Proposals to lower income tax rates are receiving a
great deal of attention from policymakers. These plans range from
across-the-board reductions in rates to fundamental reforms like a
flat tax that seek to address other problems in the tax code as
well. The reasons for seeking lower rates are varied. Some
legislators believe lower rates will ensure continued economic
growth. Others see them as the fairest way of dealing with
projected budget surpluses. Regardless of how or why, lower tax
rates are a sound idea.
tax rates diminish individual freedom and reduce the economy's
long-term performance. And even though tax rates in the United
States are significantly lower than they were 20 years ago, tax
increases in 1990 and 1993 have set back some of the economic
progress made in the 1980s. Combined with the fact that a growing
number of Americans are being pushed into higher tax brackets by
real income growth, this means the ladder of upward mobility is
becoming more difficult to climb.
should come as no surprise, therefore, that Americans are paying a
record share of their income to the federal government. According
to President Bill Clinton's recently released budget, federal tax
revenues are consuming more than one-fifth of U.S. economic output
this year, a peacetime record. Perhaps most shocking, tax revenues
have doubled since 1987.
Lowering the rates of taxation is the
fairest way to reduce this record tax burden. Rate reductions are
desirable not only because all taxpayers get to keep more of their
money, but also because lower rates will increase incentives to
work, save, invest, and take risks. Ideally, lawmakers should scrap
the entire tax code and replace it with a simple and fair flat tax.
A flat tax would tax all income, but only one time and at one low
rate. To the extent that a flat tax is not immediately achievable,
across-the-board rate reductions offer the most economic
History demonstrates that lower tax rates
are good for the economy. Tax rate reductions in the 1920s, 1960s,
and 1980s all resulted in faster growth, rising incomes, and more
job creation. And even though critics complained that these tax
rate reductions would allow the "rich" to keep too much of their
money, the rich actually wound up paying a greater share of the tax
burden in all three decades. The reason: Lower tax rates reduced
incentives to hide, shelter, and under-report income.
TAX RATES ARE TOO HIGH
fundamental precept of all economic theories is that higher prices
will reduce the amount of a product that is purchased. Taxes are
the "price" that people pay for engaging in productive behavior.
When marginal tax rates rise (the marginal tax rate is the amount
of each additional dollar of income that government takes), the
price of working, saving, investing, and taking risks rises as
well. This means some people will forgo additional income; they
will choose not to work overtime; they will decide not to take a
second job; they will consume their income instead of saving and
investing; and they will decide that some risks are not worth
taking when the government seizes so much of the reward.
every possible measure, the tax burden in the United States is
excessive and tax rates are too high. As the following statistics
indicate, the time has come for across-the-board reductions in the
rate of taxation.
The federal government is expected to
collect $1.722 trillion from taxes this year, more than $13,500 for
every worker in the country. This is nearly 50 percent more than it
took in as recently as 1993 and more than twice the level collected
in 1987 (see Chart 2
According to the Tax Foundation, taxes at
all levels now consume nearly 38 percent of the average dual-income
family's income. Medieval serfs, by contrast, had to give the lord
of the manor only one-third of their output.3
Indeed, this typical family will pay more
than $22,500 in taxes to all levels of government, and will have to
work until May 10 to meet its tax bill (see Chart 3). This is more
than the family will spend on food, clothing, shelter, and
Proponents argue that lower tax rates will
spur economic growth by reducing the penalty on working, saving,
and investing. Opponents disagree, claiming that the economy is
doing fine and that tax rate reductions, if enacted, will help the
rich disproportionately while squandering the surplus.
Fortunately, there is a way to judge the
desirability of lower tax rates. The United States has had three
major episodes of tax rate reductions--the 1920s, 1960s, and 1980s.
By looking at the ways in which the economy performed during these
periods, and by examining what happened to the deficit and the
degree to which different income classes were affected, it is
possible to gain useful evidence about the desirability of tax rate
LOOKING AT CASE HISTORIES
effect of tax rates on economic activity should not be overstated.
The economy, after all, can be affected significantly by trade
policy, regulatory policy, and monetary policy, as well as by many
other government actions. Even within the context of fiscal policy,
tax rates are not the only critical issue. Both the level of
government spending and where that money goes are very important.
And even when looking only at tax policy, rates are just one piece
of the puzzle. If certain types of income are subject to multiple
layers of taxation, as occurs currently, that problem cannot be
solved fully by low rates. Similarly, a tax system with needless
levels of complexity will impose heavy costs on the economy's
Keeping all these caveats in mind, there
nevertheless is a distinct pattern throughout U.S. history: Simply
stated, when tax rates are reduced, the economy prospers, tax
revenues grow, and lower-income citizens bear a lower share of the
tax burden; conversely, periods of higher tax rates are associated
with subpar economic performance and stagnant tax revenues.
Under the leadership of Secretary of the
Treasury Andrew Mellon during the Administrations of Presidents
Warren Harding and Calvin Coolidge, tax rates were slashed from the
confiscatory levels they had reached in World War I. The Revenue
Acts of 1921, 1924, and 1926 reduced the top rate from 73 percent
to 25 percent.
Spurred in part by lower tax rates, the
economy expanded dramatically. In real terms, the economy grew 59
percent between 1921 and 1929, and annual economic growth averaged
more than 6 percent.
Notwithstanding (or perhaps because of)
the dramatic reduction in tax rates, personal income tax revenues
increased substantially during the 1920s, rising from $719 million
in 1921 to $1.16 billion in 1928. As Chart 4 shows, the
increase was more than 61 percent (this was a period of no
share of the tax burden borne by the rich rose dramatically. As
seen in Chart 5, taxes paid by
the rich (those making $50,000 and up in those days) climbed from
44.2 percent of the total tax burden in 1921 to 78.4 percent in
surge in revenue came as no surprise to Secretary Mellon:
history of taxation shows that taxes which are inherently excessive
are not paid. The high rates inevitably put pressure upon the
taxpayer to withdraw his capital from productive business and
invest it in tax-exempt securities or to find other lawful methods
of avoiding the realization of taxable income. The result is that
the sources of taxation are drying up; wealth is failing to carry
its share of the tax burden; and capital is being diverted into
channels which yield neither revenue to the Government nor profit
to the people.6
President John F. Kennedy proposed a
series of tax rate reductions in 1963 that resulted in legislation
the following year that dropped the top rate from 91 percent in
1963 to 70 percent by 1965.7
Kennedy tax cuts helped to trigger the longest economic expansion
in the history of the United States. Between 1961 and 1968, the
inflation-adjusted economy expanded by more than 42 percent. On a
yearly basis, economic growth averaged more than 5 percent.
revenues grew strongly, rising by 62 percent between 1961 and 1968.
Adjusted for inflation, they rose by one-third (see Chart 6).
as in the 1920s, the share of the income tax burden borne by the
rich increased. As Chart 7 shows, tax
collections from those making over $50,000 per year climbed by 57
percent between 1963 and 1966, while tax collections from those
earning below $50,000 rose 11 percent. As a result, the rich saw
their portion of the income tax burden climb from 11.6 percent to
According to President Kennedy,
true choice is not between tax reduction, on the one hand, and the
avoidance of large Federal deficits on the other. It is
increasingly clear that no matter what party is in power, so long
as our national security needs keep rising, an economy hampered by
restrictive tax rates will never produce enough revenues to balance
our budget just as it will never produce enough jobs or enough
profits. Surely the lesson of the last decade is that budget
deficits are not caused by wild-eyed spenders but by slow economic
growth and periodic recessions and any new recession would break
all deficit records. In short, it is a paradoxical truth that tax
rates are too high today and tax revenues are too low and the
soundest way to raise the revenues in the long run is to cut the
President Ronald Reagan presided over two
major pieces of tax legislation that, together, reduced the top tax
rate from 70 percent in 1980 to 28 percent by 1988.
economic effects of the Reagan tax cuts were dramatic. When
President Reagan took office in 1981, the economy was being choked
by high inflation and was in the middle of a double-dip recession
(1980 and 1982). The tax cuts helped to pull the economy out of its
doldrums and ushered in a period of record peacetime economic
growth. During the seven-year Reagan boom, economic growth averaged
almost 4 percent.
Critics charge that the tax cuts caused
higher deficits, but they misread the evidence. The Reagan tax cut,
although approved in 1981, was phased in over several years. As a
result, bracket creep (indexing was not implemented until 1985) and
payroll tax increases completely swamped Reagan's 1.25 percent tax
cut in 1981 and effectively canceled out the portion of the tax cut
that went into effect in 1982. The economy received an unambiguous
tax cut only as of January 1983. As Chart 8 shows, revenues
then climbed dramatically. Personal income tax revenues led the
way, increasing by more than 54 percent by 1989 (28 percent after
adjusting for inflation).
Contrary to conventional wisdom, it was
the "rich" who paid the additional taxes. The share of income taxes
paid by the top 10 percent of earners jumped significantly,
climbing from 48.0 percent in 1981 to 57.2 percent in 1988. The top
1 percent saw its share of the income tax bill climb even more
dramatically, from 17.6 percent in 1981 to 27.5 percent in 1988
(see Chart 9).10
One of the chief architects of the Reagan tax cuts was then U.S.
Representative Jack Kemp (R-NY). According to Representative
some point, additional taxes so discourage the activity being
taxed, such as working or investing, that they yield less revenue
rather than more. There are, after all, two rates that yield the
same amount of revenue: high tax rates on low production, or low
rates on high production.11
tax rates do not mean less tax revenue.
