Tax Cuts and Falling Tax Revenues in the 2000s

Guest Author:  Menzie Chinn is Professor of Public Affairs and Economics, Robert M. La Follette School of Public Affairs, University of Wisconsin, Madison, WI – Vita

This article was originally posted at Econbrowser.  The original post has a lengthy discussion stream by commenters, well worth reading.

Detachment from Reality and Innumeracy as Impediments to Rational Discourse – Tax cut version

 On several occasions, I have observed that it is difficult to debate policy when facts are in dispute, and some individuals are impervious to the revelation of data. I was recently reminded of this by reader tim kemper’s repeated assertions that the “the 2001 act and 2003 act actually increased revenues” (3/1/10). Most recently, he repeated that assertion (on 10/31) and linked to this source as proof of his assertion that tax cuts raise revenues, without realizing that the series he was pointing to was total (not just income tax) revenues, and not seasonally adjusted. Below is the actual evolution of personal income tax receipts both before and after the EGTRRA (the 2001 Bush tax cut). 

Figure 1: Personal income tax receipts, SAAR, in billions of dollars (blue, left scale) and as a ratio to GDP (red, right scale). Vertical line at 2001Q3 (EGTRRA provisions take place starting July 1, 2001; Jan 1, 2002, Jan 1, 2004, 2006). Source: BEA, GDP 2010Q3 advance release, Table 3.2, line 3 and author’s calculations.

In other words, it is hard to discern actual evidence for the extreme supply side proposition that tax rate cuts increase tax revenues, when examining the data (and knowing which data are relevant). Now, we know that many things are going on at the same time, but as a matter of fact one cannot say that income tax revenues rose immediately after the beginning of implementation of EGTRRA.

There are more sophisticated ways of analyzing this issue — in particular one could say income tax revenues would have been even lower had not EGTRRA been passed. But I do not know of any studies that make this particular assertion, and assesses it in an econometric fashion. In any case, this counterfactual-based argument is not the typical one made by extremist-supply-siders. And the fact that revenues had not returned to pre-tax-cut levels even by the time the economy had returned to potential in 2006 [0] also counters the extreme supply-sider perspective.

Additional documentation and analysis here: [1] [2].

Of course, this is a separate question from whether output will be higher with lower taxes; for an analysis, see this post discussing the 2006 (Bush) Treasury report on the issue, as well as CBO’s assessment.

I know there are some who believe argument by mantra is the way to go, but I think constructive debate should be informed by appeal to data.

Update 11:44am Pacific 11/2/10

In response to reader Steve, who has just become my new poster-child for detachment and innumeracy by writing:

With all due respect, every time a tax cut has been passed, revenues to the treasury have risen.

I post a graph of total Federal tax revenues.

Figure 2: Federal tax receipts, SAAR, in billions of dollars (blue, left scale) and as a ratio to GDP (red, right scale). Vertical line at 2001Q3 (EGTRRA provisions take place starting July 1, 2001; Jan 1, 2002, Jan 1, 2004, 2006). Source: BEA, GDP 2010Q3 advance release, Table 3.2, line 2 and author’s calculations.

Posted by Menzie Chinn at November 2, 2010 06:21 AM

Related Article

The Bush Tax Cuts and the Economy by Thomas L. Hungerford

3 replies on “Tax Cuts and Falling Tax Revenues in the 2000s”

  1. I feel Chinn’s pain. Cassandra felt it too.

    Commenter Andrew on the original econbrowser article adds great background to the Reagan supply side debate. According to Reagan’s contemporaries and collaborators who are speaking out on this issue today, the Laffer curve suggested reducing very high marginal tax rates on very high income earners could result in increased income tax revenues IF those people used their tax reductions to increase their savings and investment. Increased savings does nothing for the economy unless a banker invests them on behalf of the saver, so an increase in savings is not the actual target. Increased investment would contribute to increased GDP and national income which, with tax rates held steady after the high income tax cut, would generate increased revenues. In fact what happened was the beneficiaries of Reagan’s tax cuts did not save and invest their tax savings, so the policy failed to achieve its desired outcome.

    Today, in a balance sheet recession where investment money is cheap and plentiful but nobody wants to invest it into an uncertain domestic economy, supply side tax cuts will do nothing but reduce tax revenues and increase the deficit without adding any investment or GDP increases at all. In the present environment, high taxes are not a “binding” constraint on investment, so there is no reason to believe that unbinding tax money will improve investment at all and the supply side arguments again crash upon the rocks of reality.

  2. derryl – – –

    Excellent points.

    I have been waiting for someone to do the research that would show the correlation of saving and investment with the size of the top tax bracket. One hypothesis to be tested is that high tax brackets encourage saving and investment rather than monetization of profits.

    Consider a successful entrepreneur who could take an income from his business of $100,000,000 a year. At a top tax bracket of 35% or 40% that large payout may be very attractive. With a top bracket of 70% (most of the 1960s and 1970s) the attractiveness of the large cash payout is greatly reduced, especially if the corporate tax rate is much lower, such as 35% which we have now.

    This entrepreneur might find it much more attractive to leave $95 million as corporate income and reinvest it back into the company. His objective would be to grow the business further and create 20, 30 or 50 years of increased income for the company and himself rather than take the $30 million after tax for the current year. If some of the reinvested income would be eligible for investment tax credits the corporation effective tax rate might be much less than 35%.

    What happens in this scenario is that additional jobs are created in a productive capacity and a pryamid of growing wealth and employment results, much greater than if the $100 million is taken as personal income and spent on extravagant living and speculation rather than investment in increased productivity and increased demand from all the additional people employed over all the future years.

    Over emphasis of the supply side can destroy future demand and find that what might have been productive capital ends up in non-productive uses.

    Everything written above is hypothesis. Hypothesis is worth nothing if it is not tested with analysis of real data. If no one does this work I may eventually get to try my hand at it. However, it deserves to be examined sooner rather than later and if I do it it will most probably be later.

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