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.
Additionally, rescinding the Bush tax cuts fails on the terms offered by proponents of tax increases. Remember I mentioned that the CBO predicts that ending the Bush tax cuts would bring in $115 billion in 2011? The federal deficit is expected to be $980 billion in 2011, so raising the tax rates, even if you accept the CBO's estimate, will only close about 12 percent of the deficit. The data shows that it is spending —not a lack of revenue—that has led to the current crisis. Federal spending is expected to be about $2 trillion more in 2011 than it was in 2001 when the Bush tax cuts were passed. That means that in 2011, again, even if the estimated figure of additional revenue is correct, government spending will have about 17 times more impact on the debt than revenues from the Bush tax cuts.
Ironically, extending the Bush tax cuts might allow the federal government to see more money in revenues than the alternative. How? Lower rates of taxation mean more money is in the hands of taxpayers. These taxpayers see the rewards of their work and are therefore encouraged to engage in economically productive behavior. People work harder, and employers hire more workers, invest in new equipment, and work to grow their businesses. These behaviors expand the tax base, thus increasing tax revenue.
Focusing on encouraging growth is a much more appealing way to fix the deficit, because it fixes the economy simultaneously. While not all tax cuts pay for themselves, tax cuts usually have an economically stimulating result. Allowing the Bush tax cuts to sunset would be far more costly in economic terms than the additional revenue that higher rates might create.
When the economy is thriving, government revenues increase because the government gets a slice of that economic success. And that slice should be enough. The real problem is that Congress is currently caught in a cycle of overspending and trying to catch up with the outflow.
Trying to raise taxes to cover a huge spending bill is not the answer. Instead we should carefully consider the impact taxes have on behavior, and how the combination of lower tax rates and lower spending could lower the national debt and restore a growing economy.