Why Are So Many People Willing to Imagine That Tax Cuts for the Rich Will Help the Economy?

Posted in: Tax and Economics

The never-ending debate over tax policy has taken a turn in the last few years—and especially this year.  With increasing bravado, conservatives claim that taxes on the wealthy and on businesses should be reduced, or even eliminated altogether.

Indeed, in recent weeks, we have witnessed an onslaught of proposals from Republican politicians (and their reliable friends in some think tanks and university Economics departments).  These partisans claim that the key to economic prosperity is to free the “job creators” (their new Orwellian code-word for rich people and the companies they own) from the inconvenience of paying taxes.

The proposals are not identical:  They range from plans to reduce tax rates for all businesses and wealthy people, to plans to reduce only certain tax rates, to plans that—most radically—would eliminate some types of taxes entirely.  What the proposals all share, however, is the common premise that taxes are too high, at least for businesses and the wealthy, and that everyone else would be better off if only we could get past our supposedly foolish commitment to progressive taxation.

That premise is wrong.  As a question of both theory and evidence (rather than wishful thinking), there is no simply no convincing support for either the claim that current levels of taxation are harming the economy, or the claim that reducing taxes for businesses and the wealthy will change the path of the economy and reduce joblessness.

What is surprising—or what would be surprising, if we had not become so jaded about political discourse in this country—is that facts and logic mean so little in this debate.  Even for those who are not ideologically committed to redistributing income regressively, however, high-end tax cuts (that is, reductions in taxes for businesses and wealthy individuals) have unjustifiably strong intuitive appeal.

Such cuts will, however, simply make the rich richer—and they will do affirmative harm to the economy as well.  If we are to make any progress toward improving the state of the economy, it is imperative that we set aside wishful thinking and recommit ourselves to progressive taxation and stimulative government spending to turn the economy around.

The Dangerous Allure of Trickle-Down Economics

One of the most basic propositions in economics is that people respond to incentives in predictable ways.  Applied to taxes, the idea is that if you make an activity less profitable by diverting some of the gains to the government, then people will be less likely to engage in that activity.

This intuitive notion presents a pointed challenge to the belief that taxes should be designed to reflect the ability to pay.  If higher taxes on businesses and the wealthy might discourage them from hiring or investing, then it would follow that assessing taxes on those most able to pay would necessarily harm the rest of us.

None of this, of course, is remotely new.  The idea that giving more to those at the top will create benefits that spread through the economy and help those in the middle and at the bottom has been a staple of conservative thought for decades, if not centuries.  Such claims have been derided as “trickle-down economics,” whereas proponents of high-end tax cuts prefer to say, for example, that “a rising tide lifts all boats.”

No matter how one spins the argument, however, the assertion that progressive taxes are damaging to growth is often presented as simply revealed truth, not what it actually is:  A highly controversial—and easily debunked—claim.  A recent article in a publication for tax specialists, for example, bluntly asserted that “a less progressive rate structure is always better for long-term growth.”   No responsible person should seriously make such a claim with a straight face.

The Trickle-Down Theory Breaks Down: Why Would Taxes Reduce Rich People’s Desire to Make Money?

When challenged, defenders of the claim that taxes harm growth will typically resort to extreme examples:  “If we were to set tax rates at 100%, surely you would have to admit that business would screech to a halt, wouldn’t you?” they might say.  And if one responds by admitting that an extremely high tax rate would, of course, do real damage to the economy, then to the trickle-down proponent, the next step seems obvious:  If high taxes are bad, then lower taxes must be good, and no taxes at all must be the best of all possible worlds.

There is no reason, however, to believe that increasing tax rates from 10% to 20% would have anything remotely like the same effect as increasing tax rates from 90% to 100%.  In fact, there is no theoretical reason to believe that people will necessarily reduce their economic activity at all in response to an increase in taxes, unless tax rates reach an extremely high level.

As I discussed in my most recent column on Verdict, the billionaire investor Warren Buffett called last month for increased taxes on the wealthiest Americans.  Buffett is, of course, hardly unaware of the claim that such tax increases would reduce the incentive to invest.  However, his experience simply tells him that such concerns are misplaced: “I have worked with investors for 60 years and I have yet to see anyone—not even when capital gains rates were 39.9 percent in 1976-77—shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

Buffett’s focus on capital gains taxes was not mere happenstance.  Capital gains are the profit that investors earn from putting their money in stocks, bonds, and other investments.  Buffett’s evidence contradicts the assertions by business advocates that people will reduce their investments if their returns are reduced by taxes.  Those assertions, however, have gained such credence in Congress that capital gains are currently taxed at less than half the rate at which we tax the wealthiest taxpayers’ other income (such as their salaries).

