Tuesday, November 13, 2012

Higher taxes on the rich would barely dent the deficit

On the eve of negotiations over the looming "fiscal cliff," here's a look at the current status of the federal budget and projected deficits, using the latest October figures released today.

Obama says it is critical that the rich pay higher taxes, and he has long argued that it was the Bush tax cuts which put us in this mess, since the rich aren't paying their "fair share." The Republicans say it is critical that we avoid raising tax rates on anyone, since higher tax rates would jeopardize the health of the economy. As the numbers show, higher tax rates on the rich would make only a small difference to the projected deficit, since the health of the economy and the level of federal spending are by far the major determinants of the deficit.

This first chart puts the federal budget in the proper long-term perspective, measuring spending and revenues as a percentage of GDP. Spending is still well above its post-War average (22.9% vs. 19.3%), whereas revenues are only slightly below their post-War average (15.9% vs. 17.3%). If you assume that post-War averages are the norm, then 72% of the current budget deficit of 7% of GDP is due to excess spending, and 28% is due to a revenue shortfall. It's important to note here that federal revenues exceeded their post-War average from 2005 to 2008 despite the Bush tax cuts. Those same tax rates are delivering disappointing tax revenues today because of a shortfall of jobs and the fact that our economy is about 10-12% below its potential output. It's the shrunken tax base, not lower tax rates, which is responsible for today's revenue shortfall. A healthier economy and faster jobs growth would do much more to close the deficit than any amount of higher tax rates on the rich.

The chart above plots the running 12-month total of nominal federal spending and revenues. Two rather surprising revelations are apparent. First,  after surging in 2008 and 2009, federal spending growth has slowed to a crawl, thanks mainly to Congressional gridlock and the unwinding of automatic stabilizers (e.g., fewer people collecting unemployment insurance). Second, revenues have surged by $446 billion since hitting a low in early 2010, without any increase in tax rates and despite a two-year payroll tax holiday, mainly because an expanding economy, rising corporate profits, and the addition of 5 million new jobs have expanded the tax base. Even if the economy were to continue growing at a measly 2% rate, there is every reason to think that revenues would continue to rise without the need for higher tax rates. Raising tax rates, however, might weaken the economy further, and that would make it much more difficult to generate higher tax revenues.

The chart above shows the impressive reduction in the federal deficit as a percent of GDP that has occurred over the past three years—from a high of 10.5% in late 2009 to the current 7%. If nothing changes and current trends were to continue (spending growth of 3% per year, revenue growth of 7% per year, and nominal GDP growth of 4% per year), the deficit would decline to approximately 6% of GDP by the end of next year, and return to its long-term historic average of 2% of GDP in seven years. Nobody's taxes need to be raised, and nobody's spending needs to be cut—the U.S. economy is already on a glide path to the restoration of fiscal sanity. Washington: are you listening?

But if anything is likely to change in a big way in coming years, it is increased entitlement spending, particularly under ObamaCare and Social Security. This is what should be getting the priority these days, not tax rates.

I happened on a Bloomberg News article this morning (which for some reason I am unable to find on the web) that reinforces my point that the shortfall in revenue today is not due to tax rates that are too low, but rather due to a weak economy:

... boosting taxes for the wealthiest 2 percent would bring in $58.1 billion in fiscal year 2013, according  to Bloomberg calculations based on data from the [left-leaning] Tax Policy Center. The CBO estimates the government's finances will show a shortfall of $1.04 trillion, assuming almost all the tax increases and automatic spending cuts that are slated to take effect next year are totally averted. 
"It's not very much, but it is a step in the right direction," Roberton Williams, a senior fellow at the nonpartisan Tax Policy Center in Washington, said in a telephone interview. "In order to close half the budget deficit by raising taxes on the rich, you would have to raise their tax rate up to about 90 percent. That's not going to happen."

According to some estimates I've seen, if Obama gets his request for higher income, dividend, capital gains and estate tax rates rise for those making more than $250K per year, that could raise up to $120 billion to federal revenues next year, assuming no adverse consequences for economic growth. That's not an assumption I'm comfortable making, but nevertheless the revenue gains that might result from boosting tax rates for the rich are still a relatively small fraction of the total projected deficit.

Greg Mankiw uses data from the Tax Policy Center to make the point that putting a cap on total deductions could raise significant revenue from the rich without increasing their marginal tax rates, and that is important since it avoids creating a disincentive to additional work and investment:

According to the Tax Policy Center, if we cap itemized deductions at $50,000 and keep tax rates as they are today, we would raise $749 billion in tax revenue over ten years. Moreover, according to the TPC's distribution table, 96.2 percent of the extra revenue would come from the top quintile, with 79.9 percent from the top one percent.

Given today's political realities, the best outcome of the "fiscal cliff" negotiations, from my perspective, would be an agreement to meaningfully reduce future spending on entitlements, extend the current tax structure for at least another year or two, and put a cap on total deductions. This would reinforce the fiscal sanity glide path (i.e., slow growth in spending coupled with continued expansion of the tax base), and give politicians and markets plenty of time to notice that the U.S. federal budget outlook is not nearly as bad as most seem to believe.

