10 myths about higher taxes

Tax increases will not reduce the deficit, improve fairness by making the rich pay more, or help the balance of payments.

On August 10, 1993, Pres. Clinton signed into law the largest tax increase in U.S. history for the stated purpose of reducing the Federal budget deficit. The Omnibus Budget Reconciliation Act of 1993 (OBRA93) is constructed to collect $24 1,000,000,000 in new taxes on personal income, corporations, and gasoline over the next five years. The act will fail to achieve its revenue and deficit reduction targets for a number of reasons that constitute 10 myths about higher taxes:

Myth #1. People willingly pay higher taxes for worthy goals. Proponents of tax increases point to public opinion polls to justify the claim that the public will accept higher taxes as the price of deficit reduction. Most economists, however, employ a methodology that rejects polling statements as evidence of actual behavior. This is captured in the phrase "watch what people do, not what people say." The reality of taxpaying, even with the current relatively modest 39.6% top marginal rate, is that noncompliance exceeds $100,000,000,000 a year. During the 1980s, about 70% of noncompliance took the form of underreporting income and 17% of exaggerating deductions.

Noncompliance responds to changes in marginal tax rates. High ones foster cheating. In 1983, the American Bar Association established a Commission on Taxpayer Compliance that undertook a three-year study of the sources of noncompliance and measures to improve compliance. This commission's report, issued in July, 1987, acknowledged that compliance improves when marginal tax rates decline and deteriorates when tax rates increase. It is unrealistic to expect American taxpayers to pay willingly the higher taxes embodied in the 1993 act. Rather, higher tax rates will encourage taxpayers to cheat even more.

In addition to greater cheating, higher rates will resurrect a variety of old tax shelters and generate a proliferation of new ones. Tens of thousands of lawyers, accountants, and sellers of tax shelters will fashion hundreds of ingenious ways to reduce taxable income. Tax avoidance, unlike tax evasion, is perfectly legal. Even before passage of OBRA93, the pages of the Wall Street Journal and other financial publications contained numerous advertisements and stories about the benefits of municipal bonds and other tax shelters. The popularity of tax-free bonds and other shelters goes up and down with changes in rates. Doubtless, some of the new tax shelter avoidance schemes will border on tax evasion. Since it takes the Internal Revenue Service and the courts several years to catch up with the not-quite-so-legal schemes of the purveyors of tax shelters, actual revenues will fall below estimates. When the predicted revenues fail to materialize, politicians likely will clamor for strengthening the enforcement mechanisms of the IRS.

Few people send additional voluntary contributions to the IRS despite daily political reiteration of the need for additional funds to finance vital, unmet social needs. Indeed, it is a safe bet that taxpayer compliance would fall dramatically, perhaps disappear altogether, if the IRS were dissolved and all taxpayers were placed solely on their honor without fear of penalty for noncompliance.

Myth #2. Tax increases reduce budget deficits. This statement is patently false both for tax increases in general and for deficit reduction tax increases in particular. Between 1950 and 1992, total Federal receipts rose from $39,400,000,000 to 1.09 trillion dollars. Total spending over the same period increased far more rapidly, from 42,600,000,000 to 1.38 trillion dollars. This trend, spending rising faster than revenues, holds for any starting date. Deficit-reducing tax increases, in particular, show no perceptible impact on deficit reduction; indeed, they appear to have the perverse effect of increasing future deficits.

The tax increases enacted during the Reagan-Bush years 1981-92) include the Tax Equity and Fiscal Responsibility Act of 1982 (to raise $98,000,000,000 over three years); Deficit Reduction Act of 1984 (to raise more than 20,000,000,000 a year into the indefinite future); Omnibus Budget Reconciliation Act of 1987 (to generate more than $10,000,000,000 a year); and Omnibus Budget Reconciliation Act of 1990, the much-criticized "budget accord" ($500,000,000,000 in deficit reduction over five years). In addition to these income tax measures, the Social Security (tax) amendments of 1983 have generated an additional $20-30,000,000,000 in new revenue every year.

These four major deficit reduction tax increases seem to have had the opposite effect. In 1981, for example, the deficit was $59,000,000,000. It peaked at 201,- 000,000,000 in 1986 despite the 1982, 1983, and 1984 tax increases. It fell to $150,000,000,000 in 1987, and then to $122,000,000,000 in 1989, following the sharp reductions in marginal tax rates embodied in the Tax Reform Act of 1986 (which passed both Houses of Congress by overwhelming majorities). Since passage of the massive $500,000,000,000 reduction package of 1990, the deficit steadily increased by leaps and bounds every year, to an estimated $300,000,000,000 in 1993. No doubt recessions and other special circumstances have contributed to these deficits. Nonetheless, those who argue that the massive tax increases in OBRA93 will reduce future deficits have a hard time proving their case on the basis of historical evidence.

