Government debt hit a record $16 trillion last week, accompanied by the usual calls for tax increases to help plug the gap between revenue and expenditures. But for those who believe that the way out of our deficit includes raising taxes, there’s a cautionary study that suggests otherwise.
A study by the American Institute for Economic Research indicates that higher taxes are not the answer. In an examination of federal tax receipts as a percent of gross domestic product since World War II, the Institute concluded that federal receipts exceeded 20 percent of GDP only once, reaching 20.6 percent in 2000.
“Except for that one time, federal tax receipts have always been less than 20 percent of GDP,” said Steven Cunningham, director of research and education at AIER.
“This is particularly telling, because during the time frame we’re discussing, tax rates varied widely,” he said. “The highest personal income rates have been as high as 92 percent and as low as 28 percent. Corporate tax rates have ranged from 35 to 53 percent of federal tax receipts. The point is that no matter what the tax rates were, we have never been able to collect more than 20.6 percent of GDP in taxes.”
Since spending exceeds revenue by several percentage points, it looks as though cutting expenditures is the only realistic means to close the budget gap.
“If we look at the expenditure side of the equation, federal government expenditure was 25.5 percent of GDP in 2011, and is projected to be more than 24 percent this year,” Cunningham said. “To close the gap between revenues and expenditures, it does not appear that there is much leverage on the tax side. Raising taxes is not likely to generate a revenue stream that is more than 20.6 percent of GDP. This isn’t politics, it is simply economic facts.”
This means that built-in commitments to expenditures above the level of 20 percent of GDP will almost certainly add to the deficit.
The reason for this is that the American public only has so much appetite for taxes, according to Cunningham. “When you raise tax rates to these higher levels, it creates increased incentives to seek out tax shelters, to move assets offshore, to look at more creative ways to manage your finances to avoid the higher tax rates,” he said.
“Ultimately people will vote with their feet,” he added. “If the tax rates become to them too oppressive, they will simply leave the jurisdiction. And we are increasingly seeing a number of higher-income individuals leaving the U.S. This is not a driving force, but there is a range of things that stand in the way of higher marginal tax rates generating higher government revenue.”
Cunningham believes this is an aspect of the culture, since there are, in fact, countries such as Sweden and Finland that have successfully increased revenue with higher taxes.
“There has been more success with higher tax rates in other countries,” he said. “This tolerance for high tax rates seems to be a cultural thing, and in this country, the 20 percent mark is a ceiling.”
Although the numbers speak for themselves, the conclusion shouldn’t come as a surprise. “People seem to forget that you should expect that, as tax rates get higher, people will find more ways to reduce tax liability,” said Cunningham. “There is an economic effect that tends to offset the arithmetic effect. The tax base starts to shrink as tax rates rise because there are incentives that drive you people to change their behavior. Incentives matter in economics.”