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Ideology, Not Economics, May Be At Core of Tax Policy

Monday, 27 Sep 2010 | 10:53 AM ET

Tax cuts are good and tax hikes are bad for the economy. Or is it tax cuts are bad and tax hikes are good?

Taxes
Lars Klove | The Image Bank | Getty Images
Taxes

One of Washington’s most enduring policy dialectics is alive and well as Democrats and Republicans court midterm-electionvotersin the face of mystifyingly weak job marketand threatening budget deficit.

Yet, for all of the political noise about the Reagan or Bush tax cuts, or the Clinton or Obama tax hikes, it may be hard to make a convincing case for either approach..

“I really don’t think you can,” says Dean Baker, co-director of the Center for Economic And Policy Analysis. “It’s really marginal.”

Baker’s analysis is rare for its candor and neutrality about a policy debate where cause and effect is usually one-sided and often over-simplified. Most participants can't recommend one school of thought without castigating the other.

Your Money Your Vote - A CNBC Special Report
Your Money Your Vote - A CNBC Special Report

The conventional wisdom of tax-cut proponents, best known as supply-siders, is that they free up capital, sparking both spending and investment, which leads to higher economic growth and job creation, thus raising government tax receipts. Tax hikes, however, have the opposite effect.

Meanwhile, members of the tax-hike school say they allow the government to redistribute income, which spurs spending, and raises tax receipts, a plus for the budget balance and lower interest rates. Tax cuts, however, are more often giveaways to the wealthy and/.or corporations—failing to trickle down or through the overall economy--and only aggravate the budget deficit by lowering tax revenue.

Yet for all of the intricacy of the arguments, the results are hardly crystal clear, based on GDP, payroll, budget and tax receipt data over the past 35 years.

Taxing Matters: Economic-Fiscal Snapshot

President GDP Payrolls Tax Receipts Budget Deficit
Carter 3.2% 2.0 million 20.8% -2.4%
Reagan 3.4% 1.8 million 18.2% -4.2%
Clinton 3.9% 2.3 million 19.2% -1.2% **
Bush 1.8% * 17.9% -2.0% **
*Net job creation was 133,000. **Clinton had surpluses in 1998-2000; Bush in 2001.Figures are annual average of presidency; tax receipts, budget deficit as % of GDP.

What’s more, overlooked in the debate is that the composition, size, duration and timing of such tax initiatives is also a important determining factor in their effectiveness.

"[Tax cuts] have to be big and well directed," says Christian Weller, a pubic policy specialist at the University of Massachusetts and Center for American Progress.

In some cases even the biggest and best plans get lost in the economic shuffle.

“There's other macro factors skewing the numbers,” adds Weller. "War, inflation, oil prices.”

Take oil prices, for example. The Carter, Reagan and Bush I presidencies were all marked by oil shocks. Prices were relentlessly high for much of Bush II's secondterm and historically low during the majority of the of the Clinton administration. The high/low between the two periods was roughly $149 vs. $11 a barrel.

Reagan

More than anything, the policy debate has been shaped by the tax reform efforts of President Ronald Reagan in the 1980s, the first income-tax cuts since the Kennedy administration, when the top tax rate went from 90 percent to 70 percent.

Together, two separate acts (1981 and 1986) reduced 15 income-tax brackets into four, with the top one going from 70 percent to 28 percent, and the lowest one from 11 percent to 15 percent. The reform package also closed loopholes deductions and shelters, as well as expanded the alternative minimum tax.

At the same time, the Reagan administration funded a massive military buildup, which exceeded 6 percent of GDP in several years.

During the two-term Reagan presidency and one term of President George H.W Bush that followed, GDP growth averaged 3.40 percent, with only one-year having an out-sized gain (7.2 percent in 1984). Job growth averaged 1.8 million a year. By comparison, the numbers for the preceding Carter administration were 3.25 percent and 2.0 million.

