Does Raising Personal Taxes Increase Federal Revenues?

Does Raising Personal Taxes Increase Federal Revenues?

One of the big arguments every election is should US tax policy raise taxes on the rich to pay for entitlement programs. Some argue that taxes need to be raised to close the deficit gap and pay for our debt. Others argue it is a question of social justice and the rich need to be punished. Leaving aside the political arguments does raising the personal income tax generate more revenue?

When the personal income tax rate was adopted by Woodrow Wilson in 1913 the top rate was 7%

Simply put, not a chance. There are several reasons for this but first look at the evidence gathered.

The 16th amendment allowing a personal income tax was enacted into law in 1913 along with the 17th amendment ending state representation in the senate and well as the passage of the Federal Reserve act allowing a central monopoly bank. A very bad year for personal liberty and freedom comparable to 1862 when private currency was removed from circulation and the federal government printed greenbacks on a massive scale.

Prior to 1913 most federal revenues were collected from tariffs. The industrial class that used imports to produce products complained bitterly that tariffs unfairly hurt their business and there needed to be an alternative source of federal revenue.

Tariffs in the 19th century were typically as high as 60%+ in 1828 and as low as 14% in 1841. The average after the Civil War was typically 40% or more. Persuaded by the industrialist argument and the need to finance an expanded federal government role in the economy that would mimic the progressive models of the European powers of England, France, and most notably Germany the personal income tax was adopted.

It should be noted that just because the income tax has been abused by politicians is not necessarily a “bad” tax or tariffs a “good” tax. In fact tariffs are one of the worst ways a government can raise revenue. Tariffs cost consumers an unbelievable amount of revenue for each job saved. For example in 2002 it cost $1,376,435 to save one Benzenoid chemical job. With a total of just 216 jobs saved it cost American consumers a whopping $297,309,960 in additional cost. In the United States we protect the luggage industry, dairy, lumber, orange juice, ball bearings, machine tools, handbags, and even canned tuna. These tariffs cost consumers millions of dollars each year to essentially to protect special interest groups. Almost all economist on the right and left agree tariffs are very costly to consumers and should be avoided in almost all cases. Fortunately, our current tariff rates are low in a historic context averaging about 4%. Still most economists would like to see that number reduced even further.

Note the name of the 1828 tariff, “Tariff of abominations” which could just as easily been applied to the 1931 Smoot-Hawley tariff that contributed to the United States plunge into the Great Depression

The first top income tax rate was 7%, and it was promised by President Woodrow Wilson (1913-21) and the politicians of the time that this was as high as the rate would go. That lasted three years. In 1916 the top rate was increased to 15% and in 1917 WWI was convenient excuse to raise the rate to 67%, then 73% in 1917. By the time the progressive Woodrow Wilson left office the nation was in a severe recession with unemployment running 9%. GDP had dropped 6.3% from 1919 to 1921, and the nation was looking to return to pre-WWI prosperity.

One of the most underrated presidents in American history Warren G. Harding (1921-23) cut the top rate from 73% to eventually 25% in 1926 posthumously and the “roaring 20’s” were born. Calvin Coolidge (1923-29) continued Harding’s economic policies of cutting taxes and spending resulting in GDP growth rate of 27% from 1921 to 1929.

In 1932 President Herbert Hoover (1929-33) raised the top rate to 63% and Roosevelt (1933-44) followed that in 1936 with an increase to 79%. It should be noted raising taxes was not Hoover’s only monumental economic blunder. He passed the infamous Smoot-Hawley tariff act that raised effective rates to over 60% as well as increased federal spending 57% in his four years.

Federal tax collections from 1947 to present

The Federal Reserve compounded the economic problems by increasing the paper money supply during the days when bank customers’ could exchange paper for real gold. This increase in the paper money supply had the opposite effect on the money supply as bank customers’ lost confidence and rushed to banks to withdraw their money, preferably gold, from the banks. This run on the banks eventually decreased the money supply 27% from 1929 to 1933. The Federal Reserve had the right idea but the wrong prescription. Substituting gold to back up banks instead of worthless paper most likely would have worked 100 times better.

Eventually the income tax rate was increased to 94% during WWII and lowered to 91% in 1950 where it remained until 1964. President Kennedy (1961-63) gave his famous tax cut speech in 1962 and in 1964 the 77% rate cut was enacted posthumously by President Johnson (1963-69). Eventually the rate was reduced to 70% in 1971 where it stayed until probably the most famous tax cutter, Ronald Reagan (1981-89) cut the rate to 50% and eventually 28% in 1988.

