Another Heritage Look at Taxes

Reader Peter Pajakowski sent me a link to this post at Heritage by J. D. Foster:

When pressed about the harmful effects on the economy, proponents of higher taxes often fall back on what can be called the “Clinton defense.” President Clinton pushed a major tax increase through Congress in 1993 and, so the story goes, the economy boomed. How then can tax increases be so bad for the economy? The inference is even stronger–that higher taxes actually strengthened the economy. The Clinton defense is superficially plausible, but it fails under closer scrutiny. Economic growth was solid but hardly spectacular in the years immediately following the 1993 tax increase; the real economic boom occurred in the latter half of the decade, after the 1997 tax cut. Low taxes are still a key to a strong economy.

In summary, coming out of a recession into a period when the economy should grow relatively rapidly, President Clinton signed a major tax increase. The average growth rate over his first term was a solid 3.2 percent. In 1997, at a time when the expansion was well along and economic growth should have slowed, Congress passed a modest net tax cut. The economy grew by a full percentage point-per-year faster over his second term than over his first term. The evidence is fairly clear: The tax cuts, especially the reduction in the capital gains tax rate, made a major contribution to a strong economy. Given this observation, it seems likely, though admittedly less certain, that the tax increases in 1993, while not derailing the economy as many had forecast at the time, did indeed slow the recovery compared to what the economy could have achieved.

Obviously, there’s a lot between those two paragraphs, but I think these excerpts make his point: if Clinton hadn’t raised income tax rates, growth would have been much stronger from 1993 to 1997, and if he hadn’t lowered capital gains tax rates in 1997, we might well have run into a recession right about then or shortly thereafter, and who knows, we might even have been invaded by the fish people of Mulgar.

As I’ve noted many, many times before, there are two ways to lower taxes. One is the public way: announce a rate cut and brag about it. The other is quieter, but more effective… up enforcement.

Here’s an example of what I mean. As I recall from my long ago days in transfer pricing, the entirety of the law when it come to transfer pricing issues is two lines a much bigger law. That’s everything that Congress said about the issue in a law that the President went ahead and signed. But there are thousands of pages of regulations on transfer pricing, and associated issues like “advanced pricing agreements.” That, pronouncements by IRS officials, and court cases brought (usually by the IRS) are what PWC and E&Y and the rest of the firms offering tax advice study carefully when determining how far they could push on behalf of clients, because that is the IRS thinking on the matter. Congress doesn’t do nuance – it passes a law, and the Executive Branch has to figure out what it means when it comes to enforcement. And its not just tax issues related to corporate clients that are treated that way – the folks at H&R Bloch and your local accountants have their own set of regulations, pronouncements by IRS officials, and court cases that they look at when figuring out how far things could be pushed with individual income tax payers.

So the important thing, in the end, is not whether the rates go up or down. Cut tax rates and raise enforcement… and taxes paid as a percentage of total income rise. Raise tax rates and lower enforcement… and taxes paid as a percentage of total income fall.

I’ve already noted graphically that the percentage of total income paid in taxesrose during every Democratic administration and fell during every Republican administration since 1952. (The underlying IRS data is here.) Despite the 1964 tax cuts, taxes paid as a percentage of income was up by 1968. (There was a slight dip from 1964 to 1965, but by 1966 that ratio was already higher than in 1964.) Similarly, look at GHW “Read My Lips” Bush – there is no year during his administration during which the percentage of people’s income paid in taxes rose. Not one year in which actual taxes increased, despite the fact that he increased marginal tax rates.

Which brings us to Clinton. Taxes paid as a percentage of income increased every single year of the Clinton administration but one – 1998. That year, they stayed constant. So score one for Foster’s story? Well, sure, if you are able to remember how the big effective hike in 1999 strangled the economy. Or maybe the big hike in 2000?

And what about the converse? It took the full 8 years of the Clinton administration for the ratio of taxes paid to income to go from 8.9% to 11.6%… but by 2003 those rates were down to 8.2% again. Shouldn’t there have been one heck of a boom going on from 2001 to 2003 if Foster’s story has any merit whatsoever? After all, the recession ended in November of 2001, and taxes were going down, down, down. That’s the exact opposite of the early Clinton years, right?

And… then let’s look at the last few years of data… what’s this? The ratio rose in 2004 and 2005? Well, those must have been the worse years during the Bush administration when it comes to economic growth, right? Right?