Tax receipts averaged 20.82 percent of GDP under Carter, vs. 18.19 percent with Reagan. The budget deficit as a percentage of GDP averaged 2.42 percent under Carter and 4.22 percent under Reagan.

“These tax cuts are not as pure as we want to think,” says Weller. “In the Reagan years...you lowered rates and closed loopholes...so the effective tax rate doesn't change that much.”

Reagan also wound up taking back pieces of the 1981 income-tax cuts to address the budget deficit and later raised corporate taxes and closed loopholes, as well as those on gasoline.

Clinton

Former U.S. President Bill Clinton seen speaking during the inaugural Rural Summit in Washington, DC
Getty Images
Former U.S. President Bill Clinton seen speaking during the inaugural Rural Summit in Washington, DC

Comparisons with the Clinton administration are also interesting, because the Democratic president and his like-minded Congress pushed through a tax-increase package in 1993.

The top income bracket was raised to 36 percent with a 10 percent surcharge for the top earners, creating am effective tax rate of 39.6 percent. The corporate tax rate was upped to 35 percent.

There were also tax increases on Social Security benefits and gasoline, as well as a repeal of the cap on ordinary income subject to the Medicare payroll tax. Taxes were cut, however, for some 15 million low-income earners.

The plan also included spending restraints and mandated the budget be balanced over a number of years.

In 1997, the Republican-controlled Congress pushed through a tax-relief and deficit-reduction bill that included a cut in the capital gains tax from 28 percent to 20 percent and a near doubling of the estate tax exemption. The package, however, did raise cigarette taxes and expanded or created tax credits.

GDP growth averaged 3.37 percent during Clinton's first time term and 4.45 percent in his second. Job growth averaged 2.3 million over the full presidency and tax receipts 19.16 percent. The deficit-to-GDP ratio averaged 2.6 in the first term and turned into a 1.1-percent surplus in the second.

Bush

President George W. Bush

The eight-year Bush presidency that followed posted average GDP growth of 1.76 percent and never once broke 4 percent in any given year. Just 133,000 jobs were created over the period

Tax receipts averaged 17.89 percent of GDP, but fell from 19.8 percent in 2001 to 17.9 percent in 2002, after the first of two tax-cut packages. The budget balance went from a 1.3-percent surplus in 2001 to a deficit in 2001 and averaged 1.97 percent over the presidency.

The combined Bush tax cuts of 2001 and 2003 were broader in scope but smaller in size when it came to income-bracket reductions. They were considered long-term, however, stretching out to 2010, which is a key in changing behavior. The top rate was reduced to 33 percent and the surcharge rate from 39.6 to 35 percent. The marriage penalty was largely eliminated and taxes on capital gains and dividends slashed.

The Bush presidency was also marked by increased spending on defense and homeland security in the aftermath of 9/11, as well as the $400 billion Medicare Prescription Drug Modernization Act, known as Medicare Part B, the biggest entitlement initiative in decades.

"We couldn't afford those tax cuts back when they were implemented by Bush. We can't afford them now," said David Stockman, Reagan's former budget director, referring to the nation's debt problem.

Even former Fed Chairman Alan Greenspan, who ardently backed the Bush tax cuts a decade ago, said extending them was unrealistic and unaffordable in the current budget environment.

Nevertheless, both Democrats and Republicans are pushing for expensive tax cuts at a time of extraordinary government spending and record-high budget deficits on the assumption that it will help an economy suffering from weak demand, which is holding back job creation.

The Democratic plan to cut taxes on all taxpayers except those in the two-top brackets would cost the government $2.9 trillion in lost tax revenue over a decade; the Republican plan--which applies cuts to all taxpayers—would mean another $700 billion in lost tax revenue.

“Whichever camp your are in—cutting taxes or raising rates—spending reductions are a necessary thing. While my side says tax reductions will produce robust growth we cant turn a blind eye to the expenditure side." says Pete Sepp. executive VP of the National Taxpayers Union. "It's been proven time and time again under Democrats and Republicans."