George H. W. Bush (1989-93) reneged on his famous “read my lips, no new taxes” promise and raised the rate to 31% in 1990.

Ronald Reagan cut the top income tax rate from 70% to 28% from 1981 to 1988

Bill Clinton (1993-2001) followed that in 1993 with a increase to 39%. It should be noted that Clinton also cut capital gains taxes from 28% to 20% as well as signed the North American Free Trade Agreement cutting tariffs between the US, Canada, and Mexico. Probably his most important contribution to the economic health of the economy was working with a Republican House and Senate to balance the budge from 1997 to 2001. This was combined with what seems like a miniscule government consumption of the Gross Domestic Product (GDP) of 18.2%, compared to 25.1% today, makes Clinton’s economic record very respectable.

Finally the second most famous tax cut by George W. Bush (2001-09), in historical terms seems minor from 39% to 35% in 2003. Capital gains taxes were also cut to 15%. The revenue increase from this tax cut seems astounding, 45.1% from 2003 to 2007, but there are some caveats involved here, to quote economist Dan Mitchell. Federal Reserve Chairman Alan Greenspan lowered the federal funds rate to 1%, the lowest it had been since 1961. Foreign investment was poring into the United States. Congress had passed laws and applied political pressure forcing banks to make risky subprime loans. Fannie Mae and Freddie Mac were buying every loan on the market with no regard to its credit worthiness, and the housing bubble was born. So although some would want to credit the Bush tax cut for the phenomenal increase in tax revenues there were certainly a horde of other factors at work to produce the astonishing number.

Looking back at history we can see the top tax rate has varied from a low of 7% to a high of 94% in 1945. What was the percentage of tax revenues collected during those years’ measures as a percent of the GDP?
Astonishingly there is very little variance once effective IRS tax collection monitoring systems were in place by WWII. From 1945 to present the percent of personal taxes collected measured as a percent of GDP has varied from a low of 5.7% in 1949, when the rate was 82.13%, to a high of 10.2% in 2000, when the rate was 39.60%.

George W. Bush cut taxes from 39.60% to 35%

Looking at the tax collections and looking for a correlation using statistical regression analysis one finds almost no correlation between the tax rate and tax collections as measured as a percent of GDP. The coefficient of determination R2, is an astonishingly low 0.08. An R2 of 1.0 indicates that the regression line perfectly fits the data and 0 means no relationship exists.

This makes sense, who in their right mind would pay 91% of their income they worked for and earned to the tax man? Anyone who remembers the 70s knows of relatives, like my father, who went to extremes to avoid the tax man. People bought investments that also functioned as household items when possible. Old guns, paintings, ceramic porcelain art work, ivory carvings, gold coins, anything that would have the chance of appreciation in value and could be utilized as a store of value away from the tax mans greedy eyes. Economists call this economic distortions or misallocation of resources. Instead of putting money into the bank, stocks, bonds, and other financial instruments that would help the economy and increase the standard of living for all Americans resources were sidetracked to old guns and porcelain figurines of birds.

Ronald Reagan economic adviser Arthur Laffer looked at this phenomena and concluded that the maximum tax collection point is about 30%. This simply means that above 30% there is less revenue feedback from the higher tax rate.

In other words raising taxes from 28% in 1989, to 39% in 1994 can in fact reduce the taxes collected. Tax collections went from 8.3% of the GDP in 1989 to 7.8% in 1994. The tax revenue increased from $1028.4 (billions) to $1356.5, a 31.9% increase. Because of economic growth, inflation, and other variables we could assume with the old 28% tax rate the tax revenues would have been around $1,443.5 or a 40.3% increase. We will never know.

What we do know is people are more willing to report and pay their taxes at rates below 30%. This does not mean that 30% is the Austrian economist choice of optimal tax rate. There is still a lot of damage to the economy with a 30% tax rate and most Austrian economist agree that 25% or less is much preferable tax rate for economic growth.

Tax rates are not the only factor in economic growth. Property rights, rule of law, governments’ share of the GDP, yearly deficits over 3% of the GDP, monetary policy, currency instability, and other factors can affect the economy just as severely and sometimes much more than tax policy. Still the evidence is very clear that there is no evidence that socking it to the “evil” rich will magically pay for all the social programs politicians’ desire. It simply does not hold up to when compared to the historical evidence.

This appeared in the Florida Political Press on 5-23-2011.