What is the Right Answer on Taxes?

By John L. Chapman, Ph.D.                                                                                                                                             Washington, D.C.                                                                                                                                                                      November 23, 2011

With a U.S. Presidential election less than a year away, and a still moribund economy struggling to climb out of a long period of sluggish growth, high joblessness, and a burgeoning fiscal debt burden, the issue of tax policy will be front and center in 2012.  With the sole exception of Mitt Romney, all the Republican candidates have outlined dramatic changes they would wish to pursue, to either the tax code itself, or to the rate structure and allowances.  And sooner or later Mr. Romney himself will follow suit; his main advisor, Columbia Business School’s Dean and putative Treasury Secretary Glenn Hubbard, is an ardent proponent of pro-growth tax reform based on flatter and lower rates, a broader tax base, and protection for savings and capital accumulation (as embodied, for example, in the X tax proposal of the late David Bradford at Princeton).  Indeed a future Secretary Hubbard, well-respected on both sides of the aisle in Washington, would be one of the brightest stars in any Romney-led firmament, and significant pro-growth reform would then be highly likely.

But Mr. Obama does not see it that way, and will seek to lead us toward a very different future.  Thus the 2012 election promises to involve a great contrast in tax policy, as President Obama favors a progressive tax structure with higher levies on higher incomes.  Not only did he reject the recommendations of his own tax panel, the bipartisan Bowles-Simpson Commission, out of hand, he veritably ignored it all, leaving the Democrat co-chair of the Fiscal Commission, Erskine Bowles, incredulous.  Given the large divide in economic philosophy between the two parties and their leading candidates, tax policy will be a defining issue in 2012; given this, what is the best way to think about the competing visions?

Economic Theory is Very Clear on the Impact of Taxation

From a theoretical standpoint with respect to economic growth, the optimal rate of taxation, whether on profits, income, or capital gains, is zero, other things equal.  A simple supply-and-demand graphic shows this, per below:

Chart I. Tax “Wedge” (Shown as Triangle abc), Depicting Loss of Output Due to Taxation

This figure shows that, absent taxes, the quantity Q* would be produced, at a price of P*.  But the imposition of a tax increases the price to be paid by the consumer, from P* up to Pc, thus causing a reduction in the quantity demanded due to the higher prices facing the consumer.  After subtracting out the amount of the tax [Pc-Ps], the price received by the supplier is Ps, reducing his profit per unit by [P*-Ps].  At the lower profit levels the supplier produces less, confirming the drop in output and consumption back to Qt.

Analytically, then, the loss in output [Q*-Qt] from the producer equals the decline in consumption, and the producer’s revenues (or, net profits, in this simple exposition) decline by [P*Q* - PsQt].  But consumer welfare has suffered as well: prior to the tax, consumers benefited from total output Q*, paying the lower price of P*; now, they are only consuming Qt, but paying the higher price per unit of Pc.  There is a “deadweight loss” of value represented by the shaded triangle abc, and it can be shown that this loss in real wealth to society is borne by both consumers and producers.   This is nothing more than the formalization of the common sense adage that “if you tax something, you get less of it” — but what most people are not aware of is the additional fact that, adding insult to injury, consumers end up paying higher prices as well, along with the fewer goods produced and consumed!

Given that taxation, ceteris paribus, reduces the wealth creation in society — indeed, given that it destroys real wealth — the goal of a tax policy seeking to maximize the creation of wealth would seek to minimize the dead-weight loss from taxation.  If however the goal is to reduce disparities in income or wealth, or promote their redistribution, the loss of output may not be a concern.  In any case the key theoretical insight is that higher levels of progressive taxation bring with them reduced output and lower incomes, or said more formally, a diminution in the base of assets subject to the tax.  This is true regardless of the particular “base” being taxed, whether production for income, investment, corporate earnings, or even estates (viz., theory predicts that higher estate tax liabilities will invite more consumption and wealth dissipation prior to death, along with tax avoidance strategies such as those employed by Warren Buffett and Bill Gates — indeed it is ironic that Mr. Buffett has called for higher taxes on the wealthy at the same time he has ensured his vast fortune of more than $60 billion will be entirely shielded from the clutches of the federal government via the estate tax).

Empirical Reality Bears Out the Theory 

This theory has borne out well in the real world over time.  A look at the empirical evidence worldwide on this topic does indeed conform to something Keynes himself said: there is an inverse relationship between taxation and economic growth.  Keynes was an advocate of cutting taxes in a recession for precisely this reason; he wanted to induce more spending and investment.  Indeed, one reason the United States is considerably wealthier than the Eurozone’s advanced economies (or the U.K. or Japan) is that our overall tax burden is lower here in the United States.  With the exception of corporate taxes, which are highest here, everything else is lower – that is to say, the U.S. is a friendlier climate for enterprise, work, and investment.  For example, in Denmark, the highest marginal income tax rate is 59.5%; they have a 25% VAT tax on consumption and purchasing; and their corporate tax is 25% — they also tax capital gains (up to 42%) and estates more than the U.S.  But per capita income is about $36,000 in Denmark, right at the OECD average, whereas it is $48,000 in the U.S.