But why would higher capital gains rates not cause investors to stop pouring money into businesses?  Buffett’s argument is that one always makes money by investing in good business opportunities.  A higher tax rate reduces what the investor keeps, but it does not—unless we are looking at tax rates at or near 100%—cause investors to reduce the amount that they invest.   The reason is simple:  Even profits that are reduced by taxes are better than no profits at all.

This argument thus contradicts the idea of a “capital strike,” which is the notion that investors would rather take their money and go home than to continue to invest when faced with somewhat higher tax rates.

Why would investors keep investing?  The answer is that investing is not easy, but it is still a much easier way to make a lot of money than any of the alternatives.  Given that the alternative to investing is to undertake some form of labor, or to forgo profits entirely, it is hardly a mystery why Buffett’s friends do not walk away even when tax rates rise.

The Evidence Does Not Support Trickle-Down Economics

The supposedly clear-cut theoretical case for passing tax cuts in order to improve the economy is, therefore, quite unconvincing.  It should not be surprising, therefore, that the evidence does not support the assertions of trickle-down economics.  The evidence, moreover, goes far beyond that which Buffett has derived from his personal experience—experience that is deep and wide, but that is arguably idiosyncratic.

A recent analysis by New York Times business columnist James B. Stewart summarized the notably weak evidentiary support for the idea that high-end taxes harm the economy.  Stewart quotes Len Burman, an economist who specializes in studying business taxation, as saying that the evidence that lower capital gains tax rates would spur economic growth is “murky, at best.”

Although Burman has advised Democrats on tax policy matters, he is solidly in the mainstream of the profession.  If anything, his methodological approach would tend to find support for the idea that taxes do, indeed, harm growth—if only such evidence could be found.

Yet Burman is, if anything, understating the lack of evidence supporting trickle-down economics.  After the publication of dozens (if not hundreds) of academic studies that have tried to identify a negative effect of capital gains taxes on investment, it is clear that the evidence is simply not there.  The most that one can say is that some studies do support the worst fears of anti-tax advocates, while many other studies do not.  If taxes were as harmful as some people claim, however, the evidence would be crystal clear, not “murky.”

Why would any sensible person base tax policy decisions on a theory that is ambiguous (at best), in the face of evidence that fails to support that theory?  There is no good answer to that question.  Even so, we continue to see the sheer power of repetition in our political debates.  In the absence of evidence, advocates for high-end tax cuts simply repeat their discredited claims—over and over.

What Actually Happens When Tax Revenue Goes Down:  The Serious Consequences That Occur When Public Services Falter or Fail

Even if one conceded the lack of evidence regarding any damage that high-end taxes might inflict on the economy, however, one might still retreat to the claim that we should err in favor of lower taxes.  Although we are not sure that high-end taxes harm the economy, one could ask:  Why risk it?

We must remember, therefore, that the case for tax cuts ignores half of the story.  The arguments for lower taxes of any kind, but especially lower taxes on businesses and wealthy taxpayers, misleadingly ask us to focus only on the taxpayers, without thinking about the ultimate use of the tax revenues that will be lost.

What happens if we stop collecting taxes from those who can most afford it?  The answer, of course, is that governments deprived of revenues must sooner or later cut back on the services that they provide.

For the last several years, we have been witnessing what happens when states and cities cannot collect as much tax revenue as they would need to continue to provide the services that the public wants.  School budgets are being savaged, infrastructure is decaying, and vital services are being eliminated.

Even at the federal level, the loss of revenues from ill-conceived high-end tax cuts in the last decade has finally come home to roost.  While much of the hysteria about the federal deficit is based on nothing more than opportunistic anti-government dogma, it is nonetheless true that deficits cannot be indefinitely financed at ever-higher levels.

With revenues reduced by regressive tax cuts, the federal budget has consequently been pruned.  Programs both small (such as low-income heating assistance) and large (such as unemployment benefits for people who lost their jobs through no fault of their own) are being cut at the worst possible time.

It is not, therefore, persuasive simply to argue that high-end tax cuts might do some good.  We know, as an absolute certainty, that the loss of revenues reduces what governments can do.  Thus, unless one simply insists on believing as a matter of faith that government spending is always wasted, we must confront the fact that reduced spending will do real harm.

Cutting taxes is, therefore, not a consequence-free gamble on the possibility that we might see some increase in investments (and ultimately more jobs for Americans).  Instead, cutting high-end taxes guarantees that we will as a nation continue to harm the vulnerable and fail to invest in the future prosperity of the country, harming all Americans now and for decades to come.

For those who care to think through all of the consequences of our decisions, and who take evidence seriously and reject wishful thinking, it is obvious that the recent clamor for more high-end tax cuts must be rejected.  Indeed, it is yet further evidence of the debased state of political debate in this country that these calls for regressive tax cuts are even being taken seriously—let alone being touted as the sole path to economic recovery.

Posted in: Tax and Economics