Tax Rates are a Red Herring

Constantly, you hear politicians, on both sides of the isle arguing about tax rates.  Specifically, you hear folks talking about the need to raise taxes to pay down the debt.  Unfortunately, it is a red herring.  

If you look at the charts in my previous posts, tax revenue tracks GDP very closely.  Both tax revenue and GDP are nearly linear over the last hundred years.  However, during this same period the top tax brackets were going down.  Based on what is in the media, how is it possible that net tax revenue is uneffected by tax rates?  Simply, the GDP, and the value of the dollar, have a much larger impact on net receipts. 

If the only factors that increase tax revenue is GDP, then the government policy should be to use any lever possible to increase GDP.  Unfortunately, as the graphs show, tax rates do not increase the GDP (in some ways, it appears they have no effect or a counter effect on GDP).  If they have no effect, then it seems pointless to squeeze tax payers for more money and better to allow them to spend it in investment (GDP altering) activities.

The Facts on Tax Rates, GDP, and Tax Revenue

In the current budget debate, two proposals have been offered to solve the current debt crisis.  One plan, attempts to reduce the debt and achieve a balanced budget through spending cuts and lower taxes.  The other, attempts to do the same by freezing spending levels and raising effective tax rates. In the interest of differentiating these plans, this article shows historical effective tax rates and their relationship to both the federal tax revenue and the national GDP. 

GDP per capita is often used as a measure of standard of living.  While it is not the most accurate metric for standard of living, it is measured consistently and has a long history.  As a result, it is effective for showing trends in standard of living.  Tax revenue is likely more relevant to this particular discussion since increased revenues will dig us out of debt faster.

First, if you are confused about the terms, please see my pages on GDP, Tax Revenue, CPI, Inflation, and Effective Tax Rates for more information. 

The following chart shows the effective tax rates for all tax brackets extending back to 1913:

The numbers in the chart have been adjusted for inflation using the value of the dollar in 2010 according to CPI. Since data is not available showing changes in the average amount of deductions, I have excluded deductions from the charts. So, consider the income levels represented in the charts to be after deductions.

In order to capture the highest tax brackets from the 30s, 40s, and 50s, an individual would need to be earning in excess of $18,000,000 in 2010. As an interesting aside, there were as many as 24 tax brackets during that time. In the chart, above all income brackets were included.  In the chart below, only "middle class" and "lower class" (as defined by the current administration at $250,000 and below) income brackets are used.

Looking at the charts, it is clear that individual income tax rates have been on the decline since their high at the end of the Roosevelt administration. Interestingly, total tax revenue (adjusted for both population and inflation) has been moving up this entire time. There have been several tax increases, through the years, that have created a short term increase in tax revenue. However, the long term trends show that as tax rates go down, tax revenues go up (at least to a point - see pre 1930). This is consistent with the economic theory know as the "Laffer curve".

The "Laffer curve" theory, named for American economist Arthur Laffer,  states that there is a tax level beyond which total tax revenue will fall as taxes increase.  It further theorizes that this maximum tax rate level may be impacted by a cost limit on what is affordable, and increase in tax evasion, and a shrinking of business caused by increased taxes. Laffer does not specify at what levels this effect would occur.  However, the following illustration demonstrates the concept:

Again, examining the charts, it is clear that GDP per Capita follows the same trend as tax revenue.  This makes sense. As individual productivity increases (GDP per capita) the associated tax revenue should also increase. GDP is not as vulnerable to policy changes.  As a result, it tends to follow a "smoother" line as compared to tax revenue.   Tax revenue, however, is more sensitive to policy changes.  So, it reflects policy changes that may create temporary deviations. In general, GDP is a better reflection on the economy as a whole.  However, tax revenue better reflects the localized impacts that policy changes create.

Individual income taxes are not the only taxes that impact tax receipts and GDP.  The following chart from VisualizingEconomics.com illustrates declining tax rates for corporate and capital gains while putting the entire period in more context:

In general, the above data shows that tax revenues, adjusted for both inflation and population growth, have been increasing while effective tax rates have been decreasing.  At the same time (from my article on medicare spending growth) government spending has been increasing at near the rate of GDP.  

As a country, we have to decide if we have a revenue or a spending problem.  If you are interested in reducing the country's debt to manageable levels, have to ask yourself the following:

• If tax revenues have been increasing at a rate near GDP 
• And government spending has been increasing at a rate near GDP
• And tax revenues increase with a falling tax rate (above 1920 levels)
• Then does it make since to: 
  1. Make significant spending cuts (to 2008 levels - $458 billion deficit/yr) and cut effective tax rates
  2. Or, freeze current spending levels ($1293 billion deficit/yr) and increase effective tax rates to resolve the current debt?

If it was your bank account, which path would you choose? Why?

As always, please leave comments.  I am interested in how others interpret the data and any errors or omissions that I may have made.

House Voting Today on Ryan's Plan

The U.S. House is preparing to approve Republican Budget Committee Chairman Paul Ryan’s proposal for deep spending cuts and an overhaul of Medicare, a move that will help defineWashington’s debate on finances in next year’s election campaigns.

Bloomberg

Obama Proposal Roundup

Yesterday, President Obama described his updated budget proposal. In it, President Obama outlined, in broad strokes, his perspective on how the government needs to change to address our country's fiscal woes.

Reform should protect the middle class, promote economic growth, and build on the fiscal commission’s model of reducing tax expenditures so that there is enough savings to both lower rates and lower the deficit 

Bloomberg

He hopes to acheive a $4 trillion dollar savings, over 12 years, by raising taxes on the wealthy and reforming the tax code to reduce the number of deductions available to individuals and businesses.  While he has not released any specifics outlining exactly what changes he would make, the net result would likely be a lower tax rate, but with individuals and businesses paying more in total tax dollars - effectively a tax increase.  He is also proposing a series of modest cuts to mandatory spending programs.  While he was not specific on the cuts, there are some hints as to what he has in mind.

