home pay for every dollar earned if the Clinton plan is approved, a tax burden that woold significantly affect the decision to work outside the home. Scholarly studies have found that inc r easing the tax rates for married women from 50 percent to 65 percent reduces their work force participation by one day a week. l4 13 The 1986 Tax Reform Act also involved a transfer of the tax burden from the individual income tax to the corporate income t ax. Nor surprising, individual income tax revenues, at least prior to the 1990 budget deal, grew rapidly in response to lower tax rates. Corporate income tax revenue, on the other hand, fell in response to the steeper tax rates 14 Martin Feldstein Tax Rat e s and Human Behavior The Wall Street Journal, May 7, 1993, p. A 15 8 CONCLUSION Raising tax rates on income is the most economically damaging element of the Clinton plan. There is little reason to expect that the higher rates would generate much, if any, a d ditional revenue. By contrast, there is every reason to believe that higher rates on income would fuel new government spending, increase the budget deficit, depress savings and in vestment, destroy jobs, boost tax shelters, punish families, and hinder A m ericas interna Notwithstanding these serious drawbacks to enacting higher tax rates on income, the tional. co-mptitiveness Clinton Administration seems determined to push forward, apparently believing that lower- and middle-income taxpayers will acquiesce to tax increases on their own in comes if they think that wealthier taxpayers are being punished even more. This calcula tion may work politically, but it will mean only harm to the American economy 9

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