Lawmakers debating tax reform, the FY 2018 budget resolution, and the Democrats’ new “Better Way” agenda often operate within fundamentally opposite frameworks on tax policy. Clearing up misinformation is a necessary first step to reform, beginning with the following six common beliefs that are demonstrably false:
Myth #1: Long-term deficits are driven by tax cuts and falling revenues
Fact: They are driven entirely by rapid spending growth
Revenues are projected to rise from 17.8 to 18.4 percent of GDP over the next decade – well above the 17.4 percent average of the past 50 years. This means lawmakers could cut taxes by $1.7 trillion over the decade and still leave revenues at historically-average levels. Long-term deficits are entirely driven by projected spending, soaring from 20 percent to nearly 30 percent of GDP over the next few decades
Myth #2: Democratic tax proposals would significantly reduce the deficit
Fact: Their most common proposals would raise little revenue
Despite insisting that “fair share” tax policies negate the need for major entitlement reforms or spending caps, elected Democrats have not rallied around any tax blueprint that would even cut the deficit in half. Their revenue claims are a bluff.
President Obama’s last budget proposal was not modest. Freed from having to face voters again, it contained large tax increases far beyond those proposed in his first term, and beyond even what congressional Democrats would endorse. Yet those taxes still would have closed less than one-quarter of the budget deficit by 2026.
Congressional Democrats’ seven most common tax proposals – raising investment taxes, repealing tax breaks for oil and gas, taxing carried interest as ordinary income, imposing a Wall Street fee, imposing the “Buffet tax,” repealing the depreciation schedule for corporate jets, and taxing the business costs of moving overseas – would together close just 3 percent of the $9.4 trillion ten-year deficit. If they caused annual economic growth rates to fall from 2.1 percent to 2.0 percent, those tax increases would actually lose revenue.
Myth #3: Taxing millionaires and corporations can balance the long-term budget
Fact: These taxes cannot cover Washington’s current commitments, much less new liberal wish lists
It is mathematically impossible to balance the budget solely on the backs of upper-income earners. Seizing all income earned above the $1 million threshold would fund the federal government for less than two months per year. Setting the threshold at $500,000 merely adds a third month. The 39.2 percent corporate tax rate and 23.8 percent capital gains tax rates (both among the highest in the world) are already considered near the revenue-maximizing level. The only sustainable way to spend like Europeans is to tax like them – with a 15 to 28 percent value-added tax (similar to a national sales tax) aimed right at the middle class. Democrats have wisely avoided such a painful and unpopular proposal.
Myth #4: The U.S. income tax is more regressive than other nations
Fact: It is the most progressive in the entire OECD
In 2008, the OECD reported that the U.S. had the most progressive income tax code of all its 24 nations, even adjusting for relative income inequality. The 2013 upper-income tax increases made our tax code even more progressive.
While many other countries tax the rich more than does the United States, they also tax the middle class substantially more, resulting in a flatter tax code. Furthermore, this analysis does not account for the painful, regressive value-added taxes imposed by all other OECD countries.
Myth #5: The U.S. tax code is becoming more regressive over time
Fact: It has become increasingly progressive over the past 35 years
The top 20 percent of earners pay 88 percent of all income taxes – up from 81 percent in 2000. When including all federal taxes, the top quintile’s share has increased from 66 percent to 69 percent over that period. This increased tax progressivity occurred during a period in which the top quintile’s share of pre-tax income slightly dipped to 53 percent.
Meanwhile, the top 1 percent earns 15 percent of pre-tax income and pays 38 percent of all federal income taxes – significantly higher than in the past.
The bottom 40 percent of earners collectively pay no income tax, and less than 5 percent of all federal taxes.
This leads to the question of how progressive is enough? Should the top quintile be forced to shoulder 95 percent of the income tax burden? 100 percent?
Myth #6: Tax rates do not matter much to economic growth
Fact: They are among the most important factors
Nobel Laureate Ed Prescott has shown that much of America’s widening economic advantage over other major economies between the 1970s and 1990s can be traced to America’s decision to lower tax rates while other countries raised them. Harvard economist Martin Feldstein estimates that a $1 increase in taxes costs the economy 76 cents of growth. Even liberal University of California-Berkeley economist Christina Romer – formerly President Obama’s Council of Economic Advisers chair – calculated that, in most circumstances, a “tax increase of 1 percent of GDP reduces output over the next three years by nearly three percent.”
Between the 1950s and the 1970s the economy grew despite a top marginal tax rate between 70 percent and 91 percent (which barely anyone paid). That growth was driven by historic labor force growth, the maturation of earlier technological innovation, and America’s status as the lone Western economic superpower while Europe and Japan rebuilt after the war. Since 1950 there has been a consistent, negative correlation (-0.19) between the top marginal income tax rate and income tax revenues. What matters more is the income tax brackets for all taxpayers, the amount of available deductions, and economic growth.
The broad lesson is that lawmakers should not assume they can tax their way out of escalating budget deficits. The commonly-proposed tax increases would raise little revenue and could significantly harm the economy.
Brian Riedl is a senior fellow at the Manhattan Institute.