The United States used to be the economic engine of the West, with growth rates in gross domestic product (GDP) often in the range of over 3% or 4% per year, some years close to 8% That all stopped around 2006 (growth rate 2.667%). In some years since then it has been a little over 1% or negative. Some people claim that growth of 1% to 1.5% is the new normal. Yet other countries are growing faster.
In 2016, if we limit our analysis to countries with advanced economies (emerging countries are often growing at 5% to 8% a year), even slow-growing economies are growing faster than the United States. Germany was the fastest growing in 2016. The United Kingdom, in spite of the economic problems that led it to leave the European Union, grew faster than the United States. The Eurozone, including the sick economies of France, Portugal, and Greece, also grew faster. The United States came in an anemic fourth. Only Italy, pulled out of the EU statistics and measured separately, came in lower than the United States.
To promote faster economic growth, many economists say we should lower marginal income tax rates. President Trump also urges lower marginal rates to promote U.S. growth. To paraphrase presidential candidate Bill Clinton, “It’s the economy, stupid.”
Ask yourself, has the United States ever increased economic employment and GDP by raising taxes? If raising marginal tax rates on the rich would improve the economy and reduce unemployment, by all means, let’s do it. History teaches a different lesson.
The economists say everything interesting happens at the margin. We have found that lowering marginal rates helps the economy and raises more tax revenue because the economy grows faster. Let’s look at a few historical examples.
The Andrew Mellon Tax Cuts. During World War I, the top income tax rate was 77%. After the war, Secretary of the Treasury Andrew Mellon eventually persuaded Congress to cut the top rate to 20%, which it did in a series of cuts. (Then, in the second half of it started to increase the rates.) Mellon thought that once federal marginal tax rates were over about 25%, richer people would invest in areas that are less productive but offer higher after-tax benefits.
Here’s an interesting and surprising table, based on statistics from the U.S. Department of the Treasury, Statistics of Income, 1920 through 1928.
In 1920, 29.9% of federal revenue came from those who earned $100,000 per year or more. By 1928, 61.3% of the income tax revenue came from incomes $100,000 and higher, even though the top marginal rate, at the beginning of 1928, was much lower (20%) than it was in 1920 (77%). As the marginal rates decreased, the money the federal government collected from the filthy rich increased. Those who earned over $100,000 in 1920 paid (as a group) $321 million in taxes. By 1928, when the top marginal rate was 20%, the federal government collected $714 million from this group.
As Andrew Mellon famously said, “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.”
Those who earned less than $10,000 per year—poorer people—paid, in 1920, 24.5% of federal tax revenues. By 1928, this lowest economic group paid only 3.1% of tax revenues. In 1920, the federal government collected $264 million from those who earned $10,000 or less. In 1928, the federal government collected only $36 million from these lower income taxpayers.
The economy grew briskly, with the “rising tide lifting all boats,” as President John F. Kennedy later said in a 1963 speech. The Gross National Product grew an average of 4.7% a year, from 1922 to 1929. Lowering the marginal tax rates also helped the unemployed, because unemployment fell from 6.7% to 3.2%. The best antipoverty program is a job.
The low marginal rates did not last. In the Revenue Act of 1928, Congress raised the top marginal rate by 25% by adding a surcharge. In addition, the stock market got ahead of itself, and there was the great crash of 1929, followed by the federal government raising more taxes, first under Hoover and then under F.D.R. The year 1931 gave us the drought and the dust bowl, wreaking havoc for farmers. In 1932, Congress raised the top income tax rate from 25% to 63%. In 1936, F.D.R. raised the top marginal rate to 79%. (It eventually rose to 91%.) To add icing on the case, the Federal Reserve tightened money, instead of loosening it, and we had over a decade of the Great Depression, the decade of our discontent.
The John F. Kennedy Tax Cuts. President Kennedy learned from Mellon and pushed Congress to reduce marginal taxes. J.F.K. proposed cutting “income taxes from a range of 20-91% to 14-65%. He also proposed a cut in the corporate tax rate from 52% to 47%.” He ended up reducing the lowest bracket by six percentage points, and the highest bracket 21 percentage points.
Yes, J.F.K supported greater reductions in marginal rates for the rich than for the poor. In Lake Woebegone, all the children are above average, but in the real world, that cannot be. The poorest people do not pay taxes, and the lower economic classes pay substantially less than the upper one-percent. Lowering the marginal rate—some will argue—will benefit the rich more than it will the poor, but that argument applies only if we look only at the nominal rates rather than the whole economy. The rich pay higher marginal rates than the middle class does, while the poor pay nothing.
