To Tax Or Not To Tax (Jan 19, ’08) – Notes

Liberals decry lower taxes citing politics of envy while these self-same tax cuts are most beneficial to those with limited incomes – namely, middle and working class families. This message will attempt to put modern debate in an historical context by citing the ancient Roman regime (in Cicero’s day) juxtaposed with both right and left-leaning columnists’ views toward tax debate.

Click here for a brief video synopsis of the candidates’ positions on taxes and a brief tutorial of the cost of capital.


I. [An Author Recounts] Cicero On Governorship of a Province of Rome Near the Twilight of Empire

Cicero had found widespread anxiety about the future among all he met. No chief political players had shown their hands. Cicero’s own view remained much as it had always been; he preached moderation, compromise and reconciliation.

[The former governor’s] policy had simply been to enrich himself. Cicero was shocked when he saw the consequences. Writing while on the road, he described a ‘forlorn and, without exaggeration, permanently ruined province.’ Local communities had been forced to sell prospective tax revenues to tax farmers in order to meet [the former governor’s] rapacity for cash. ‘In a phrase, these people are absolutely tired of their lives.’

– Cicero: The Life and Times of Rome’s Greatest Politician, by Anthony Everitt


II. a) Corporate Tax Bills Are Footed By the General Public

Corporations cannot possibly pay the corporate income tax because they are not human beings. Instead, that tax always is fully passed to one or all of three groups of human beings: to customers through higher prices, to shareholders through lower returns on capital, or to employees through lower take-home pay. Under fierce global competition, the potential of shifting corporate taxes to customers often is limited. Similarly, in a global capital market, the corporate tax cannot easily be shifted to capital owners who have the option of taking their capital elsewhere. Economists therefore suspect that the bulk of the corporate income tax is shifted back to the least global mobile target, the employees.

Appearances to the contrary, cuts in the individual income tax help corporate executives more than cuts in the corporate tax because income tax reductions accrue to themselves, whereas corporate tax cuts accrue to other people (e.g., employees and investors – which may or may not be one in the same).

– notes paraphrased from: Uwe Reinhardt, Political Economy Professor, Princeton University

II. b) Cost of Capital –

The Bush tax program, particularly the 2003 Tax Act, boosted productivity by encouraging the investment to make a larger capital stock possible. That investment is what finally kicked the recovery into a higher gear.

For a capital asset to be worth creating and employing, it must be projected to earn enough to recover its cost before it becomes unproductive (depreciation), pay taxes imposed on its revenues, and leave about a 3% risk-adjusted real (after inflation) rate of return to its owners. That combined [net] rate of return is the the service price of capital, or the4 hurdle rate. The lower the service price, the higher the sustainable capital stock, the average wage and the level of GDP. The 2003 Bush ;tax cut knocked the service price down by nearly 10%.

How? The 15% cap of tax rates on dividends and capital gains was a very large reduction in the double taxation of corporate income. It was equivalent to a big cut int the corporate tax rate and the biggest boost to investment of the Bush tax packages. Lowering the marginal income tax rates in the top four tax brackets cut the service price for noncorporate businesses and rewarded work and risk-taking.

Nevertheless, the investment surge from the Bush tax cuts will taper off as the added capital made possible by the lower service price is finally acquired, by about 2008-2013. Historically, it has taken about five years for the quantity of equipment to adapt to major tax changes, and about 10 years for structures. Growth should then revert to a more normal pace, but from a higher base.

Keeping growth near the 3.2% rate of the last three years would require more reductions in the service price of capital. We need more than an extension of the Bush tax cuts: deeper cuts in the tax rate on dividends and capital gains, cutting the corporate tax rate and marginal tax rates on noncorporate businesses, and letting businesses write of their investment spending faster.

If, instead, the Bush tax cuts expire as scheduled at the end of 2010, much of the newly acquired capital made possible by the tax cuts would no longer be sustainable. We would see businesses disinvest – investment would slump to allow the capital stock to shrink back to the old-law levels through attrition. That would flirt with recession.

Killing the 15% tax rate caps on capital gains and dividends, the marginal rate cuts, the bracket widening for joint returns (marriage penalty relief), and the partial estate tax relief currently in place, would jump the service price of capital by more than 10% (to 22.5% from about 20.3% currently), according to the Heritage [Foundation] service price calculator.

A 10% jump in the service price is a big deal. A lot of capital would be unable to earn enough to pay the higgher tax; I estimate that the stock of buisiness plant, equipment, and inventories would ultimately be about 16% less compared to what it would be under current tax rates. Hours worked would fall 2%. Private-sector output and wage and capital income would drop 7%. That would mean an eventual 5%-6% reduction in GDP.

The present Congress thinks it can raise $200 billion a year (at 2006 income levels) by letting the growth provisions of the present tax system die, but with no damage to GDP. Wishful thinking.

The tax calculator shows that a 7% reduction in private-sector income would depress federal individual income-tax revenues by $140 billion (more than a 7% drop because lower incomes drop people into lower tax rate brackets). That’s not all.

I estimate that payroll taxes, federal corporate income taxes, customs and excise taxes, and the estate tax would drop $85 billion. Result: a net loss of $25 billion. State and local governments also would take a revenue hit, and likely raise taxes, further depressing GDP. Worse, this would all cost workers and savers roughly $700 billion to $800 billion in lost output and income.