Rather than reducing the Pentagon's budget, the president wants to hold growth below inflation, which could reduce the budget by $400 billion on an adjusted basis, the research firm said Wednesday. A portion of this is also expected to come from continued efficiency savings, and from capability adjustments, such as reducing the size of the Army and USMC posts in Afghanistan.

MarketWatch

Obama's new plan doesn't name programs or services to be cut, but calls for a reduction of more than $1 trillion in non-security spending over 12 years.

Discretionary accounts, which require annual funding from Congress, will be hardest hit. Obama would reduce spending in that small part of the budget by a total of $770 billion. An additional $360 billion would be stripped from mandatory accounts.

CNN

While most are reserving judgement until specifics are revealed, the speach was noted to be very partisan and setup a heated battle bewteen Democrats and Replublicans. Paul Ryan spoke about both his expectations going in and his disappointment afterwards:

"I was excited when we got invited to attend his speech today," Ryan said after Obama's appearance. "I thought the president's invitation of Mr. Camp, Mr. Hensarling and myself was an olive branch. Instead, what we got was a speech that was excessively partisan, dramatically inaccurate and hopelessly inadequate to addressing our country's pressing fiscal challenges."

"What we heard today was not fiscal leadership from our commander in chief," Ryan said. "What we heard today was a political broadside from our campaigner in chief."

Obama's spending plans are "a doubling down on a failed politics of the past," Ryan said.

USA Today

In fact, Dallas Rep. Jeb Hensarling called it "a new standard for class warfare." (Dallas News).  CNN's Laurence J. Kotlikoff claims that it is more "kick the can down the road" in his reaction.

Indeed, when it came to describing how he would fix federal health care spending, Obama stayed pretty close to his budget document in which he said that Medicare and Medicaid costs would come down because they'd come down and, if they didn't, a panel of experts would tell Congress to lower them.

Give us a break.

CNN

Newt Gingrinch "blasted a budget address by President Barack Obama calling it a job-killer and not a serious proposal:

"To propose some $2 trillion worth of tax increases in an economy such as this is to claim the Herbert Hoover award," Gingrich said. Hoover was president when the Great Depression began. 

AP

The Washington Post's Dana Milbank thinks that it will have a hard time being passed.

Ellison and the progressives probably would have a better chance of influencing the weather than they would passing their budget, which they are floating as an alternative to the House Republican bid and President Obama’s plan.

Washington Post

It will be interesting to see the detail of the proposal.  There are some positive ideas.  Mandatory and automatic spending reductions if certain budget to GDP ratios are not acheived is not a bad idea for capping government spending.  In general, though, the idea of pegging spending to current levels (which are already running a 1.65 trillion dollar defecit) while raising taxes to make up the difference seems to be a non starter among the public. Consistently, the public seems to be asking for a balanced budget one way or another.  Continuing deficit spending practices while raising taxes to cover the shortfall appears to strike most as "kicking the can down the road".

Budget Breakdown: The Facts on Medicare, Part 1

The Medicare/Medicaid portion of the federal budget has recently gained a sharp public focus.  Budget chairman, Paul Ryan, in his Path to Properity plan, identified Medicare and Medicaid as key components to getting the federal budget, and subsequently the national debt, under control.  

In the interest of understanding the details, let's dig into the Medical care budget. The following graph represents the federal government's "medical care" budget over the last ten years and for the next 6 years.  

The data comes from The White House and represents historical data and the government's best estimate of future expenditures. In these numbers, all "medical care" expenses in the federal budget are listed.  See the legend for a full list. The medicare portion is divided into hospital insurance and suplementary medical insurance. 

 

By breaking the chart into historical and projected, you can see that from 2000 to 2010 that the growth of government medical expenses was linear.  The projections, however, show an x^2 growth.  It's hard to understate the size of the projected acceleration.  In fact, if you fit a curve to the growth from 2000 into the projected years we are actually growing at an exponential rate.  

In 2010, the us government spends $865 billion on medical care.  That's 5.1% of the nation's GDP and 22.9% of the federal budget. Using the curves calculated in the chart above, medical expenditures in 2020 will be $1.8 trillion.  Using a simlar mechanism for projecting GDP and the federal budget, that will be 7% of GDP and 30% of the budget.  If you look out to 2038, the government spends $6.8 trillion at 11.2% of GDP and 47.86% of the budget. 

For reference, the several applicable metrics have been overlayed onto the medical care budget in the chart below: 

Note that the overlay is not scaled to proportion in terms of dollars.  It is, however, accurate from a trend perspective (slope of the curve).

It's interesting to note that the expansion in federal medical care expenditures represented by the 2011-2016 projections do not correlate well with inflation, medical inflation, or population growth.  Instead, the correlation appears strong both debt and gdp.  

There are a few questions apparent in the data.

• How are the projections done?  
• What factors influence the growth that the government is expecting in medical care costs?  
• Is the exponential growth solely an reflection of the new health care laws?  
• If so, are there similar projections showing medical cost inflation (as measured in CPI) dropping at a similar rate to acheive a net reduction to tax payers?

One thing is clear from the numbers.  Something must change.  At the current growth rate, the increase in government medical care expenses will exceed the capacity of the government to cover costs.  The choice that is facing us is whether that occurs by raising taxes, by making the agencies more efficient, by reducing medical costs, or by continuing to sell debt to fund it.  More than likely, it is some combination of things.  Either way, radical change will be necessary to resolve the costs going forward. 

In the next article, we will try to dig deeper into the numbers to understand better how they relate to cost and how the different plans impact the big picture.

Please leave comments below if you find errors or have questions.