Why Do We Simply Accept on Faith That Taxes Are Always Harmful? Economists Begin to Acknowledge the Weak Empirical Case for Tax Cuts, but We Should Say More About the Real Costs of Cutting Taxes

Posted in: Tax and Economics

One of the sacred tenets of modern U.S. politics is that taxes are bad.  Really, really bad.  Bad in every way, every day.  So bad that we must do everything possible to reduce taxes.  Although there is disagreement about whose taxes should be cut immediately, it often seems that everyone simply knows that tax cuts have nothing but good effects, with no downside.  This is simply not true.

Economists and tax scholars are largely to blame for this state of affairs.  Although most of us have never said anything as lacking in nuance as the standard Republican stump speech on taxes (which is echoed, far too often, in Democratic stump speeches, as well), we nonetheless have remained largely silent in the face of this country’s mass delusion about the effects of taxes.  As I wrote in a recent Verdict column (here), a large part of the reason that economists have gone AWOL on the policy front is that their professional incentives do nothing to encourage clear thinking about policy issues.

Unfortunately, the rest of the world bestows great respect upon economists, giving us, as a group, much more credit for possessing real-world wisdom than we generally deserve.  Recently, however, some prominent economists have finally begun to respond forcefully to the anti-tax myths that have come to dominate and distort our political system.

We economists, however, need to do more.  Most importantly, we need to broaden the discussion of taxes so that we consider all of the consequences of a change in the tax system, rather than simply focusing on the narcotic-like high that supposedly comes to those whose taxes are reduced.  In the big picture, tax cuts have consequences, many of them quite negative.  Wise policy can only be made if we stop being obsessed with reducing tax rates and, instead, begin to think about broad-based economic prosperity.

The DNA-Level Assumption That Taxes Are Bad: Where Did It Come From?

In another recent Verdict column (here), I described the basic logic that drives the vast majority of economic analyses of taxes.  Imposing a tax on any activity lowers its after-tax benefit, which supposedly reduces the incentive to engage in that activity.  Although economists and other tax scholars occasionally acknowledge the so-called “income effect”—the possibility that people will need to engage in more of an activity, rather than less, in response to a tax increase—the basic story always begins with “Taxes reduce incentives.”

From there, it is a rather straight path to condemning all taxes.  Because of the particular (and, to be honest, quite peculiar) set of assumptions that have now become standard in most economic analyses, tax scholars will typically assume that the effects of a tax increase are bad—that is, that it would have been better to have allowed people to do what they would have done in the absence of the tax.

This position is often justified as an embrace of personal freedom, allowing people to do what they would want to do, if only there were no government interfering in their lives.  If we think more clearly, however, we find that there is no particular reason to assume that what people would do if, say, there were no tax on real estate transactions, is any more “right” or “free” than what they would do without such a tax.

Our decisions about how to spend money are so intertwined with all of the incentives and laws that are built into our system that it makes no sense to think about a “state of nature” in which people would be earning money in the absence of a government, and then deciding how to spend that money.  And even if it did make sense to imagine that state of nature, there is no reason to think that reducing any particular tax will move us in the “right” direction toward it.

The simple fact is that there is no “freedom-maximizing” baseline against which to measure taxes (or anything else).  When economists talk as if a tax is bad because it changes—or, in the revealing term preferred by most economists, distorts—people’s behavior, therefore, we wrongly perpetuate the mistaken idea that the current set of laws and taxes is a sensible baseline against which to measure policy.

Even if Taxes Are Bad, How Bad Are They?  Empirical Evidence Begins to Penetrate the Conversation

Even if the no-tax presumption described above were sensible, and people did in fact always change their behavior in meaningfully negative ways in response to taxes, a more prosaic question would still arise: How much do people change their behavior (in this supposedly bad direction), in response to taxes?  It is this question that is finally beginning to re-emerge, in the public debate about taxes.

Several prominent economists have recently weighed in on the question of just how much taxes affect the economy.  Christina D. Romer, a former chair of the Council of Economic Advisors (who is an Economics professor at Berkeley), in a recent column in The New York Times (here), described some recent empirical research about the behavioral changes that tax changes might cause.

As Romer summarizes the results: “[T]he strong conclusion from available evidence is that [the] effects [of income tax rates on people’s earnings] are small. This means policy makers should spend a lot less time worrying about the incentive effects of marginal rates and a lot more worrying about other tax issues.”

