In the static world of the left

Posted: May 09, 2005 12:00 AM

The left's latest misinformation campaign claims that if President Bush would just call off the tax cuts, there would be more than enough revenue to make Social Security solvent in perpetuity. As perpetually wrong economist Paul Krugman put it in Monday's New York Times, "Repealing Mr. Bush's tax cuts would yield enough revenue to call off his proposed (Social Security) benefit cuts, and still leave $8 trillion in change."

What those on the left never tell you is they make this calculation assuming, contrary to all available empirical evidence, that no one's economic behavior changed at all when the Bush tax rate reductions were enacted. Under this ridiculous assumption, you don't need a Ph.D. in economics to calculate the so-called "revenue loss" - in Krugman's words $8 trillion. Here's how he calculates the so-called decline in revenues.

If nothing else transpires when tax rates on capital and labor are reduced, he simply multiplies the reduction in the tax rate times the amount of capital and labor that is subject to the tax (this is commonly called the tax base).

In the static world that liberals like Krugman inhabit, people don't save and invest more when the tax rate on dividends and capital gains is lowered. People don't work harder when the tax rate on labor is reduced. Entrepreneurs don't start more new ventures when the capital gains tax rate is reduced, and businesses don't invest in more plant and equipment when they are allowed to write the investments off in the first year rather than having to depreciate them over a decade or more.

Of course, nothing could be further from reality. The laws of supply and demand work just the same for capital and labor as they do for other commodities. Raise the price of a good and you will sell less of it. Lower its price and you will sell more of it. Therefore, firms can't maximize their revenue by simply raising their prices. They must optimize prices by finding the one unique price - not too high, not too low - that will lead to just the right amount of sales to maximize revenues.

The dynamic consequences of changes in tax rates, like any other price changes, ripple across all sectors of the economy. Raise taxes on labor, for example, and you lower workers' after-tax wages. Workers will work less at the prevailing wage, which means some or all of the higher revenues Krugman calculated will evaporate as fewer workers report to work. Moreover, firms must counteract or circumvent workers' reaction to higher labor taxes by paying them higher wages, substituting capital for labor to compensate for fewer workers willing to work at prevailing wages or by producing and selling fewer goods and services, probably some combination of all three.

In any event, the cost of production rises in all three cases and output falls, which means there is another downward force exerted on government revenues, once again upsetting Krugman's revenue estimates.

Raise taxes on capital, and the story is the same. Firms will produce and sell fewer goods and services at current prices. Less labor will be hired, and fewer inputs will be purchased.
Again, after all dynamic adjustments have rippled through the economy, tax revenues will not increase as much as Krugman might project. In fact, depending on the circumstances, revenues may actually decline from their pre-tax-increase level.

Increase the capital gains tax rate and you increase what economists call the hurdle rate for new ventures, namely the rate of return a new venture must yield to entice investors to put capital into the project. As the hurdle rate rises, fewer new projects can successfully get over it; fewer new ventures are undertaken, fewer jobs are created and revenues, in most cases, end up lower than they were before the capital gains tax was raised.

Krugman would call this voodoo economics, but listen to what his hero, John Maynard Keynes said, "Nor shall the argument seem strange, that taxation would be so high as to defeat its object and that given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. To take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price. And when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, he decides that prudence requires him to raise the price still more. And who, when at last, his account is balanced with naught on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss."

The evidence indicates that this is precisely what happened when President Bush convinced Congress to cut the tax rate on dividends and capital gains and to allow small businesses to recover their capital investments quicker by writing them off in a shorter period of time.
Revenues continue to pour into the U.S. Treasury so fast the Congressional Budget Office projects that if the tax cuts are left in place permanently, the budget will be balanced within a few years, and revenues as a share of Gross Domestic Product will remain pretty much where they have stayed since the end of World War II, right about 18.5 percent of GDP.