Why Lower Tax Rates Will Help Tax Revenue Rebound

There has been a significant amount of hubbub over President Obama’s tax deal with Congressional Republicans. Democrats have argued that passing tax cuts for the rich is irresponsible “at a time when the deficit is at unacceptable levels.” I find it interesting that Democrats are in a position to talk about the deficit considering the stimulus and historic levels of spending. Beyond that, too much emphasis is being paid to how much the tax cuts are going to add to the deficit.

To understand why you must keep in mind that tax rates and tax revenues are two completely different things. In fact, tax revenues show very little correlation to the tax rate. In fact, the top marginal rate (the one we’ve been arguing over so heartily) has fluctuated wildly.

  • In 1913 the top rate was 7 percent
  • In 1919 it jumped more than tenfold to 73 percent
  • In 1929 it fell back 24 percent
  • In 1945 it had skyrocketed back to 94 percent
  • In 1971 it ebbed down to 70 percent
  • In 2005 we got to the current top rate of 35 percent

Given those rates, one would expect revenues to also wildly fluctuate. For instance, they should be much higher in 1945 than they were in 2005. That just isn’t the case. The reason? Something called Hauser’s Law.

As you can see, revenue as a percentage of GDP remains almost constant over time. The short-term fluctuations are statistically significant, ranging from a low of 14.4 percent in 1950 to a high of 20.6 percent in 2000, but over relatively short amounts of time they always trend back to the mean of 18.2 percent.

This tells us that tax rates aren’t that important. Instead, what me must focus on is raising GDP. As White House economic adviser Larry Summers said, “the first priority for addressing the budget deficit has to be getting the economy growing again at a rapid rate.” In that regard, he said, the tax deal “offers the best prospect that was available for achieving the kind of escape velocity that we’ve been seeking for the past two years.”

In other words, don’t get caught up in the Democrats’ arguments that the mere idea keeping tax rates the same for high earners is “an absolute disaster.” Rates, by and large, don’t matter. Revenues matter. And the best way to raise revenue is to increase GDP and what better way to accomplish that than through maintaining low tax rates?

by Brandon Greife, Political Director