During the postwar period, Federal revenues as a percentage of Gross Domestic Product have fluctuated narrowly within a range of 17-19%. This generalization holds true despite periodic increases and decreases in tax rates, which fell from a top marginal rate of personal income tax of 91 % during the Eisenhower years to 28% after the Tax Reform Act of 1986. Federal revenues as a share of the Gross Domestic Product averaged 17.6% in the 1950s, 18.2% in the 1960s, 18.3% in the 1970s, 19% in the 1980s, and 18.2% during 1990-92. Federal spending, in contrast, shows a pronounced rising trend: 18% of GDP in the 1950s, 19% in the 1960s, 20.5% in the 1970s, 23% in the 1980s, and 23.9% during 1990-92. Spending increases, not tax cuts, are the direct cause of the rising deficit from 0.5% of GDP in the 1950s to 4.3% in the 1980s, peaking at 5.3% during 1990-92. Cutting spending, not increasing tax rates, is the only realistic means of deficit reductions.

Myth #3. Tax increases improve fairness" by making the rich pay more. Between 1981 and 1986, marginal tax rates were reduced across the board. The top rate of 70% was reduced to 28%. How did the rich respond? The share of total Federal income taxes paid by the top one percent (by adjusted gross income) rose from 17.6% in 1981 to 25.6% in 1990. The share paid by the top five percent rose from 35 to 44.1%; by the top 10%, from 48 to 55.8%. The bottom 50% reduced its contribution from 7.5% in 1981 to 5.6% in 1990.

Why did cuts in marginal rates raise the share of the tax burden paid by the well-to-do? The reason is obvious. When tax rates fall, upper income households shift assets out of instruments that generate tax-exempt income, or from schemes that are designed to shelter income, into taxable economic activity. In 1986, for instance, the value of so-called Federal tax expenditures - items that represent revenue lost from deductions, exemptions, credits, and other loop-holes" - amounted to $500,000,000,000. By 1990, tax expenditures had fallen to $400,000,000,000. More than 100,000,000,000 of economic activity was brought into the tax net. Lower rates also curbed tax evasion.

The 1990 budget accord raised the top personal tax rate from 28 to 3 1 %. This marginal tax rate increase was part of Pres. George Bush's $500,000,000,000 deficit reduction package, which his aides negotiated with the leadership of Congress. In mid 1993, the Internal Revenue Service released preliminary statistics of personal income tax receipts for 1991, the first full year after the 1990 act. The rich" - in this case defined as the top 0.5% of the income distribution - paid $106, 1 0,000,000 in income taxes in 1991. After an increase in their top rate from 28 to 31 %, they reduced their total tax payments to 99,600,000,000 in 1991. Everyone else - the remaining 99.5% of taxpayers - increased their payments from $345,300,000,000 to $348,600,000,000. The 1990 budget accord was constructed to ensure that the rich would pay a higher share of the total tax burden beginning in 1991. In fact, they paid less taxes and a lower share.

The prospect of higher rates means a return to tax-exempt bonds and the proliferation of new tax shelters. If recent history is prelude to the future, the rich will pay a still smaller share of total income taxes in 1994 and beyond, until marginal tax rates are reduced.

Reactions to increases

Myth #4. Tax rate increases do not affect economic behavior. This novel proposition holds that higher tax rates do not discourage work, saving, or investment. It is the basis for the "static" revenue gains and losses calculated by various government agencies when determining the revenue impact of proposed changes in tax rates. This flies in the face of the one genuine law in economics - the law of demand - which stipulates that prices and quantities are related inversely. Consumers understand the effect of fluctuations in price. When prices fall, they buy more of an item; when prices rise, they buy less.

Tax rates are the equivalent of price on economic activity. Higher rates reduce the demand to work, save, and invest by reducing after-tax rates of return. Lower rates increase the demand to work, save, and invest by increasing after-tax rates of return. Evidence for the price effect of higher tax rates can be seen by comparing the government's projections of new revenues attached to tax-increase legislation with actual revenues that eventually materialize.

