Sunday, April 26, 2009

Tax Rates & Tax Revenues

In hindsight, I think I should have elaborated more on the point of the supply-side tax theory in the previous post. But now that I didn't, I think it is worth writing a separate post on it.

As I wrote then, while Austrians and supply-siders do agree that marginal tax rate reductions will increase productive activities, Austrians are usually skeptical of the exaggerated claims of supply-siders that even at more moderate tax rates, further reductions will increase tax revenues. See for example Murray Rothbard's analysis of this in his essay "A Walk on The Supply Side" (he also analyses the supply-side view on monetary policy there).

Just what the exact effect of tax rate reductions on tax revenues will be is largely an empirical issue. Pure economic theory will not tell us what effect a reduction in the marginal rate of taxation from say, 39.6% to 35% will have on tax revenues.

However, we can use economic theory to conclude one important conclusion, namely: that the lower the rate of taxation, the less likely is it that further tax rate reductions will really increase revenues.

The reason is actually mathematical (so much for Salsman's nonsense of "disdaining math"): Namely that the lower the rate of taxation, the higher will the necessary increase in the tax base be in order to keep tax revenues constant, while a lower rate of taxation will mean that any further reductions will mean a smaller increase in the incentive to increase the tax base. The amount of the tax base being here so to speak a positive function of productive activities and a negative function of tax avoidance activities.

Take for example, the Kennedy tax cuts, which lowered the top rate of taxation from 91% to 70%. In order for tax revenues to stay constant, the necessary increase in the tax base is 30% ((91-70)/70). The increase in the tax base incentive is however all the greater, being a full 233% ((100-70)/(100-91)). With the increase in incentives being more than 7 times as large as the necessary increase in the tax base, it would seem likely that this tax cut would result in higher tax revenues.

Contrast this with the effects of the Reagan tax cuts. During Reagan, the top rate of taxation fell from 70% to 28%. That might seem like an even more dramatic tax cut than the Kennedy tax cuts, and indeed it was in terms of how big the necessary increase in the tax base was in order for tax revenues to stay unchanged. The required increase in the Kennedy tax cuts was again only 23.1%, while for the Reagan tax cuts it was a full 150% ((70-28)/28). However, the increase in the tax base incentive was actually lower, "only" 140% ((100-28)/(100-70)). The increase in incentives was here slightly less than the required increase in the tax base.

After Reagan, the top rate was increased under the Bush Sr. and Clinton administrations from 28% to 39.6%. Under Bush Jr., the rate was lowered to 35%. Here the necessary increase in the tax base was 13.1% ((39.6-35)/35). The increase in the tax base incentives was however even smaller ((100-35)/(100-39.6) or just 7.7%, more than 40% lower.

In short, the theoretical principle here is that the lower the initial rate of taxation the less likely is it that further tax rate reductions will increase revenues.

It could be objected that increased productive activities won't just increase the revenues of the tax being lowered, but also other taxes. For example, if a lower corporate income tax increases investments, it won't just increase corporate income tax revenues but also individual income tax and payroll tax revenues. But while that will create a downward bias in estimates of how much tax revenues higher productive activities will create, the higher interest rates created by tax rate reductions unmatched by tax cuts will create the opposite effect.

And at any rate, it will not really affect the principle that the lower the initial rate of taxation the less likely is it that it will increase revenues. It will only affect the estimate of where exactly the revenue maximizing rate of taxation is.

1 Comments:

Blogger Henry said...

The connection between tax rate and total collected depends on the entity taxed. Taxes which fall directly on the rental value of land cannot be avoided and there is no loss in tax revenue at higher rates provided these do not go above 100% of rental value in which case land will of course be abandoned.

11:52 PM  

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