The tax cuts of the 1920s: Personal
income tax revenues increased substantially during the 1920s
despite the reduction in rates. Revenues rose from $719 million in
1921 to $1.164 billion in 1928, an increase of more than 61 percent
(this was a period of virtually no inflation).
The Kennedy tax cuts (1960s): Tax
revenues climbed from $94 billion in 1961 to $153 billion in 1968,
an increase of 62 percent (33 percent after adjusting for
The Reagan tax cuts (1980s): Total
tax revenues climbed by 99.4 percent during the 1980s. The results
are even more impressive, however, when looking at what happened to
personal income tax revenues. Once the economy received an
unambiguous tax cut in January 1983, personal income tax revenues
climbed dramatically, increasing by more than 54 percent by 1989
(28 percent after adjusting for inflation).
- The rich pay more when incentives to
hide income are reduced.
The tax cuts of the 1920s: The
share of the tax burden paid by the rich rose dramatically as tax
rates fell. The share of the tax burden borne by the rich (those
making $50,000 and up in those days) climbed from 44.2 percent in
1921 to 78.4 percent in 1928.12
The Kennedy tax cuts: Just as
happened in the 1920s, the share of the income tax burden borne by
the rich increased following the tax cuts. Tax collections from
those earning more than $50,000 per year climbed by 57 percent
between 1963 and 1966, while tax collections from those earning
below $50,000 rose 11 percent. As a result, the rich saw their
portion of the income tax burden climb from 11.6 percent to 15.1
The Reagan tax cuts: The share of
income taxes paid by the top 10 percent of earners jumped
significantly, climbing from 48.0 percent in 1981 to 57.2 percent
in 1988. The top 1 percent saw its share of the income tax bill
climb even more dramatically, from 17.6 percent in 1981 to 27.5
percent in 1988.14
MYTH AND REALITY
major argument against pro-growth tax policies is that the "rich"
will benefit disproportionately. This argument is used against
across-the-board reductions in the tax rate; it is used against
capital gains tax relief; and it is thrown up against fundamental
reforms like a flat tax. No matter the policy, opponents charge
that the result will be to make the tax code less fair.
key element of this debate is the question of what constitutes
fairness. Advocates of tax reduction and reform generally believe
that fairness means treating all taxpayers equally before the law.
As such, a wealthy person who makes 100 times more than another
person should pay 100 times more in taxes. Others believe in
equality of results rather than equality of opportunity. With this
perspective, they want government to impose increasingly punitive
tax rates on higher-income taxpayers to facilitate income
battles over tax policy involve more than the subjective meaning of
fairness. Often, opponents of pro-growth tax policy make assertions
that are at odds with easily verifiable numbers. Class warfare
advocates frequently rely on the following three myths:
- Myth: The
rich don't pay their fair share.
Reality: According to data from the
Internal Revenue Service,15 the top 1 percent of
earners pays more than 30 percent of the income tax burden; the top
10 percent pay more than 60 percent; and the top 25 percent pay
more than 80 percent. The bottom 50 percent of income earners, on
the other hand, pay less than 5 percent of income taxes (see Chart 10).
- Myth: Lower tax rates mean the rich
get richer and the poor get poorer.
Reality: President Kennedy was
right: A rising tide does lift all boats. Data from the Bureau of
the Census show that earnings for all income classes tend to rise
and fall in unison. In other words, economic policy either
generates positive results, in which case all income classes
benefit, or causes stagnation and decline, in which case all groups
suffer. As Chart 11 illustrates,
the high tax policies of the late 1970s and early 1990s are
associated with weak economic performance, while the low tax rates
of the 1980s are correlated with rising incomes for all
- Myth: The United States no longer
is the land of opportunity. Those who work hard and play by the
rules cannot climb the economic ladder.
Reality: President Clinton's own
Council of Economic Advisers reports that "studies indicate a
reasonably high degree of [income] mobility over time" and that
"almost two thirds of households change income quintiles over 10
years."16 A study by the
Department of the Treasury of those filing tax returns finds that,
over a 10-year period, the poorest 20 percent were more likely to
have climbed to the top 20 percent of taxpayers than to have
remained in the bottom 20 percent (see Chart 12).17
rates of taxation and a tax code that punishes working, saving, and
investing do not comprise a recipe for long-term prosperity.
History shows clearly that lower tax rates are an integral part of
a reform package to maximize freedom and prosperity. A flat tax is
the best way to ensure that all income is taxed at a single, low
rate. The movement to implement across-the-board reductions in the
rate of taxation also is a positive step in this direction.
Daniel J. Mitchell,
Ph.D. is McKenna Senior Fellow in Political Economy
for The Thomas A. Roe Institute for Economic Policy Studies at The