For example, consider the Tax Reform Act of 1986, which raised the maximum capital gains tax rate from 20 to 28%. Capital gains realizations fell sharply, from $350,000,000,000 in 1986 to an annual range of $100-150,000,000,000 during 1987-91. Treasury and Congressional Budget Office (CBO) predictions of capital gains realizations for 1987-91 were far higher, by several hundred billion dollars, than actual reported gains. In January, 1990, for instance, the CBO projected that capital gains in 1991 would total $269,000,000,000, while the actual figure turned out to be $108,000,000,000. As a result, revenues from capital gains fell sharply.

The loss in estimated or anticipated capital gains revenues amounted to about half a percent of GDP. The fall in realized gains was more dramatic among the middle 60% of taxpayers than among the top 20% because those with incomes as low as $22, 1 00 saw their effective capital gains tax rate increase from 14 to 28%, while taxpayers in the top bracket experienced a somewhat smaller fractional rise, from 20 to 28%. Half a percent of GDP lost in anticipated capital gains taxes that failed to materialize amounts to about $30,000,000,000. The reason for the gross overestimate of capital gains realizations is that the CBO did not take into account the fact that taxpayers, facing sharply higher taxes on capital gains, significantly reduced their sales of assets at all income levels.

So why do supporters of higher tax rates cling to a price-free model of human behavior? They point to something known as the target income hypothesis, which posits that people work and invest to attain a target level of after-tax income. Based on this view, higher rates will encourage working harder and saving more. If this proposition were remotely true, it implies that the country should consider returning to the 91 % top marginal tax rate of the 1950s to get the maximum effort and savings from the most productive segment of the population. A hidden implication in this argument is that the government should impose higher rates on poverty-level and lower-middle income households, forcing them to work harder to keep from slipping further into poverty.

In the midst of mythology, Congress has discovered one verity - the price effect of taxes matters. Both Houses of Congress agreed to repeal the 10% luxury tax on boats, jewelry, furs, and airplanes because - through its "price effect" of raising prices - it reduced demand, lowered sales, put people out of work, and lost revenues. How the Congress could overlook this concrete lesson as it crafted the largest tax increase in U.S. history remains a mystery.

Myth #5. America is undertaxed compared to Western Europe. The view that Americans can handle higher tax burdens rests on the statistic that European Community (EC) governments, on average, tax away a substantially higher share of their GDP than do all levels of U.S. governments. The most egregious examples are Sweden and Holland, which, respectively, collected 52 and 48% of their GDP in taxes in 1991, while Belgium and France took more than 40%. Apart from the EC's relative newcomers, Spain and Portugal, Britain enjoyed the lowest tax burden at 36% of GDP. The U.S., in contrast, collected 31% of GDP in tax revenues in 1991. The presumption of the comparison is that American taxpayers have a reservoir of untapped taxable capacity that can and should be brought to bear on deficit reduction or other worthy goals.

What is left out of the comparison are the consequences of sharply higher taxes in Europe. In the EC, average unemployment stands at 10.5% (and is projected to rise to 12% this year), compared with seven percent in the U.S. Higher payroll and social insurance taxes in the EC have resulted in labor costs that are higher than in the U.S. In Sweden, total tax and social security on someone earning about $60,000 in salary a year amounts to more than 75% of that salary. These taxes on labor exceed 60% of wages in Belgium, Italy, and France. The corresponding figure in the U.S. is around 40%. As a result, 3,000,000 new private-sector jobs have been created in the EC since the mid 1970s, compared with 30,000,000 in the U.S. In 1993, projected U.S. economic growth was 2.5% as against negative growth in the EC. Those who propose to remedy the state of "undertaxation" in the U.S. can not point to superior economic performance in the more highly taxed EC countries. A better recommendation is that, if EC governments want more jobs, they should reduce taxes to lower levels that prevail in the U.S.

Energy conservation

and infrastructure

Myth #6. Higher taxes promote conservation energy, a cleaner environment, and reduced dependence on foreign oil. The conference committee accepted the Senate version of an energy tax on gasoline sold at the pump, rather than the House version, which recommended a broad-based tax on most forms of energy. The specific form of energy taxation determines which sources will be conserved and the impact on the environment. Since natural gas and alcohol fuels are relatively clean and since hydroelectric and nuclear power sources emit no gases, it makes environmental sense to limit new energy taxes to gasoline and other fossil fuels. It is important to keep in mind, though, that most of the growth in the use of fossil fuels is taking place in developing countries where U.S. energy taxes will have no impact.

