I continue to receive criticism and questions over my articles pointing to the futility of pursuing tax cuts. I am happy to answer all those questions, and I will gladly continue to point to why structural spending reform is the only way to go. I will publish my own reform plan soon after the election; for a glimpse of what it will cover, check out my 2012 book on welfare-state reform.
In the meantime, let me reinforce the point about supply-side economics and further tax cuts. I am not the only one to point to the limitations of what this theory can do; last year Cato Institute fellow Ryan Bourne suggested that taxes have become too low for the Laffer Curve to still be effective. In short, he proposes that the tax cuts that have swept across the industrialized world in the last few decades have taken taxes down to where a cut no longer has the stimulative effect on revenue that it had when Art Laffer first introduced his famous curve. When tax rates were in the “ineffective” segment in Figure 1, a cut would increase revenue; once the rates fall into the “effective” segment, a cut reduces revenue:
Figure 1: The Laffer Curve
Bourne has no data to back up his claim, but in order for his argument to work he would need to show that labor supply no longer responds positively to tax cuts. It does, as shown by every tax cut in the United States the past 40 years. The Trump tax reform was particularly effective in increasing workforce participation.
The problem with the supply-side school is not that taxes are too low for the Laffer effect to work. The problem is that we don’t get enough growth out of the workforce participation that comes from lowering taxes. That problem, in turn, is related to the large presence of government in the economy; there is ample evidence – as I have reported in my book Industrial Poverty – of a 40-percent-of-GDP threshold: once government spending is higher, it permanently depresses GDP growth.
Supply side economists have inadvertently helped government grow. As much as a lot of supply-side libertarians want to dislike me for making this point, the evidence is irrefutable: the tax cuts they have helped bring through Congress were all good and necessary in and of themselves, but since they were not accompanied by any spending-reform efforts of even remotely similar magnitude, all that happened when tax revenue surged was that Congress decided to spend even more money.
If the supply-side school had stood equally strongly on both legs – tax cuts and spending cuts – things would have looked very differently in our economy. As it is now, the tax-cut strategy has allowed government to grow to a point where its size depresses the very growth effect that supply-side economists rely on to make their tax cuts work.
Again, that is not to say the tax cuts weren’t good. They were. But since government has continued to grow, the efforts to cut taxes have at least in part become a shuffle game. The tax burden in the U.S. economy has shifted, and not in a way that we should necessarily celebrate. First, consider Figure 2, which reports the aggregate tax burden on corporate profits:
Figure 2: Effective tax rate on corporate profits
Clearly, U.S. tax policy has moved away from heavily burdening businesses. This is good, of course, even if it for a long time happened through measures that invited advanced – and costly – tax avoidance (which unlike evasion is legal). The federal corporate-tax system we got with the Trump reform was much welcome, but as Figure 3 explains the reduction in taxation of corporate profits has come with a shift toward heavier reliance on other sources:
Figure 3: Composition of U.S. taxes
In other words, individuals bear the brunt of the tax burden. That does not mean it is better to have high taxes on corporations – all taxes should be minimal – but Figure 3 is a hint of what happens when we do good tax reforms without equal emphasis on spending reform.
So long as the balloon is of the same size, a squeeze on it on one size must result in a bubble on the other side.
With taxes shifting over onto personal income and consumer spending, the pertinent question is what this means for households and their finances. Since consumer spending accounts for about 70 percent of GDP, a concentration of taxes onto households will inevitably depress economic activity. The scope of this problem emerges from Figure 4, which reports the striking decline in work-based earnings and the rise in household dependency on government and equity-based income:
Figure 4: Personal income and taxes
We can see a good part of the problem with the Laffer Curve in Figure 4. First and foremost: the three big tax reforms over the past 40 years – Reagan, Bush and Trump – have not lowered the tax burden on personal income. They have helped keep that burden flat, but that is also all they have accomplished.
Furthermore, the composition of private income is such that the intended effects of another tax reform would be limited. Today, wages and salaries account for only half of personal income. This is the share we need to target with tax cuts if we are going to bring about more workforce participation. The Trump tax reform showed, again, that this can be done, but the tax cuts would have to be concentrated to the lowest income segments; the higher a household’s income is, the larger a share of it comes from equity. Cuts in taxes on equity-based income are not as effective in stimulating economic growth.
At the same time, lower-earning households depend to a larger extent on tax-paid entitlements. Their total share of personal income is approximately 17 percent, and will very likely increase further in the future.
The tricky thing with this income source is that households tend to lose entitlements as their work-based income increases. Even if they increase their workforce participation thanks to a tax cut, their total income does not increase accordingly. Thereby, consumer spending is not boosted, depriving the economy of some of the growth the tax reform would otherwise generate.
Again, Figures 3 and 4 tell us with painful clarity that our government has not become cheaper as a result of the practice of supply-side economics. Figure 5 makes this point from a different angle. Suppose we bundled together the cost of federal, state and local government taxes and other revenue sources and created one “all inclusive” personal income tax. What would the rate look like? Figure 5 explores that question with the tax base defined as total personal income (grey), employee compensation (dashed blue) and wages and salaries (solid blue):
Figure 5: The total cost of government as share of personal income
Again, our government is not solely funded through taxes on personal income and consumption, but as Figure 3 showed we are moving in that direction. It is also worth noting that even a corporate income tax is ultimately paid by the employees, the investors and the customers of that corporation. Therefore, the experiment in Figure 5 is quite telling of what the cost of our government actually looks like today.
Bluntly: four decades’ worth of tax reforms have not helped reverse the growth in government. Its cost has tapered off, but we have to keep in mind that Figure 5 does not take budget deficits into account. They really aren’t more than a hidden tax on future personal income.
Long story short: all that matters is structural spending reform. Once that is under way, there will be room for further tax cuts. As a bonus, budget deficits will gradually disappear.