If the "fiscal cliff" negotiations end up being driven by political considerations rather than economic realities, higher tax rates on the rich would only increase the odds that the economy is likely to continue growing at a sub-par pace (i.e., growth that is insufficient to return the economy to its full potential) for the foreseeable future. That would be a very unfortunate conclusion to such an important policy debate.


Jake said...


"But will raising top tax rates significantly lower economic growth? In the postwar U.S., higher top tax rates tend to go with higher economic growth—not lower. Indeed, according to the U.S. Department of Commerce's Bureau of Economic Analysis, GDP annual growth per capita (to adjust for population growth) averaged 1.68% between 1980 and 2010 when top tax rates were relatively low, while growth averaged 2.23% between 1950 and 1980 when top tax rates were at or above 70%.

Neither does international evidence support a case for lower growth from higher top taxes. There is no clear correlation between economic growth since the 1970s and top tax-rate cuts across Organization for Economic Cooperation and Development countries."

Source: http://online.wsj.com/article/SB10001424052702303425504577353843997820160.html

Joseph Constable said...

I just never understood arguments for doing something because it appears it won’t hurt. Really Jake, there has to be a good reason to do something. Taking money from the rich to squander it on life style consumption, because it may not reduce investment and thus not hurt economic growth, is not a good reason to tax the rich.

Here is an idea. Get the budget balanced over ten years from economic growth and reduced consumption expenditures and then put a surtax on the rich to reduce the public debt outstanding.

Public Library said...

All for Scott's idea. Limit deductions which amount to loopholes and leave rates where they are. In a perfect world, we would see flat taxes across the board for any income. On both individual and corporations. However, I will take the above before I get hammered next year with the current proposals including Prop 30.

Joe said...

Joseph: This is not about "not hurting", it is about doing something that is proven to work better than the current "low taxes for the rich" meme. From the mid-1930s through 1970s when the top tax rates were between 70 and 90% we had much better GDP growth and equally distributed income growth. The question is why we continue to do something that is proven to work worse over the last 30 years (talk about a slow learning curve!). I never understand arguments for doing something that produces a persistently inferior outcome. So, there you have a good reason for doing something (like raising top tax rates to 80%): it works much better! I am amazed how many people discard doing something simply because it requires looking back more than 30 years.

Bill said...

Arguing about marginal tax rates is silly since the most important rate is the effective tax rate on your income. It's been very steady for the top earners since 1979. No one paid a 90% effective rate in the 1950s- with exemptions, deductions and loopholes the effective rate was probably about the same as it is today. Joe: Do you think wealthy folks would stick around for long if the govt., federal, state and local, took more than 50% of their income?

Gloeschi said...

Funny - when Republicans talk about cutting taxes, it's "stimulating" and "temporary". When those temporary cuts are about to expire, the big whining starts, and the benefits for the budget deficit are belittled.

Scott Grannis said...

Jake: counter-counter argument: The 70% tax rates of the 60s and 70s yielded revenues of about 17% of GDP, which is less than the revenues generated by the lower tax rates of the 80s and 90s. Very high tax rates were tolerated because there were massive deductions available to upper income earners. Given the choice between high marginal rates with big deductions and low marginal rates with smaller deductions that yield similar revenues, it is always better to choose lower marginal rates since they will result in less distortion to the economy and better tax efficiency.

Scott Grannis said...

It's also very important to note that, as Milton Friedman famously said, "spending is taxation." Tax rates and deficits are not as important as the level of spending, because excessive spending eventually requires excessive taxation.

The debate today should focus on the fact that we have excessive spending, not on level of tax rates.

If we want to avoid excessive taxation in the future, we must reduce the level of spending now. Trimming the deficit by shrinking government spending is far better for the economy's future than raising taxes.

Benjamin said...

Still, neither party is talking about the largest of federal agencies, in terms of spending: Defense, Homeland Security and the VA---$1 trillion a year.

Cato Institute says defense could be cut in half.

But Cato said that before real outlays doubled in these categories, during the Bush jr. years.

We face no military threats. None.

We face the threat of terrorism, which is a much, much smaller threat. No one plans to invade the USA and take over, or crush our infrastructure, flatten our cities. They plan to set off bombs when they can. Ugly, but a very manageable threat.

IN 2001, just more than 3,000 American died in a heinous act of terrorism. In the same year, 30,000 Americans died in auto accidents, and 18,000 by gunshot.

IN the years since, about 300,000 Americans have been killed in auto accidents, and 180,000 by gunshot.

Terrorism, in perspective, is a mouse that roars like a lion.

Cut Defense, Homeland Security and VA outlays in half, and you save $500 billion a year. Raise the retirement age to 68 for Social Security and Medicare.

End taxes in interest income and dividends and capital gains.

Start a 2 percent national sales tax, and a new $1 a gallon tax on gasoline.

What i would really like is to cut federal outlays to 15 percent of GDP, and fund through national consumption taxes.

Joseph Constable said...