Still, the law of demand applies to energy products. Insofar as higher gasoline taxes increase travel costs for private transportation and for getting raw materials to producers and finished products to markets, they reduce consumption. Since international competition does not permit producers of traded commodities to pass greater transportation costs along in higher prices, the effect of increased U.S. gasoline taxes is to reduce profits of such industries as agriculture and transportation, as well as business activity in general. Higher gasoline taxes mean lower corporate profits taxes (and less deficit reduction).

Higher taxes on gasoline can not be justified on the basis of reduced dependence on foreign oil. A domestic gasoline tax applies equally to domestic sources of energy, thereby discouraging their development.

Myth #7. Higher taxes are needed to pay for infrastructure and other public investments. Much of the country's infrastructure requires repair, restoration, or expansion. However, Federal spending plays a small role in financing it. States and cities typically fund more than 85% of all physical infrastructure. The failure to maintain or develop new infrastructure can not be traced to a shortage of Federal revenues. During the 12 years of the Reagan and Bush Administrations (1981-92), Federal receipts escalated by 82%, from 599,000,000,000 to 1.091 trillion dollars. This amounts to a real increase of 27%, after subtracting 55% inflation.

Higher taxes can finance greater infrastructure spending only if the proceeds are earmarked - linking those revenues to specific expenditures - into specially designated infrastructure accounts such as a highway trust fund. Otherwise, any new revenues just will end up in the Treasury's general fund to be used for any program or purpose, not necessarily for infrastructure. It should be noted that most public finance economists dismissed earmarking as bad policy a century ago because it limits flexibility in spending. In the absence of earmarking, any putative increase in taxes to finance infrastructure is no more likely to rebuild bridges, harbors, and roads than have occurred in past administrations. Rather, most or all of the new revenues are likely to find their way into politically popular social programs.

Myth #8. Higher taxes are needed to spare further cuts in programs for those segments of the population that were hit hard by cuts in spending during the Reagen-Bush years. The areas that contributed most to deficit spending during the Reagan-Bush years consisted of health, Medicare, income security, and Social Security - the entitlement programs. In 198 1, Federal spending on those items was $305,300,000,000, or 45% of total on- and off-budget Federal outlays. In 1992, these four categories consumed 694,200,000,000, or 50.2%. Spending on these social programs grew by 5.2% as a share of Federal outlays.

Although several individual Federal programs in the budget areas of education, training and employment, and other discretionary programs experienced a decline in spending during the 1980s, over-all spending on social initiatives far outpaced the growth in revenues.

Myth #9. Higher taxes will improve the balance of payments and attract foreign investment. The implied argument would be that deficit reduction, by lowering interest rates, will revitalize the U.S. economy. Any student of international trade immediately would point out that higher business taxes will harm U.S. exports. At the very time the Clinton Administration is decrying trade deficits and the need for exports to boost job creation, higher personal, corporate, and energy taxes, by raising costs, will reduce overseas sales of American goods and services. In addition, since higher taxes lower the after-tax return to investment, foreign businesses will be discouraged from expanding their current operations or opening new plants and offices in the U.S., while American firms and U.s.-based foreign companies will face incentives to shift a portion of their current domestic operations offshore.

Myth #10. Higher taxes improve the quality of the article taxed. Higher taxes on alcohol, cigarettes, boats, furs, and other goods and services have not resulted in better products. Indeed, the difficulty in passing higher costs along to consumers is an incentive for producers to cut costs, sometimes to the detriment of quality.

Ten myths do not exhaust the full sales list of the advocates of higher taxes. Some contend that, because many corporate executives endorse higher taxes, we should listen to leaders of the business community. Others say that the effects of higher taxes will be modest and not large enough to cripple the economy. Still others say that higher taxes are the price we must pay for a civilized society. Or some argue that we all will feel better in contributing to solving the government's fiscal crisis.

At least one prominent academic, Herbert Stein, says we must raise taxes just to show that the country can accomplish some big, difficult task (deficit reduction) it has set for itself, almost regardless of its success. He states his support for the budget package, even though he doesn't "see any great gain from doing it." Moreover, he admits that raising taxes cuts private after-tax income and so cuts private demand for goods and services.... The cut in demand reduces employment." Therefore, the tax increases will vitiate the job-creating goal of the 1993 act.

The important point is that not a single one of these arguments stands the test of logic and evidence. They are what they are - myths.

COPYRIGHT 1994 Society for the Advancement of Education
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