Think of this example: Assume four army buddies get together once a week to play golf. The cost of a round is $50. Two of the four have average incomes and pay $50 each. The third is wealthy and offers to pay $100, because the fourth (who is not financially secure) will pay nothing. After a few years, the golf course lowers the green fees by 20%. Now, each of the middle class golfers pay $40 and the rich fellow pay $80. “Wait a minute,” says the one who has paid no green fees. “Why don’t I get the benefit of the 20% cut?” In the iron law of mathematics, the two middle golfers saved $10 each, while the rich person saved $20. And the one who pays nothing does not get any direct benefit of the reduction. Yet, they all benefit, if we see the bigger picture: the four buddies now can play golf 20% more frequently.
Kennedy understood this iron law. Speaking before the Economic Club of New York, he said:
[I]t is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country’s own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.
I repeat: our practical choice is not between a tax-cut deficit and a budgetary surplus. It is between two kinds of deficits: a chronic deficit of inertia, as the unwanted result of inadequate revenues and a restricted economy; or a temporary deficit of transition, resulting from a tax cut designed to boost the economy, increase tax revenues, and achieve—and I believe this can be done—a budget surplus.
Eventually, he got his tax cuts and the richest people saw their marginal rate reduced substantially more than the poorest. As in Andrew Mellon’s day, the rich ended up paying more taxes and the poor found they were getting richer and richer.
In 1965, the first year for which the new J.F.K. rates applied, high-income taxpayers declared more taxable income and paid more taxes than they paid under the old law. Those earning more than $500,000 annually paid $701 million in federal taxes before the JFK tax cuts, and $1.02 billion after the tax cuts. This development was true at every level.
Economists predicted a loss of revenue because of tax cuts, but tax revenue increased in 1964, 1965, 1966. In 1966, the growth rate was 6.6% and unemployment was 3.8%, falling from 5.2% in 1964. A larger percentage of working-age Americans were holding jobs. The 1960s were the golden age of peaceful economic growth—cut short by the Vietnam War.
The Ronald Reagan Tax Cuts: Between 1981 and 1986, President Ronald Reagan and Congress lowered marginal tax rates across the board. The reduction began in 1981; the 1986 tax reform act further reduced top rate from 50% to 28%. As the marginal rates lowered, the poor paid a reduced percentage of taxes, while the percentage that the rich paid increased substantially, repeating the experience of Andrew Mellon and J.F.K.
The share of total individual income taxes that the top one percent paid in 1981—before Reagan reduced marginal tax rates—was 17.9%. In 1984, that figure increased to 21.9% and increased even further (as the marginal rates decreased) to 25.6%. Similarly, the bottom 50% of taxpayers paid 7.4% of federal income tax. By 1981, they paid, as a group, only 5.7% of federal income tax. (Federal revenues increased substantially, but Congress decided to increase expenditures even faster.)
As Andrew Mellon said, high marginal rates restrain economic growth and encourage tax shelters, which hurt the poor and the middle class. On the bright side, higher marginal rates help employ tax accountants, tax lawyers, and tax lobbyists.
President Trump’s tax proposals. Trump’s proposal is still being formed, but we know that it will include reducing marginal rates (like Mellon, J.F.K., and Reagan), reducing or eliminating many itemized deductions, and increasing the standard deduction.
Now, 70% of tax returns do not itemize and, instead, take the standard deduction. Richer people use itemized deductions to lower their taxes, which mean that, in effect, the poorer 70% are subsidizing the richer 30%. President Trump wants to double the standard deduction to $12,700 for individuals and $25,400 for married couples filing jointly. That means the percentage of taxpayers who itemize will fall to 5%. Good news for most of us; bad news for those relying on tax shelters.
There are cries that lowering marginal rates and limiting many itemized deductions will help “the rich” and hurt “the poor.” Yet, in the past, doing that has helped the poor, improved the economy, and caused the rich to pay a larger percentage of taxes.
An improving economy will also help the rich. Some people don’t like that, so, to be “fair,” they want to raise the marginal tax rates, which hurts the poor. That thinking reflects an old Soviet tale. A farmer rubbed a magic lantern and a genie appeared. “I grant you one wish,” said the genie. The farmer said, “I have two goats and my rich neighbor has four. My wish is that you kill two of his goats.”