But that 25% gap is actually low – the real gap in the standard of living between Denmark and the U.S. is greater, because the U.S. is a 24/7 society, with greater variety, quality, and choice of goods.  Additionally, consumer prices are generally lower here in the U.S., and thus the *real* standard of living differential may well be 40% or more (for example, the cost of a Combo Meal in the U.S. is typically $6.00 or below, whereas in Denmark the same purchase is roughly $11.43).   Further, unemployment has usually been lower here in the U.S. than in western Europe for most of the post-war era (though that is no longer true at the moment).

The key insight here is that higher taxes, while providing for a more comprehensive government-provided safety net, have stunted growth in Europe and in Japan, and hence stultified their progress in standard of living improvements.  And this has been going on for much of the past fifty years; indeed Europe and Japan would be even poorer if they did not live in the “backdraft” and hence were direct beneficiaries of all the marvelous invention and innovation coming out of the U.S. – and they also live under the American defense umbrella (hence expending less of their societal resources on the non-consumer good category of defense).

Here in the United States, several episodes of strong growth have been associated with tax rate reductions.  The 1980s recovery which followed the Reagan tax cuts in 1981 are all recent memory in the United States: 21 million jobs in eight years, 4% average real GDP growth and a stock market that tripled across that time, and unemployment back down in the 5% range after being more than double that in 1982.  But major tax cut programs – on marginal incomes, but also on capital – occurred as well under Treasury Secretary Andrew Mellon in the early 1920s, and John F. Kennedy in the early 1960s as well.  Perhaps not coincidentally, those were three of the four best decades for economic growth in the last century (the 1990s were also years of solid growth in the U.S., fueled in part by a significant cut in the capital gains rate and related preferences in 1997 that generated a boom in new productivity-enhancing technology investment).  Revenues grew dramatically in all three cases: during Reagan’s eight years in office, for example, tax revenues doubled.  (Unfortunately for Mr. Reagan, federal spending almost tripled during the same timeframe, so the Reagan era was one of deficits – but it was due to spending by the government growing faster than tax revenues).

The 1920s tax cuts are particularly instructive when seeking policy clues for today.  The U.S. economy went into a deep recession in 1920 following a credit-induced bubble in asset prices, not unlike the aftermath of the housing bubble by 2008.  Between the summers of 1920 and ’21, unemployment tripled to rise above 10%, and industrial production fell 21%. In contrast to the current-era response of massive government stimulus through federal spending, the Harding and then Coolidge Administrations did the opposite, in a series of tax cuts engendered by Secretary Mellon.   Said Mellon at the time:

 The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business.

While Mellon cut taxes on incomes, profits, and capital gains, the dramatic effect of how lowering marginal rates can broaden the tax base is shown by this startling graphic of high income-earner remittances during the Roaring ’20s, reproduced here as follows from the Cato Institute in a 2003 paper by Veronique de Rugy:

Chart II. Marginal Tax Rates, Taxes Paid, and Share of Total Paid by the Wealthy in the 1920s

This is a dramatic illustration of the growth-inducing effects of tax rate reductions that broaden the base: the marginal rate dropped from 60% down to 24% across the decade, while the “tax take” from the wealthy  (>$100,000 in income) more than tripled, from $200 million to over $650 million.  Meanwhile, the share of income taxes paid by the uber-wealthy soared from 30% to more than 65% of all receipts.

Conclusion and Implication for Tax Policy Moving Forward

The Bowles-Simpson Commission offered ample proof that there is a bipartisan consensus in the United States for fundamental tax reform not unlike that which occurred in the 1920s, involving a lowering of rates and closing of loopholes and preferences that broaden the base.  The present Administration’s reticence to pursue this form of tax reform, which has worked so well at closing the tax wedge and driving growth in output and employment in the past, stems from their concern that the “millionaires and billionaires and corporate jet owners” are not paying their fair share of the total tax burden.  This however is an irrelevant concern in an era where today, the top 1% of all income earners pay 38% of all federal income taxes, versus the 17% they paid when President Reagan was elected in 1980.  And, total marginal burdens on high income earners are now higher than 50%, all-in, in states like New York and California.

The good news is, this fundamental pro-growth tax reform will one day happen. This is axiomatic in an era of an increasing government debt burden and trillions in unfunded liabilities now approaching the American economy like a tidal wave.  And, even the Soviet commissars eventually learned this lesson: Russia’s 13% flat tax has been a boon to their economy in the last decade.  But the longer our policymakers wait to change current tax policy — and we must add, the longer they fail to rein in spending — the more hardened the challenges become, and the more economic sclerosis sets in.  It is at least of some solace that for investors in U.S. equities, recognizing when the shift to a pro-growth fiscal stance occurs will prove to be one of the more profitable instances of market timing in the new century.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com

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