The half of the defense spending that could be cut is for defending “our” foreign oil. Defense will be reduced along with the reduced need for foreign oil. So eliminating the road blocks for gas and oil production will do wonders for the deficit especially when the U.S. is able to start exporting energy in large quantities.

Back to the numbers. Republicans say the complete repeal of the Bush tax cuts will bring in tax revenue of $70 billion a year. Christina Romer said the complete repeal of the Bush tax cuts will bring in $60 billion. This isn’t even a dent. Obama plans to raise taxes on capital gains, dividends, death, along with a partial repeal of the Bush tax cuts to raise $120 billion per year. This I guess qualifies as a dent but points out that we can’t tax our way out of the deficit. Besides, the increase in tax revenue is theoretical.

Benjamin said...

Drill, baby, drill, but also tax gasoline.

BTW, the Cleveland Fed says inflationary expectations for the next 10 years are at 1.5 percent.

That's well under the 2 percent target of the Fed, a dubiously low target in a recession anyway.

The Fed should print money to the moon.

News Release: October 16, 2012
The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.5 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the "break-even" rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium. For more details, see the links in the box at right.

Estimates are updated once a month, on the release date of the CPI.The methodology used to generate the estimates was changed slightly starting June 15, 2011, and it is documented in this working paper.

Unknown said...

in reply to Scott Granis:

Who says that the problem is spending, and we must reduce spending now:

The problem with this proposition is that no one ever really wants to cut that spending. Romney-Ryan was completely unwilling to specify any spending cuts. I think republicans just don't have the guts to really campaign on that. Maybe because they fear they would not be elected.

If the republican candidate can't get out there and advocate for the spending cuts, who can? Specific cuts like let's cut defense spending in half, or let's cut back on medicare for your sick mother.

And a question: Just how did Bill Clinton produce that budget surplus anyhow?

steve said...

the ideal tax: 20% flat tax with NO deductions. NONE! have a $12,500 "exemption" per dependent/taxpayer so that a family of 4 w/ $50K income pays 0 fed tax while same family w/ $500K pays (500-50X.2) $90K or 18% and same family with $5M income pays
19.8% rate. of course the dems lose POWER by losing control so very apolitical.

Gil Rodveltz said...

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” Scott every time you quote Milton Friedman you remind me of Keynes quote above. It detracts from your argument.

Gil Rodveltz said...

.. "boosting taxes for the wealthiest 2 percent would bring in $58.1 billion in fiscal year 2013, according to Bloomberg" ....Well every little bit helps. Fixing the economy takes a combination of decrease spending and increases revenues but the details are the devil.

Public Library said...

Steve has done the right maths. It's not rocket science. Sadly, not a single politician is willing to do the same.

steve said...

obama just proposed a $1.6T tax hike for "wealthy" with nothing but dubious cuts. fiscal cliff anyone?

NormanB said...

I still would like to see a graph of Federal spending divided by Federal receipts. It'll show that they are spending 20%-40% more than is taken in. That's what will inflame the folks. These GDP ratios are meaningless to a lot of people.

Dr William J McKibbin said...

For America to contend with its national debt and budget deficit, all incomes will have to be taxes at the 50% level minimum, and probably much higher -- said another way, tax rates need to triple for everyone in order to make a dent in the national debt.

The other austerity alternative is to cut spending, which has been soundly rejected by Americans in the last election.

If you are against either: a) an immediate 40% cut in government spending; or b) an immediate tripling of tax rates for all Americans; then your only remaining alternatives are: c) monetary expansion leading to default via inflation; or d) outright default/restructuring of the national debt.

The multiple avoidance choices are grim indeed. However, options a through d above are apparently mutually exclusive according to the Republicans, Democrats, and apparently Americans at large.

Assuming you had to chose, a, b, c, or d above, which would you choose? Again, no combinations are permitted, and no other options are feasible...

My vote would be for...

Scott Grannis said...

Re "I still would like to see a graph of Federal spending divided by Federal receipts"

That graph would be very similar to the chart of the surplus/deficit % of GDP posted above, only inverted. The ratio hit a high of 1.72 in early 2010, which was when the deficit hit a high of 10.5% of GDP. The ratio has since declined to 1.45.

Ralf Graute said...

Guys, please focus. Barak Obama doesn't care about ANY numbers, and especially not about any deficits. His idea is "steal from the rich", until now to get elected and from now on just to get applause. Unless you can instill in people the sense that stealing in general is wrong, he will go on winning. Who cares about jobs and the economy if you can get things for free by stealing from someone else. It is so simple and unfortunately so effective.

Bob said...

What's never mentioned on this board is the "what for", or the reason for the progressives policies. IMO, most progressives live under the illusion that prosperity can and should be shared through wealth redistribution. They think it is altruistic. What they don't realize is that they are pawns in a bigger game.

What we are witnessing is a longterm concerted effort to reduce the economic and military power of the U.S. so that the "rule of law" can slowly be transferred to a world governing body based on a socialist model. Some call it the New World Order. It doesn't matter what it is called, for us in America the result will be the loss of our country as the dominant player on the world stage.