The Case For An Across The Board Tax Rate Reduction

Policy Backgrounders | Taxes

No. 140
Wednesday, September 25, 1996
by Bruce Bartlett

Dealing with the Deficit

Figure VI - Dole Plan vs. Baseline Spending and Revenues

Opponents of an across-the-board tax rate cut argue that it would either require massive spending cuts or lead to higher deficits. Liberals contend that the necessary spending cuts would be so large that they would devastate essential programs. While conservatives have no objection to cutting spending, many worry that it will be politically difficult to do so because the tax cut will widen the deficit. Both arguments implicitly exaggerate the size of both the tax cut and the needed spending cuts, making them appear much larger than they actually are.

Revenue Loss: 1 Percent of GDP. The "huge" tax cut that both liberals and many conservatives fear would emaciate the federal government would lower revenues by only 4 percent over six years. With GDP expected to total $54 trillion between 1997 and 2002, the $548 billion tax cut proposed by Dole amounts to just 1 percent of GDP, or 0.5 percent less than federal revenues have risen just since early 1993.

Similarly, the cuts in projected spending necessary to pay for the Dole plan are modest, only 5.6 percent lower than what is now projected. But even this figure is overstated because congressional Republicans have already passed a budget resolution containing $400 billion in spending reductions. All Dole is really proposing is taking another $217 billion, or 2 percent, out of expected future spending. This would pay for the tax cut and balance the budget in 2002 without the necessity of touching Social Security or Medicare.

"With the spending 'cuts' necessary to pay for the Dole tax cuts, federal spending would increase 14 percent from 1996 to 2002."

Paying for the Tax Cut by Holding Down Spending Increases. Although many people are legitimately concerned about the deficit, arguments about government spending actually are about cutting planned increases in federal spending, not about reducing the current level of federal spending.

  • Federal spending in 1996 is set at $1.566 trillion.
  • Federal spending in 2002, without any reductions in planned increases, is expected to be $1.968 trillion, or an increase of 26 percent from 1996.
  • With the spending "cuts" necessary to pay for the Dole tax cut proposal, federal spending in 2002 would be $1.783 trillion, or an increase of 14 percent from 1996.

The truth of the matter, then, is that the Dole plan is quite modest. As Figure VI indicates:

  • Over the period from 1997 through 2002, the federal government expects to collect more than $10 trillion and spend almost $11 trillion.
  • Enactment of the tax cuts proposed in the Dole plan would only lower revenues to slightly less than $10 trillion and spending to just over $10 trillion.

Paying for the Tax Cut through Higher Economic Growth. If a tax cut produces economic growth, an important consideration is the amount of new tax revenue the growth produces for the government, or as economists term it, the "feedback" effect. There is virtual consensus spanning the political spectrum that substantial revenue feedback would result from tax cuts. And the impact on growth need not be large for there to be large revenue effects. According to a table in the federal budget for fiscal year 1997:7

  • A sustained increase in growth of 1 percent per year would increase federal revenues cumulatively by $420 billion between 1996 and 2002, while lowering spending by $183 billion.
  • Thus even an increase in growth of 0.1 percent per year would lower the deficit by some $60 billion over seven years.

"The Dole plan would lower revenues to slightly less than $10 trillion and spendin to just over $10 trillion over six years."

It is certainly not the case, as some critics continue to charge, that the Reagan administration predicted that its tax cut in the 1980s would pay for itself. Every official document ever produced by the Reagan administration showed large revenue losses from its tax cut.8 But the Reagan tax cut had feedback effects. In testimony before the Joint Economic Committee on February 23, 1981, Professor Richard Musgrave of Harvard estimated that 30 percent to 35 percent of the revenue loss might be recouped based on standard Keynesian assumptions. Later, Lawrence Lindsey, then also a professor at Harvard and now a member of the Board of Governors of the Federal Reserve System, calculated that by 1985, 70 percent of the direct revenue loss had in fact been recovered through higher growth and behavioral changes.9

No one has ever seriously argued that an across-the-board tax rate reduction, such as that enacted in 1981, would recoup 100 percent of lost revenue through higher growth. What tax cut advocates have said is that some tax cuts, such as a cut in the capital gains tax, might well pay for themselves. They also have said that tax rate reductions do not lose as much revenue as static revenue loss estimates predict. This is, in fact, the view generally accepted by economists. For example, a 1978 CBO report estimated that:

  • A one-third reduction in income tax rates would produce a static revenue loss of $21 billion the first year, but a net cost of just $16 billion.
  • By the fifth year after enactment, the static cost had risen to $164.6 billion, but the net cost was just $79.1 billion.

"Tax cut advocates have said some tax cuts, such as a cut in the capital gains tax, might well pay for themselves."

In other words, even the CBO, then headed by Alice Rivlin, who was the president's budget director until earlier this year, thought that this proposal would produce 24 percent revenue feedback the first year, rising to 52 percent after five years.10 [See the Sidebar on Dynamic and Static Scoring.]

Another CBO report reviewed the experience of the Kennedy administration tax cut in the early 1960s. The CBO concluded that:

  • The direct effect of the tax cut was to reduce federal revenues by $12 billion per year.
  • However, because of the higher growth resulting from the tax cut, $3 billion to $9 billion of the direct cost was recouped after two years.
  • Thus the feedback from the Kennedy tax cut was between 25 percent and 75 percent.11

In 1982, the CBO discussed in detail the dynamic effect of tax cuts on revenues. In How Changes in Fiscal Policy Affect the Budget: The Feedback Issue, the CBO estimated the effect of an across-the-board tax rate reduction and concluded:

Generally, the figures suggest that between roughly one-tenth and two-tenths of the static revenue loss from the tax cut may be recouped through induced increases in revenues during the first fiscal year after the tax change, and that roughly one-third to one-half of the static revenue loss may be recovered in later years.12

Lawrence Chimerine, former chief economist for both Chase Econometrics and the WEFA Group and now chief economist for the liberal Economic Strategy Institute, conceded that "credible evidence overwhelmingly indicates that revenue feedback from tax cuts" may be as high as 35 percent.13

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