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HOW TAX CUTS (AND HIKES) AFFECT THE ECONOMY

A very distinct pattern has been observable throughout American economic history: When tax rates are reduced, the economy's growth rate rises, government tax revenues increase, and living standards improve across all of society. Conversely, periods of higher tax rates are associated with sub-par economic performance and stagnant tax revenues. Veronique de Rugy of the Cato Institute explains:

“Changes in marginal income tax rates cause individuals and businesses to change their behavior. As tax rates rise, taxpayers reduce taxable income by working less, retiring earlier, scaling back plans to start or expand businesses, moving activities to the underground economy, restructuring companies, and spending more time and money on accountants to minimize taxes. Tax rate cuts reduce such distortions and cause the tax base to expand as tax avoidance falls and the economy grows.”

An examination of the four major instances of U.S. tax-rate reductions illustrates the point.

(1) The Tax Cuts of the 1920s

When the federal income tax was enacted in 1913, the top rate was just 7 percent. In 1917 and 1918, tax rates were increased dramatically at all income levels; by the end of World War I, the top rate stood at 77 percent. America's real Gross National Product (GNP) fell by 16 percent between 1919 and 1921.

Then, behind the leadership of Treasury Secretary Andrew Mellon -- who served in both the Warren Harding and Calvin Coolidge administrations -- tax rates were cut sharply under the Revenue Acts of 1921, 1924, and 1926. Mellon explained his rationale:

"The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business and invest it in tax-exempt securities or to find other lawful methods of avoiding the realization of taxable income. The result is that the sources of taxation are drying up; wealth is failing to carry its share of the tax burden; and capital is being diverted into channels which yield neither revenue to the Government nor profit to the people."

As a result of the Mellon tax cuts, federal government revenues derived from personal income taxes rose from $719 million in 1921 to $1.164 billion in 1928, an increase of more than 61 percent. Between 1922 and 1929, America's real GNP grew at an average annual rate of 4.7 percent, and the unemployment rate fell from 6.7 percent to 3.2 percent.

Notably, as tax rates were reduced, the share of the tax burden paid by the rich (those earning $50,000 or more in those days) rose from 44.2 percent in 1921 to 78.4 percent in 1928. Moreover, taxes paid by people earning in excess of $100,000 soared from roughly $300 million to $700 million per year.

(2) The Kennedy Tax Cuts

After Herbert Hoover had dramatically increased tax rates in the early 1930s, and Franklin Roosevelt had pushed marginal tax rates to more than 90 percent, President John F. Kennedy recognized that high taxes were hindering the U.S. economy. To remedy the situation, he proposed across-the-board tax-rate reductions; the top tax rate, for example, was slashed from 91 percent to 70 percent. Said Kennedy:

"Our true choice is not between tax reduction, on the one hand, and the avoidance of large Federal deficits on the other. It is increasingly clear that no matter what party is in power, so long as our national security needs keep rising, an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits.... In short, it is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now."

As a result of Kennedy's tax cuts, the federal government's tax revenues climbed from $94 billion in 1961 to $153 billion in 1968, an increase of 62 percent (33 percent after adjusting for inflation).

Moreover, in a manner similar to what had occurred in the 1920s, the share of the income-tax burden borne by the rich increased following the Kennedy tax cuts. Tax collections from those earning more than $50,000 per year climbed by 57 percent between 1963 and 1966, while tax collections from those earning below $50,000 rose by just 11 percent. Consequently, high earners saw their portion of the income-tax burden climb from 11.6 percent to 15.1 percent.

(3) The Reagan Tax Cuts

After the inflation of the 1970s had pushed millions of Americans into higher tax brackets (even though their inflation-adjusted incomes were not rising), President Ronald Reagan took office and promptly proposed sweeping tax-rate reductions. The cornerstone of his economic policy was a 25-percent across-the-board tax cut, enacted in 1981. According to then-U.S. Representative Jack Kemp (R-NY), one of the chief architects of the Reagan plan:

"At some point, additional taxes so discourage the activity being taxed, such as working or investing, that they yield less revenue rather than more. There are, after all, two rates that yield the same amount of revenue: high tax rates on low production, or low rates on high production." 

As a result of the Reagan tax cuts, total federal government revenues climbed by 99.4 percent during the 1980s. The average annual growth rate of America's real Gross Domestic Product (GDP) from 1983 to 1989 was 3.8 percent per year, compared with 2.8 percent from 1974 to 1981. By the end of the Reagan years, the American economy was almost one-third larger than it had been when they began. From 1981 through 1989, the U.S. economy produced 17 million new jobs, or roughly 2 million new jobs each year.

Also, the share of income taxes paid by the top 10 percent of earners jumped significantly, climbing from 48.0 percent in 1981 to 57.2 percent in 1988. The top 1 percent of earners saw their share of the income tax bill climb even more dramatically, from 17.6 percent in 1981 to 27.5 percent in 1988.

