President Obama’s debt commission met this summer and painted a bleak picture of the national budget. The bipartisan group called our current situation fiscal “cancer” and warned that it will “destroy the country from within.” Americans are right to be concerned with our huge national debt. What is the solution? Erskine Bowles, President Clinton’s Chief of Staff, put it simply: “We've got to cut spending or increase revenues or do some combination of that.”
Bowles is right. Note that he said “increase revenues,” and not “increase tax rates.” He probably went with this phraseology because it sounds better—after all, who wants to talk about raising taxes? But the difference goes beyond semantics. Raising tax rates isn't the answer to the budget problem, because it would pull more resources out of the already-suffering private sector. Increasing revenues can happen even without a change in tax rates, if the economy begins growing again.
Unfortunately, many in Congress seem focused on raising taxes rather than increasing revenues as the key to closing the deficit. The Bush tax cuts are set to expire at the end of this year, and Democratic leaders want to blame the Bush tax cuts for today’s budget crisis. According to the Congressional Budget Office, the Fed would miss out on $115 billion in tax revenues in 2011 if the Bush tax cuts were to stay in place, and increasing amounts after that.
Yet the reality is more complicated than that. Assumptions about how much could be raised with higher tax rates ignore how tax rates affect behavior and the economy more broadly.
Basically, income tax revenues rest on two main variables: the amount of taxable income and the tax rate.
Mathematically, the higher the two variables are, the greater their product will be. But in reality, these two variables aren't independent: tax rates affect the size of the tax base. When individuals decide how much to work, they consider how much money the government will take from their additional earnings. If the government takes away too much, people have less reason to work harder. This dynamic means that tax rates actually affect behavior.
This is particularly important to consider today, given our current economic predicament. The U.S. is suffering not just from a historic deficit, but a sluggish economy that's failing to produce jobs. Higher rates of taxation discourage hard work, savings, investment, and entrepreneurship – the foundations of economic growth that will create a larger tax base.