Cutting Taxes – the View from 2001

Back in February of 2001, the President’s economic blueprint , which was subtitled “A Responsible Budget for America’s Priorities” assured us that: “the President’s Budget pays down the debt so aggressively that it runs into an unusual problem—its annual surpluses begin to outstrip the amount of maturing debt starting in 2007. This means that the United States will be effectively unable to retire any more debt than what is assumed in the Administration’s Budget over the next 10 years—the President achieves “maximum possible debt retirement” in his budget.” In fact, the plan was to do more, to “pay off the debt, deliver meaningful tax relief and address needed priorities, while preserving nearly a trillion dollars as protection against uncertainties.” Note – that’s a one trillion dollar rainy day fund we were going to have by 2010.

On this initiative, as with many others, GW has failed to live up to his promises. But this case was a bit different, in that the results were predictable from the start, and predictable using that tool beloved of the tax-cutters, the Laffer curve. Now, the Laffer curve is like the weather – everyone talks about it, but nobody does anything about it. In particular, nobody ever seems to bother to find the high point on the Laffer curve.

Consider tax receipts as a percentage of GDP and the highest marginal personal income tax rate. (Personal taxes are the largest component of income taxes, generally accounting for between about 2/3 and 85% of total income taxes.) The correlation between the two series between 1950 and 2000 (the last year of data available when GW’s blueprint came out) was –0.36. This would indicate that as the highest marginal personal income tax rate rises, taxes collected fall. But… a closer look at the data reveals something else.

The following table shows the average highest individual marginal tax bracket for each sample period. It also shows the correlation between the highest individual marginal tax bracket and the tax collections as a percentage of GDP:

_Sample_____Av High__Correlation
1950 – 2000___64.72___-0.36
1960 – 2000___58.43___-0.26
1970 – 2000___51.36___-0.17
1980 – 2000___42.40____0.11
1990 – 2000___36.98____0.55

Notice… the later data used in the sample, the lower the average of the highest marginal tax rate in the sample, and the higher the correlation between tax rates and tax collections.

This fits nicely with the Laffer curve – when taxes are high, the correlation between tax rates and collections is negative, meaning that to increase collections, tax rates need to be decreased. However, if tax rates are below a certain point, they become positively correlated with tax collections, so to cutting taxes further will only reduce tax collections.

The table above indicates that the US economy was on one side of the Laffer curve when the 1970s were included, and on the other side (i.e., the correlation flipped) when the 1970s were excluded, at which point the average of the highest marginal rate in the sample went from 51.36% to 42.40%. (Not surprisingly, including data through 2005 doesn’t seem to change results much. And to those who insist that somehow Clinton is at fault for everything, re-running this analysis leaving out the Clinton years actually leads to a higher “optimal” highest marginal tax rate.)

Anyone accustomed to using macroeconomic data should have known, back in 2001, that cutting taxes was going to lead to reduced tax revenues as a percentage of GDP, and therefore, a return to deficits rather than the ridiculous story peddled in GW’s Economic Blueprint. Perhaps, just perhaps, GW himself could be forgiven his ignorance – the American public didn’t elect him because he was a smart man, after all, but we were told by his cheerleaders that he had good advisors. The grownups were in charge. And what of these grownups, these cheerleaders and advisors? What of the Bartletts and the Kudlows, the Hubbards and the Mankiws, the O’Neill’s and the Snows? These are people that call themselves economists, and are all quite well paid. (Certainly much better paid than I am.) What were they thinking when they cheerleaded and implemented? What responsibility do they bear for the chain of events they helped put in place?

Postscript – my spreadsheets are available to anyone who wants them.

Update – error corrected – changed sentence that begins with “The table above indicates that”