(4) The Bush Tax Cuts

In 2001 the George W. Bush administration passed income-tax cuts that reduced individual tax rates by roughly 7.4 percent on the low end of the income spectrum, and by 9.3 percent on the high end. Two years later, capital gains tax rates were reduced from 20 percent and 10 percent (depending on income) to 15 percent and 5 percent, respectively. Cumulatively, these cuts led to a period of economic prosperity that lasted until the housing crisis of 2008. A few statistics are worthy of notice:

  • America's GDP had grown at an annual rate of just 1.7 percent during the six quarters preceding the 2003 tax cuts; in the six quarters following the tax cuts, the growth rate was 4.1 percent.
  • The S&P 500 had dropped 18 percent during the six quarters before the 2003 tax cuts, but it increased by 32 percent during the six quarters following the cuts.
  • The economy had lost 267,000 jobs during the six quarters before the 2003 tax cuts. During the six quarters after the cuts, it added 307,000 jobs. And during the seven quarters thereafter, another 5 million jobs were created.
  • After the capital gains tax reduction of 2003, capital gains revenues to the government more than doubled, to $103 billion. Previous capital gains tax cuts had shown similar results. By encouraging investment, lower capital gains taxes increase funding for the technologies, businesses, ideas, and projects that make workers and the economy more productive. Such investment is vital for long-term economic growth.

The salutary effect that lower tax rates have on an economy can be seen not only at the federal level, but also at the state level. As of May 2012, seven states had no personal income taxes (PIT) — Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Two states taxed only income on interest and dividends — New Hampshire and Tennessee. From 2000 to 2009, the average state and local revenue growth of these nine states was 81.53%. By contrast, average revenue growth in the nine states with the highest PIT rates — Ohio, Maine, Maryland, Vermont, New Jersey, California, Oregon, Hawaii and New York — was 44.88%.

Similarly, the nine states with no PIT collectively experienced 58.54% growth in their gross state product from 2001 to 2010; the corresponding figure for the nine states with the highest PIT rates was 42.06%.


Adapted from "
The Historical Lessons of Lower Tax Rates," by Daniel Mitchell (August 13, 2003); "Ten Myths about the Bush Tax Cuts, by Brian M. Riedl (January 29, 2007); and "Obama-Loving Media Spin the Economy," by Larry Elder (May 11, 2012).

 

RESOURCES:

Tax Cuts
By Thomas Sowell
2012

The Historical Lessons of Lower Tax Rates
By Daniel Mitchell
August 13, 2003

Calvin Coolidge and the Moral Case for Economy
By Amity Shlaes
February 2013

Is President Obama Really A Socialist? Let's Analyze Obamanomics
By Peter Ferrara
December 20, 2012

Policies Meant To Achieve Equality Are Very Unfair To The Least Equal
By Peter Ferrara
November 29, 2012

Why 70% Tax Rates Won't Work
By Alan Reynolds
June 16, 2011

Debunking Liberal Myths About Tax Cuts and the Economy
By Michael T. Griffith
2009

You Can’t Tax the Rich
By Thomas Sowell
September 15, 2011

Slaves to Words
By Thomas Sowell
May 17, 2011

Understanding Tax Cuts 
By David Kamerschen
2004

Economically Illiterate Obama, re: Corporate Jets
By Edmund Contoski
July 12, 2011

Ignorance, Stupidity or Connivance?
By Walter E. Williams
August 10, 2011

Two-Thirds of Millionaires Left Britain to Avoid 50% Tax Rate
By The Telegraph
November 29, 2012


THE LAFFER CURVE:

The Laffer Curve: Past, Present, and Future
By Arthur Laffer
June 1, 2004

The Laffer Curve, Part I: Understanding the Theory (video)

The Laffer Curve, Part II: Reviewing the Evidence (video)

The Laffer Curve, Part III: Dynamic Scoring (video)


THE MELLON TAX CUTS OF THE 1920S:

1920s Income Tax Cuts Sparked Economic Growth and Raised Federal Revenues
By Veronique de Rugy
March 4, 2003

Brass Oldies
By Thomas Sowell
October 26, 2010


THE KENNEDY TAX CUTS OF THE 1960S:

President Kennedy Appeals to the Congress for a Tax Cut (Transcript of Speech)
April 20, 1961

[John F.] Kennedy v. [Ted] Kennedy
By Jeff Jacoby
March 16, 2001


THE REAGAN TAX CUTS OF THE 1980S:

Supply-Side Tax Cuts and the Truth about the Reagan Economic Record
By William A. Niskanen and Stephen Moore
October 22, 1996

The Reagan Tax Cuts: Lessons for Tax Reform
By Congressional Joint Economic Committee
April 1996


THE REPUBLICAN CONGRESS' TAX CUT OF 1997:

Tax Cuts, Not the Clinton Tax Hike, Produced the 1990s Boom
By J.D. Foster
March 4, 2008


THE BUSH TAX CUTS OF 2001 & 2003:

The Tax Relief Program Worked: Make the Tax Cuts Permanent
By J.D. Foster, Ph.D.
June 18, 2008

A Rising Tide . . . In More Ways than One
By Thomas E. Nugent
July 28, 2006

Ten Myths about the Bush Tax Cuts
By Brian M. Riedl
January 29, 2007


HOW TAX LAWS AFFECT "INCOME INEQUALITY"

The Real Causes of Income Inequality
By Phil Gramm and Steve McMillin
April 6, 2012


PRESIDENT OBAMA'S PROPOSED TAX HIKES OF 2012

Ernst & Young: Obama Tax Hike Will Shrink Economy, Cost 700,000 Jobs
By The Washington Examiner
July 17, 2012

Despite Tax Increase, California State Revenues in Freefall
By Chriss Street
December 8, 2012


CAPITAL GAINS TAXES

Capital Gains Taxes
By Thomas Sowell
October 2, 2012

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