The studies that Romer describes, by the way, are completely orthodox in their assumptions.  They do not challenge any of the “baseline issues” that I described above, nor do they take a big-picture approach to the tradeoffs that are involved in designing a complete tax system.  Even working completely within the orthodoxy, however, as these studies do, it turns out that the supposedly deleterious effects of tax rates on people’s economic decisions are simply not a big deal.

Similarly, the Princeton economist Uwe Reinhardt recently took on the claim that it is important to cut capital gains taxes (the taxes that are levied on investment income) in order to encourage businesses to expand.  Reinhardt argued (here) that the case for such a regressive tax preference is “extremely shaky,” both philosophically and as a matter of “plain economics.”  And his colleague Paul Krugman, assessing the case for lower capital gains taxes, wrote (here): “There is, however, no evidence that this effect is at all important.”

Because of the overwhelming weight of the evidence, therefore, some economists are finally beginning to overcome their presumption that taxes must always be bad.  It might be that, at least within the current range of possibility, even the most orthodox analyses cannot support the case against raising taxes (and, especially, the case against raising taxes on higher-income Americans).

The Theory Strikes Back: Even in Light of Clear Evidence, There is Always a Presumption that Taxes Are Bad

I should emphasize, too, that the evidence about the effects of taxes has, for decades, been just as one-sided as the evidence from Romer, Reinhardt and Krugman that I cited above.  The post-WWII era, in which income tax rates were at their highest, was also a time of great prosperity.  As Professor Romer noted in her recent column, there is simply no evidence that the economy has been responsive (in either direction) to changes in overall tax rates over the last 70 years.

Even the evidence regarding the effects of specific kinds of taxes has been rather clear-cut.  For example, it has long been clear that estate taxes have the smallest effect on behavior, among all kinds of taxes.  If we wanted to design a tax system based on the idea that that system should change behavior as little as possible, therefore, we would be expanding the estate tax, not considering abolishing it.

Even so, many economists simply find it impossible to allow the evidence to intrude upon their theories.  I once had a conversation with an economist who had tenure at a top-five Economics department.  After he likened the estate tax to a confiscatory scheme worthy of the North Korean regime, I asked him why he was so worried about a tax that—according to all the evidence—simply does not inform people’s decisions as to whether or not to do what is required to become wealthy.

The economist’s response (which I think I recall nearly verbatim) went as follows: “I just cannot believe that evidence.  I mean, the estate tax just has to affect the way people think about business.”  This was an especially extreme version of the old saying “If the evidence conflicts with the theory, so much for the evidence.”  Again, however, these were not the ravings of some political operative, but rather the statement of a widely respected economist.  Thus, the conversation was, for me, a window onto the degree of commitment that far too many economists feel toward their basic assumptions about the way people must behave.

The Big Picture: Even Assuming Taxes Do Change Behavior, They Can Also Finance Spending on Projects that Increase Everyone’s Wealth

Suppose, however, that it were true that taxes have large effects on people’s behavior, and that those effects would—when viewed in isolation—cause the economy to shrink.  That is not by any means the end of the story.

We do not, after all, impose taxes for the sake of imposing taxes.  Thus, we would only want to collect enough tax revenue to finance the tasks that we have asked the government to perform.  We therefore need to think not only about the tradeoff between different kinds of taxes, but also about the tradeoff between collecting taxes to finance government programs versus not collecting taxes, but also not being able to finance those programs.

For example, suppose that—as has been claimed again and again by Republicans in the primaries—an increase in tax rates on wealthy individuals will cause some of them not to create as many jobs as their potential investments might otherwise be able to create. Even so, we might still find that the tax revenue would do us even more good than “job creation” would have, if it were spent, say, on medical research, or on improving the educational system.

In other words, the discussions about tax policy in this country are, at best, based on half-truths.  We talk a lot about the possibly negative effects of taxes on behavior, but—other than tolerating the absurd claims that all government spending is wasteful—we almost never acknowledge the connection between spending and taxes.

To economists’ credit, some among us have finally begun to speak up about the weak empirical case against taxes.  It might be too much to hope that we might also begin to challenge the idea that it is always bad to “distort” behavior, but at the very least, we should certainly insist on describing the big-picture consequences of cutting taxes.

As a famous economist once said, there is no such thing as a free lunch.  Cutting taxes has consequences, and in the current economic environment, reduced tax revenue too often means cutting spending that improves the lives of the American people, both immediately and in the long run.

Posted in: Tax and Economics