We believe that our government’s current trajectory presents one of the greatest threats to global economic stability today. In the Federal Reserve Bank of St. Louis’ Review from July/August 2006, Lawrence Kotlikoff stated that “partial-equilibrium analysis strongly suggests that the U.S. government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context,are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.”
This incredible statement was made in 2006, long before the worst of the credit crisis and subsequent surge of federal bailouts!! Three years later, our current administration has promised us deficits north of $1 trillion per year for at least ten years. And that doesn’t take into consideration when the really heavy lifting of Social Security and Medicare comes into play.
The above picture is a consequence of a series of poor choices made in the past. As John Mauldin reminds us, our future will be a consequence of the choices we make today. Unfortunately for us, there are no longer any good choices, only bad ones. We have created a situation that is going to cause a lot of pain; and our choices now boil down to simply timing and duration (not unlike ripping off a band-aid). To date, we have chosen the “quick fix”. The short term focus of our current administration has pushed for an immediate “return on investment” even if that “investment” is not sustainable. We wonder if one-off tax rebates and Cash for Clunkers will stimulate greater ongoing domestic demand than the potential benefits to disposable personal income created by a permanent reduction in income taxes?
Unfortunately, we are afraid that the short term focus of our political system has only compounded long term problems. And now that many of our leaders are considering how to address the multitude of issues that they have indeed created, we thought it might be an appropriate time to share the excerpts below from Niels C. Jensen’s Absolute Return Letter.
Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve3. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.
Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.
It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).
So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented), US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.
Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling. It is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?
Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite.