How Capitalism Will Save Us (31 page)

He concludes, “I have to say that I do feel, often, that the sensual enjoyment of our lives, the fact that we have no consumer debt and an emergency fund, and the time we can spend with our kids, raises our quality of life well above that enjoyed by most people making a little above $40,000 a year. I FEEL rich.”
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N
o one doubts that we need government for essential services such as ensuring law and order, providing a national defense, providing disaster relief, and building and maintaining roads and highways, among other functions. But to pay for government, you need a healthy, growing economy. Excessive taxes defeat this objective by slapping an enormous financial penalty on work and enterprise. This penalty is even higher than most people realize. On top of what you or your business pays the government, there’s the additional cost of compliance—the thousands of dollars spent on accounting and sometimes legal fees, not to mention the hundreds of hours you spend gathering data and filling out your returns
and other records—the W-2s, 1099s, and so on. In 2004, the Office of Management and Budget estimated the cost of the nation’s total tax compliance to be some $200 billion.
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Billions of dollars in money and human resources are wasted on taxes and tax compliance that could have gone into launching or expanding business-creating jobs. Taxes also end up making economic transactions more expensive. So what happens? Fewer of them take place. That’s why high taxes sooner or later produce a stagnant economy, with fewer and poorer taxpayers who generate less money for government coffers.

Politicians love to talk about taxes being an “investment” in society. Sometimes taxes are supposed to be a way of “protecting jobs”—as in the case of tariffs on imports. Other times they’re proposed as a way of encouraging what certain groups deem to be “desirable” behavior—for example, so-called obesity taxes discouraging consumption of sugary foods and beverages. Proponents of these taxes often don’t understand that markets are millions of people expressing their desires. Trying to control their behavior through what is basically a coercive measure usually backfires.

No matter how they’re sold to the public, taxes rarely produce the market outcome their advocates want. As Andrew Chamberlain, Gerald Prante, and Patrick Fleenor of the Tax Foundation explain, taxes tend to produce unexpected economic effects:

Economists teach that, in general, taxes do not stay where lawmakers put them. Instead, some portion of taxes are generally shifted onto others.
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For this reason, taxes intended to protect the economy almost always do just the opposite—they kill jobs. The classic example, mentioned in
chapter 2
: the devastating Great Depression that ensued after the Smoot-Hawley Tariff slapped oppressive taxes on imports.

Smoot-Hawley was supposed to help preserve American jobs by making a vast array of imported products more expensive. What it produced was a trade war that made countless products unaffordable. Consumers simply stopped buying. Manufacturers had to cut back on employment. Millions of jobs were destroyed. Profits shriveled and investment capital dried up, undermining banks and precipitating the economic slump. The massive tax increases enacted in 1932 in the name of balancing the
budget crushed an enfeebled economy and made the Great Depression even worse.

Taxes also helped create the infamous economic “malaise” of the 1970s. The Great Inflation of that decade pushed up salaries, forcing people into higher tax brackets. What did Congress do? It squeezed people and businesses further by, among other things, substantially boosting the capital gains tax. Would-be ventures couldn’t get financing. Productivity fell. A family making $18,000 a year in 1979 was less well off than a family that had made $7,000 in 1968.

When tax rates are cut, however, the opposite takes place: the economy booms. Tax revenues grow. This has happened after every major tax cut in the last eighty-five years. Economist Arthur Laffer explained this continuum effect in the 1970s using what came to be known as the “Laffer curve.” Higher taxes may initially increase government revenues. But they retard economic growth.

A classic case was the Clinton tax increases of 1993. They cut in half the 5 percent growth rate the economy had achieved by the end of 1992. This slowdown—combined with a rejection of Clinton’s proposed plan for national health care—helped defeat the Democrats in 1994. With the Republicans in charge of Congress, the capital gains tax was slashed by 29 percent. The capital gains levy on people’s primary residences was virtually eliminated; new taxes on the then-emerging Internet were barred. Welfare was also reformed and the growth of government spending was curtailed. The tax reductions, combined with slower spending, set the stage for a boom decade.

Would-be tax hikers forget that high tax rates hinder productive work, risk taking, and capital formation. That means a slower-growing economy generating less government revenue than it otherwise would have. But when tax rates are cut, more economic activity produces more tax revenues.

To observe the beneficial impact of tax cuts on the economy, all you have to do is look at history. In 1921, when President Warren Harding took office, the nation was in a depression, the result of the Federal Reserve raising interest rates to fight the inflation triggered by World War I. Unemployment had reached 13 percent.

Harding’s plan for a “return to normalcy” included a major income-tax cut. After his untimely death from food poisoning, his successor,
Calvin Coolidge, pushed through additional tax cuts. The result: the Roaring Twenties. The federal budget surged into surplus. Increased revenues plus spending restraints saw the national debt shrink by one third. Real GDP growth went from 2 percent to 3.4 percent.

John F. Kennedy’s proposed income-tax cuts, enacted in 1964, had much the same effect: real income-tax revenue growth surged from 2.6 percent to 9 percent. GDP growth increased to a robust 5.1 percent. Same for the Reagan tax cuts legislated in 1981: income-tax revenue, which had been shrinking by 2.6 percent a year, grew by a robust 3.5 percent. Real GDP growth soared from 0.9 percent to 4.8 percent, ushering in an era of prosperity that lasted almost three decades.

Not all tax cuts, however, are created equal. Some officeholders seeking political credit for cutting taxes will attempt to portray nominal rate cuts or rebates as Kennedy- or Reaganesque tax reduction. But these onetime gimmicks do not have the effects of substantial, across-the-board cuts in rates. The Bush tax cuts of 2001, for example, were largely useless. The tax rebates provided a small, one-shot boost to the economy and then fizzled, as rebates always do. The rate cuts that were enacted were phased in over so many years that their initial impact was virtually nil. The result: the economy treaded water in 2001 and 2002.

However, the Bush administration did get it right with its second round of tax cuts in 2003. Income-tax rates were reduced by an average of 10 percent. The capital gains levy was slashed; the personal income tax on dividends was meat-axed over 60 percent, from almost 40 percent to 15 percent. Small businesses were given incentives for investment by being allowed to write off capital expenditures of up to $100,000 immediately, instead of over several years. The economy bloomed.

The consistently salutary effects of tax cuts on the economy have been documented in a powerful study by Christina Romer, now chair of President Obama’s Council of Economic Advisers. She and her husband, UC Berkeley economist David Romer, studied all federal tax cuts and tax increases from 1947 to 2005. They found that tax cuts have a direct and pronounced impact on our economic output. A tax cut of 1 percent will increase GDP by about 3 percent.
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The real issue is not whether we should have high taxes or have no taxes. It is what level of taxation is necessary to fund essential services while enabling society to grow at its full potential. A 2009 annual poll by
the Tax Foundation showed that Americans, on average, believe taxes should be only around 16 percent of their income.
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Unfortunately, we’re a long way from that.

Taxes don’t just stifle economic activity. They’re used by politicians to influence behavior that might otherwise be considered beyond the reach of government. Political debates over taxes frequently center on whether or not to impose a particular incentive—say, a tax credit for “caregiving” or for hiring American citizens. Libertarians like Yaron Brook, president of the Ayn Rand Institute, question whether the government should really be in the business of using taxes to influence what are essentially personal decisions: