Critiquing Cato’s Alan Reynolds Views on Tax Rates and Growth
I recently critiqued Larry Kudlow. One thing I didn’t really make much of a note about was his citing Alan Reynolds of Cato. Reynolds has since responded – his letter is posted here. But the post Reynolds wrote covers other ground as well and I was interested in a few things he wrote.
Here’s one thing where I (and it seems to me the facts) would disagree with Reynolds
The economy was in recession almost as often as not in those days – in 1953-54, 1957-58 and 1960. John F. Kennedy, Bower rightly noted, campaigned on slashing [Republican] tax rates to get the economy moving again. When tax rates were finally cut in 1964, it worked (as always).
A recent post (to which I’ve since linked several times) shows the real GDP per capita growth rates and change in the rate of taxes as a percent of personal income for presidents beginning with Ike. JFK’s administration (from 1960 to 1963) produced the second fastest growth rate since the end of WW2. (Truman isn’t shown in that graph, but Truman didn’t exactly produce growth.) Faster than Clinton (#2) or Reagan (very close #3), and some distance behind LBJ. Now, perhaps one can argue that LBJ produced faster growth than JFK because of the cuts in marginal rates in 1964, but then why was growth so fast under JFK? Bear in mind, the top individual marginal rate was 91% at the time.
Another place I’m not sure Reynolds has the facts right is here:
The two parties switched sides recently, with Republicans adopting JFK’s approach by cutting the most destructive tax rates in 1981-86, and Democrats sounding and acting more like Ike since 1993.
The recent post of mine I referenced above has two graphs. One shows economic growth, and but the second one, which is worth a look at this point, shows the share of income that gets paid in taxes. As I keep stating, there are two ways to raise (or lower) taxes. One is to raise (or lower) tax rates. The other is to increase (or decrease) enforcement and how stringently the IRS interprets tax law. Every single one of the Dem administrations in the sample raised the share of people’s income paid in taxes (LBJ included), and every single one of the Rep administrations in the sample (Ike included) reduced it.
Finally, I would note this paragraph by Reynolds as well:
The Eisenhower-Nixon years defined the phrase “fiscal conservative.” If Democrats spent too much, a “fiscal conservative” would regard it as his duty to do the honorable thing and raise tax rates as much and as often as required, if only to protect the military budget.
I would think, and perhaps I’m wrong but I suspect Ike and Nixon were defined as fiscal conservatives because they paid down debt, something no Republican president has done since Ford was in office, and something every Dem president has done since Truman took office.
I also note… does it make sense for one side to criticize the other for spending too much if the other side is paying down debt and producing faster economic growth rates? The only way I can see that being OK is if one either doesn’t know the facts about economic growth and debt, or one doesn’t like the other things that were a part of the platform (and perhaps which helped achieve the results), such as the focus on the little guy.
Also, Nixon may have raised capital gains rates, but he lowered the top marginal rate on individuals. (LBJ left him with a 77% rate in 1969… by 1971 it was down to 70%.) I also note… Ike didn’t touch cap gains rates, but he lowered individual income tax rates. Not much, but he lowered them. When he took office, the bottom marginal rate was 22.2% and the top marginal rate was 92%; a year later these rates were 20% and 91%, respectively.
Frankly, I think the Cato blog is one of the better ones on the right side of the blogosphere, and it will be on our new blogroll when we’ve gotten it up. (Poor Dan has had all the work dumped on him.) As an organization, Cato is often quite willing to accept what the data says, even if it shows that a formerly admired character has stepped off the reservation. Now and then they (Cato) even dust off a few of the more obvious failings by St. Ronald the Reagan. But it seems to me that they aren’t willing to accept that the data simply doesn’t show what they so badly want it show about tax rates and economic growth rates. And its a pity… because there is some truth to what they say about tax rates. But that truth, just like the one adhered to by the far left, seems to be a boundary condition. They could do a lot of good if they noticed what happens, what really happens in the vast middle.
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Update… minor changes for clarity made to the last paragraph.
My e-mail to Kudlow was not meant to disrespect Eisenhower. I wore an “I Like Ike” button in 1956. It’s hard not to like a general who wisely warned voters about the big spending “military-industrial complex.” (As songwriter Don McLean wrote in a different context, “They did not listen, they’re not listening still, perhaps they never will”).
The point of my note was simply to voice my opinion that the pre-Reagan “fiscal conservative” view that tax rates of 77-91% were needed to balance budgets or tame inflation was economically destructive and politically foolhardy.
Several friends tell me I was mistaken to worry that John McCain might likewise hope to shrink the deficits with steeper marginal tax rates on top incomes and/or investments. Time will tell.
Angry Bear finds fault in my suggestion that the economy grew slowly under Ike (2.4% a year), but very fast after tax rates were cut in 1962-64. As proof of my error, he offers a graph showing that per capita GDP growth was unusually slow under Ike and fastest of all from 1964 to 1969. It is inadvisable to use per capita comparison over time, in my view, because that makes all those baby boom children looks like a liability (kids don’t produce GDP). The figure for George Bush looks low, even with the 2001 recession, unless population has been growing twice as fast as Census believes. In any case, his graph nonetheless confirms my point.
Angry Bear thinks I should have mentioned that “JFK’s administration (from 1960 to 1963) produced the second fastest growth rate,” even though tax rates were not cut until1964. There are two problems with that. Growth of real GDP spurted from 2.3% in 1961 to 6.3% in 1962, aided by the 1962 investment tax credit. In the introduction to the 1988 book from MIT Press, “Two Revolutions in Economic Policy” (meaning JFK and Reagan), former Kennedy advisers Robert Solow and James Tobin explained, “as an incentive for business investment in equipment, [the investment tax credit] could enhance both short-term demand and long-run supply. . . Advances in supply determine long-run progress.”
When comparing JFK’s sadly short time in office to regimes that lasted as long as 8 years, we have to take into account cyclical gyrations. JFK took office right after the 1960 recession ended. The first few years of cyclical recovery usually look strong because they start from a low base. Paul Krugman recently made that same point about 4% annual GDP growth from 1983 to 1989, claiming it was just a routine recovery. Unfortunately, that stretches a good point much too far – about 7 years too far. Before Reagan took office, real GDP had peaked in the first quarter of 1980 at $5221.3 billion, measured in 2000 dollars. By the first quarter of 1983, real GDP reached $5253.8 billion, surpassing the previous peak during the Carter years. The recovery phase completed, the economy then entered a long expansion which peaked in the third quarter of 1990, reaching $7130.8 billion.
Angry Bear’s graph comparing growth rates by presidential term cannot be used to make the points he hopes to make. That is because (1) a president’s term in office rarely describe the years in which tax policies were changed, and (2) average annual growth rates are commonly dominated by recessions. Those recessions may have been caused or aggravated by previous monetary, tax or trade policies, or by global events beyond a president’s control.
On the first point, the initial Reagan tax cuts were not phased-in until 1983-84 and the 1986 tax reform was not phased-in until 1988. In a recent New York Times piece, Austan Goolsbee incorrectly assumed the lower tax rates took effect in 1981 and 1986. By depicting all years of the Regan presidency as a single lump, Angry Bear implicitly assumes both tax changes happened on January 1981.
On the second point, Angry Bear’s method blames President Ford rather than Nixon for the recession that followed the inevitable collapse of wage-price controls. Since core inflation exceeded 11% in 1980, should we blame Reagan or Carter for the fact that the Fed felt obliged to lift the fed funds rate from 9% in mid-1980 to 19% a year later? Does it make more sense to blame Bush Sr. or Saddam Hussein for the surge in oil prices when Iraq invaded Kuwait? Does it make more sense to blame his son or global oil demand for the huge spike in oil prices in recent years?
Presidents lucky enough to take office shortly after a recession (JFK in 1961 and Clinton in 1993) are bound to have better averages than those who find themselves stuck with a leftover recession right after taking office — Truman in 1949, Ford in 1975, Reagan in 1981, Bush in 2001.
Inflating-Away the Debt:
I also wrote that “The Eisenhower-Nixon years defined the phrase ‘fiscal conservative.’ If Democrats spent too much, a “fiscal conservative” would regard it as his duty to do the honorable thing and raise tax rates as much and as often as required, if only to protect the military budget.”
Angry Bear answers, “I suspect Ike and Nixon were defined as fiscal conservatives because they paid down debt, something no Republican president has done since Ford was in office, and something every Dem president has done since Truman took office.”
Ike had a budget surplus in only two years, 1956 and 1957. LBJ ran a deficit in every year but his last. Nixon ran a budget deficit every year, even though ending the Vietnam war slashed defense spending. How could Nixon and LBJ pay down debt while running deficits?
Angry Bear links to a graph showing publicly held debt as a share of GDP. The privately-held share of gross debt fell because the publicly-held share rose when the Federal Reserve bought too many Treasury bill in the late 1960s and early 1970s. The Fed monetized a lot of debt. The resulting inflation raised nominal GDP (the denominator of the ratio) and eroded the real value of the national debt. That is, LBJ and Nixon used inflation to steal from people who held low-interest savings bonds. Rather than describing that as responsible fiscal policy, I’d call it irresponsible monetary policy. It was a sneaky form of partial default.
Tax Rates v. Revenues:
Angry Bear questions my remark that “the two parties switched sides recently, with Republicans adopting JFK’s approach by cutting the most destructive tax rates in 1981-86, and Democrats sounding and acting more like Ike since 1993.”
To dispute my indisputable observation, Angry Bear changes the subject from marginal tax rates to average revenues — federal income tax collections as a share of personal income. By comparing this ratio of tax revenues to incomes in the first and last years of each president, he concludes that “every single one of the Dem administrations . . . raised the share of people’s income paid in taxes (LBJ included), and every single one of the Rep administrations in the sample (Ike included) reduced it.”
That should not be hard to figure out. JFK started out with weak receipts as a legacy of the 1960 recession, and his investment tax credit proved to be a boon. LBJ started with a big tax cut and ended with a nasty 10% surtax on even the lowest tax brackets. Ike began with the Korean War boom and ended in recession. Nixon started with recession and ended with bracket gallop – inflation pushing more and more people into higher and higher tax brackets. Bush Sr. raised tax rates in the middle of the 1990 recession, which didn’t help the economy or the Treasury.
Despite raising tax rates on gasoline, Social Security benefits and the top 2%, Bill Clinton’s tax increase brought in just 9.3% of personal income in 1993-95 – down from 9.4% in 1988-90 when the top tax rate was 28%. After the capital gains tax was cut in 1997, however, the Treasury had a huge revenue windfall as investors cashed-out on the tech boom (even prices fell in 2000).
Capital gains accounted for 12% of individual tax receipts from 1997 to 2000, compared with 7.9% in Clinton’s first term (when the capital gains tax was still 28%).
Angry Bear ignores all these ups and downs in tax rates and the business cycle, and offers an amazing alternative explanation: He imagines IRS enforcement is always much tougher when there’s a Democrat in the White House. What is even more amazing is that he failed to notice how remarkably unchanged the ratio of federal income tax to personal income has been.
Reynolds’ Law:
I have long made use of the same IRS data Angry Bear uses to make a quite different point, which I dubbed (with typical modesty) “Reynolds’ Law” in The Washington Times, April 9, 1996.
This is a Reynolds Law: “The individual income tax will bring in about 10% of personal income, give or take one percentage point, regardless whether the top tax rate is 91% or 28% and regardless whether loopholes are opened or closed.”
Revenues briefly exceeded 11% of personal income only three times, always followed by recession – the surtax of 1969, bracket creep of 1981, and the tech bubble of 1999-2000.
In Eisenhower’s last year in office, 1960, the lowest income tax rate was 20% and the highest rate was 91%. Yet the individual income tax brought in only 9.6% of personal income.
Tax rates were dramatically reduced in 1964, and by 1967 income tax collections reached 9.7% of personal income.
Tax rates were cut by 30% across-the-board in 1983-84, when the income tax amounted to 9.2% of personal income.
After the 1986 tax reform, the top tax rate dropped from 50% to 28% by 1988, when the income tax amounted to 9.7% of personal income.
The top tax rate was raised to 32% in 1991, and raised further by phasing-out deductions and exemptions at higher incomes. Revenues fell sharply to 8.9% of GDP in 1991-92.
President Clinton added to new tax rates at the top, bringing the top rate to 39.6% (much lower than the 50% rate of Reagan’s first six years). Revenues were nonetheless just 9% of personal income in 1993 and did not pass the 1988 level until 1996.
In 1997 the capital gains tax was cut from 28% to 20% and the Internet began. That combination sparked a huge boom in tech and telecom stocks, which generated an equally huge boom in capital gains tax receipts, as well as tax windfalls from exercised stock options of the sort taxed as ordinary income.
If capital gains are excluded (a spreadsheet I’m working on), Reynolds Law shows even more stability in the ratio of income tax collections to personal income, regardless of changes in the higher tax rates.
Reynolds Law suggests a high elasticity of reported taxable income with respect to tax rates above 28% on salaries or 20% on capital gains. When it comes to long-term revenues, raising tax rates much above those rates appears subject to rapidly diminishing returns.
Cyclically-adjusted revenues from the individual income tax have been a nearly-constant percentage of personal income since 1951, despite massive changes in tax rates and deductions. If any government wants revenues from this tax to rise in real terms, that can only happen with growth of the economy and therefore growth of the tax base (personal income less transfers).