Sunday, December 12, 2010

We should cut, not increase, top income tax rates

Published in The Tennessean, Sunday, December 12, 2010

We should cut, not increase, top income tax rates

by Richard J. Grant

Just as there seems to be a universal speed limit, the speed of light, there seems also to be a limit to the proportion of economic output that can be turned into tax revenue. With apologies to Einstein, if we were to accelerate a rocket, it would seem to shorten and grow heavier as we approached the speed of light. We would have to inject increasing amounts of energy for each mile per second that we eke out.

Since the middle of the 20th century, the U.S. government has applied a wide range of top marginal income-tax rates, from 92 percent down to 28 percent. But so far, the level of tax revenue as a proportion of Gross Domestic Product (GDP) has not managed to break above the 20-percent level (though it did test that level at the peak of the tech boom). This is a historical observation, sometimes called “Hauser's Law,” after Kurt Hauser of the Hoover Institution at Stanford University. The 20-percent “barrier” could change over time as legal and social institutions change.

Why should we care about this? Some people believe that we can increase government spending and then fund it by increasing the top marginal tax rates. But Hauser's Law suggests that the only way the dollar amount of government tax receipts can be increased is through an increase in the size of the economy. This further suggests that there is a range of top marginal tax rates above which both economic growth and high-income tax revenues will be reduced.

This has implications for the size of the national debt as well. Budget data over the last 20 years show the actual proportion of tax revenue to GDP fluctuating between 14 percent and 20 percent. During the same period, the level of government spending as a proportion of GDP has fluctuated between 18 percent and 25.5 percent. The Hauser phenomenon suggests that the limit on government revenue collections at any given time is not merely political but also natural. In contrast, the ability of the federal government to borrow raises significantly any natural limit on government spending, at least in the short term. We have federal budget deficits because the federal government spends more than it is currently capable of funding through taxation.

Perhaps if our governments, at all levels, were to reduce the scope and distortion of their fiscal, monetary, and regulatory activities, then the economy would grow more quickly for any given set of tax rates. Similarly, for any given set of spending and regulatory institutions, we are more likely to observe increased economic growth rates when we reduce top marginal tax rates on income and capital than when we increase such rates.

In recognizing the Hauser phenomenon, we are really just looking at the Laffer Curve through a different window. The Laffer Curve describes the relationship between the marginal tax rate on a particular tax base and the amount of tax revenue obtained from that base. The importance of understanding this relationship is that it warns us against inadvertently reducing people's incomes in a futile attempt to increase government revenue by increasing tax rates on relatively fluid tax bases.

The more the government tries to take, the shorter the supply of everything and the heavier the burden on everyone. It's not rocket science; it's a bit more complex than that.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

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