Those would be the permanent effects. The transition is even dicier. Reverting to a lower capital stock would mean slashing business fixed assets and inventories by $2.5 trillion over 10 years. It would require cutting investment spending by 18%, or 1.9% of GDP (more in the first five years, less later). The investment slump would reduce a 2.5% annual expansion to a crawl. If disinvestment spread to the homebuilding sector, it could mean recession.

Alarmist? Consider precedent. Lyndon Johnson pushed a 10% war surtax on income through Congress in April 1968. It was the primary trigger for the 1969-1970 recession. Congress rushed to end it early in 1970. Investment spending crashed by 7%, and rebounded after the surtax was history. That surcharge had a fraction of the impact on the service price of capital that would occur if the Bush tax cuts expire.

Consider Japan as well. In 1988-1990, the Miyazawa tax program aped and outdid the worst anti-capital elements of the U.S. Tax Reform Act of 1986. Japan instituted a capital-gains tax where there had beeen none, and ended near universal tax-favored saving incentives for everyone below retirement age. It raised land taxes twice. These hits to capital crashed stock and land prices, made banks insolvent, and crushed investment. It took Japan 15 years to recover.

If Congress goes down this road, expect a similar outcome. When Congressmen do not study history, the rest of us are condemned to repeat it.

We should rather be thinking of more rate cuts. Growth will slow even if the Bush cuts are simply extended, but we would keep the increase in the base level of GDP they made possible. Letting the cuts expire would undo a fair bit of the capital formation since 2003, forestall gainst yet to come, and shunt GDP to a lower baseline. Hiking other taxes would only make matters worse.

– Stephen Entin is President and Executive Director of the Institute for Research on the Economics of Taxation


III. McCain Lies His Head Off; NY Times Asleep at Switch

One of the most common-supply-side talking points is that tax cuts always lead to higher tax revenues. It’s not really true (revenues crashed after the 2001 Bush tax cuts) but even if it were, it’s misleading: Tax revenues tend to rise over time as a natural result of inflation, rising population, and economic growth. Taken at its face value, the supply-side logic would imply that tax hikes always cause revenue to fall, which is ridiculous on its face, and which explains why supply-siders never mention this silly corrollary to their claim.

Until now! John McCain is a recent convert to supply-side economics and still working on getting the talking points down. Speaking yesterday in South Carolina , the straight talker:

proclaimed himself a believer in the notion that cutting taxes increases revenue for the government by spurring economic growth. “Don’t listen to this siren song about cutting taxes,” Mr. McCain told supporters gathered here under a tent in a driving rain. “Every time in history we have raised taxes it has cut revenues.”

What? Every time? Okay, how about we go back and look at the last time taxes were raised — 1993. It’s true that conservatives predicted revenue would fall as a result of the tax hike. (Typical quote: “Higher taxes will shrink the tax base and reduce tax revenues” — Newt Gingrich.) But it didn’t exactly work out that way:

The amazing thing is that New York Times, which printed McCain’s quote, made no effort whatsoever to ascertain the truth of his point. Just the typical, “McCain says earth is flat, and meanwhile in other news…” stuff. I realize that campaign reporting is hard, and reporters don’t usually have time to check on the truth of candidate’s statements. (And yes, this is a huge flaw with reporting, but that’s another story.) But this claim is so obviously false it could have been refuted after maybe thirty seconds of research. Didn’t the author (Michael Cooper) realize that tax hikes don’t always, or even usually, lead to reduced revenue? Does he remember the 1990s? Is he aware that the federal government raised taxes and started collecting dramatically higher revenues during World War II? (Taxes were raised and revenues quintipled.)

The expecially annoying thing is that when Mitt Romney promised he could rebuild Detroit’s auto industry, the media hammered him as a liar — and it wasn’t even a lie, just a matter of opinion, albeit a highly optimistic promise. Meanwhile, McCain disagreed and was treated to another worshipful round of press coverage. (The Washington Post credited him with telling “hard truths,” which, again, takes McCain’s side on an issue that’s a question of opinion rather than fact.)

As my book explains, political coverage almost never bothers to check on the truth of candidate’s claims about public policy. So, okay. But can they at least stop praising McCain as a brave truth-teller when he’s totally reversed his position on the Bush tax cuts and now defends them with obvious lies?

–Jonathan Chait

IV. Conclusion:

The analysis by the big government, tax-and-spend left ignores the cumulative effects of stimuli in the form of lower taxes, which reduce costs of capital and spur investment, leading to a virtuous cycle of increased: jobs, income, consumption, and investment. Welfare statists impute that simply increasing taxes leads to overall general welfare in that more income for the government can create jobs via bureaucracy etc. However, bureaucracy is not business and business requires truck, barter and trade – all individual activities performed by human beings who need incentive to get off their [fill-in-the-blanks] and work.

In short, a policy (and propaganda supporting it) which simply increases the tax rate and acts like a cache pulling in a greater percentage of wealth forthcoming (spurred by previously pro-business tax cuts) is an intellectually dishonest productivity freeride and a stalking horse for bureaucratic extortion.

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