Why Tax Increases Won’t Fix Our Budget Problems

April 13th, 2011 by Lee Eldridge

I’ve had a number of conversations recently about tax policy and our federal deficits. I have many friends who would have liked to have seen the Bush tax cuts expire on the rich. It was estimated that this would generate $700-800 billion over the next ten years, not including any economic repercussions from the tax increases. The math is pretty easy on this one. That’s $70-80 billion per year (we’ll pretend as if there are no economic effects from the tax increases). And with a projected deficit this year of approximately $1.65 trillion, that extra revenue from the increased taxes on the rich means we still have a $1.57 trillion deficit this year.

Matter of fact, if you increase the top tax bracket from 35% (the current marginal tax rate on the highest income earners) to 100%, you still cannot collect enough in tax revenues to run a balanced budget.

The math doesn’t work. You cannot increase taxes and solve our nation’s budget crisis. But that’s just part of the story.

As I mentioned in my last post, too often we ignore history. Too many people believe that tax rates determine tax revenues. They do not. Proof? How’s this:

Tax Revenue as Percentage of GDP

This table shows the top marginal tax rates since the mid-’40s (the tax rate paid by the “rich”). Tax rates have been as high as 94%, and as low as 28%. And the table shows total tax revenues collected by the federal government as a percentage of GDP.

During this time, tax revenues have remained extremely stable as a percentage of GDP — varying from a low of 14.4% to a high of 20.6%. So no matter how high we have made the tax rates, or how low, we still have not collected much more than 20% of GDP. Ever.

Maybe the rich should pay a higher percentage than they do today to be “fair”. That’s a discussion for another day. The point today is that no matter what tax rate you pick, you don’t ever collect much more than 20% of GDP through taxes. And on average you collect less.

Why? That’s an easier answer than you might expect. Higher taxes are a disincentive to work. Let’s say we reverted to the tax rates of 1970, where the “rich” were paying a marginal rate of 71.75%. And let’s say you’re earning $250,000. For every extra dollar you earn, you have to pay almost 72 cents to the federal government. Then kick in a little more to your state government. Why would you waste your time earning more money? If you’re a small business, such as an S-corp or an LLC, and the company profits are reported on your personal taxes, why would you want to grow your business? What’s the incentive? It’s no longer money, because the government is taking almost every additional dollar of profit you make. Why would you create more jobs? Create new products? Once you hit $250k, it’s time to kick back and head to the beach. High tax rates kill productivity, creativity, and economic activity.

Federal Spending
Do you know how big the federal government is compared to GDP? How about one more table (I almost excluded 1945 because the war spending made this a statistical outlier, though I found it interesting so I left it in):

Federal Expenditures as Percentage of GDP

This table shows total GDP in billions of dollars. And the percentage of GDP that was spent by the federal government. Think of it as the relative size of the government compared to the economy.

Historically the size of our government has been less than 20% of GDP until about 1970. From 1970 until the mid-’90s we were in the low 20s. It’s no coincidence that the last budget surplus we had seen was in 1969. It wasn’t until the mid-’90s when we restrained government spending that government expenditures fell below 20% of GDP. The result? Budget surpluses from 1998-2001.

Now let me state the obvious. If our government spends more than about 20% of GDP, we will have a budget deficit. If we spend less than 20% of GDP, there’s a good chance we’ll run a budget surplus.

How have we done the last couple of years?
2009: Government expenditures were 25% of GDP.
2010: Government expenditures were 23.8% of GDP.
2011 (estimated): Government expenditures will be 25.3% of GDP.

And in these three years alone we will have added approximately $4.35 trillion to our national debt.

Our government doesn’t have a tax revenue problem. It has a spending problem.

Source: these numbers are from the White House’s website.

8 Responses to “Why Tax Increases Won’t Fix Our Budget Problems”

  1. Bobby Says:

    now THATS a scoop. how come you never see this in the lamestream press? as if I didn’t already know the answer to that.

  2. Frank Says:

    You lost me on the second graph. What is Exp % of GDP? And how does it relate to the tax rate point you are making?
    But I get the first graph. GDP stays roughly the same % of GDP, no matter what the tax rate is on the rich. Interesting.

  3. Lee Eldridge Says:

    Hey Frank. Sorry about that. Let me try again.

    The middle column shows the size of our economy, typically referred to as GDP (gross domestic product).

    The column on the right shows the size of the government compared to the size of the economy.

    Example: In 2000, the federal government spent approximately $1.8 trillion. The economy generated $9.8 trillion (GDP). Take $ government spends and divide by GDP (1.8 / 9.8 = 18.2%). This shows us the relative size of the gov’t compared to the size of the economy.

    What we’ve found in our history is that when the size of the federal government exceeds 20% of GDP, we will have budget deficits, no matter what the tax rates are.

    And if the size of government is under 19% of GDP, we will likely have a budget surplus, no matter what the tax rates are.

    If we’re going to be serious about fiscal responsibility, we must lower spending to below 20% of projected GDP. It’s really that simple.

  4. Lee Eldridge Says:

    And thanks Bobby!

  5. Eat The Rich Video | Lee Eldridge Blogs on Sports and Politics Says:

    [...] my last post I pulled data from our history to illustrate how even very high tax rates on the rich do not lead [...]

  6. President and Media Say Tax Rates Too Low | Lee Eldridge Blogs on Sports and Politics Says:

    [...] few weeks ago I posted an article about tax revenues as a percentage of GDP. My point at the time was to explain how tax rates have had little effect on tax revenues [...]

  7. Mike Says:

    Tax rate is not complete picture. Deductions (loopholes/writeoffs) must also be included.
    2011 top income tax rate-36%, top capital gains tax 15%. Include other deductions like oil/jet and we can see why the rich can be paying less than their employees.
    Check with Warren Buffet on that. He went public so check out youtube.com
    Before Reagan, The rich were looking for tax shelters. Bankrupt companies were a popular one.
    These charts do not make anything clear and seems motivated by Republicans.
    Just ask the Democrats why they don’t ask Republicans the fairness of super rich paying a lower tax rate than their employees. Ask Warren.

  8. Lee Eldridge Says:

    Hello Mike. Thanks for your input.

    The charts are motivated by facts. You are correct that tax rates are not the entire picture. With the Kennedy, the Reagan, and the Bush tax cuts, each time they lowered the rates, they also closed loopholes in the tax code. Which is the same suggestion we’ve gotten from the Obama debt commission, and from Paul Ryan (lower rates and close loopholes).

    In particular certain liberals like Warren Buffet have complained about capital gains being taxed below the rate of other income. But capital gains is a very specific and unique behaving tax. Every time we’ve lowered the capital gains tax rate, it’s increased business activity, and the government then collects MORE in capital gains tax revenues than they did at the higher rate. I discussed this here:

    http://www.leeeldridge.com/redistribution-of-wealth/