Do tax hikes fix budgets?

JULY 21, 2010

By JOHN SEILER

The U.S. and California economies continue to struggle to push up from the Great Recession. Even as revenues at all levels of government have been hit hard, businesses and citizens complain that, even if they have jobs, they’re finding it hard to make ends meet. In particular, last year’s $13 billion California state tax increases still are digging in, and well could be extended in whole or in part to close this year’s $19 billion state budget gap.

Is the solution, then, tax cuts that could spur economic growth at the state and national level? And would such growth be enough to expand the tax base enough make up for lost tax revenues from the cuts themselves?

A new report by the California Budget Project concludes that the answer is: No. The study is entitled: “No Free Lunch: Tax Cuts Widen Budget Gaps.” Although the study doesn’t note it, the title is a reference to the phrase, “There ain’t no such thing as a free lunch,” which dates back at least 80 years, and sometimes is referred to as its acronym, TANSTAAFL. It was made popular in libertarian science fiction writer Robert Heinlein’s 1966 book, “The Moon is a Harsh Mistress.” And by Nobel economics laureate Milton Friedman, who named the title of his book collecting Newsweek columns, “There’s No Such Thing as a Free Lunch,” straightening out the grammar.

The point is that you don’t get something for nothing. That you have to pay for what you get.

The CBP study contends:

A longstanding myth about taxes has resurfaced in the policy debates around California’s dual budget and economic crises. Some proponents of tax cuts argue that reducing taxes could spur economic growth and cause a net increase in state tax revenues. Some even claim that the revenue gain from cutting taxes would be sufficient to put an end to California’s budget problems. These claims fail to hold up under scrutiny.

Although the phrase is only mentioned in the study’s Footnote No. 19, this all really is about what’s called “supply-side” economics. Based in classical economics, especially Say’s Law, in the past half century this school of economics was developed by several economists, the main ones being Robert Mundell, a Nobel economics laureate, and Arthur Laffer, who helped devise both Ronald Reagan’s tax cuts and the 1978 Proposition 13 tax cuts here in California. Another major contributor was the late journalist Jude Wanniski.

Most schools of economics, including Friedman’s monetarism and the Keynesianism popular with the Obama administration (and the George H. Bush administration in its later years), emphasize the demand side of the supply-and-demand equation. During a recession, Keynesianism especially tries to stimulate demand through such things as deficit spending and increasing the money supply, as we have seen in the latter Bush years and in President Obama’s first two years. It emphasizes people and businesses first as consumers.

By contrast, supply-side economics emphasizes supply. It looks at people and businesses first as suppliers of goods. Perhaps producers of goods might be a better way to look at it. All people produce, the supply-siders insist, so the way to prosperity is to encourage production through low tariffs, stable money and reasonable taxation.

The Laffer Curve

Supply-siders popularized what’s called the Laffer Curve, shown below:

Named after economist Arthur Laffer, who first drew it, the curve is basically the law of diminishing returns applied to taxation. Although people have critiqued it, and the CBP study does so implicitly, it really is just common sense. At the right side of the curve, the tax rate is 100 percent. At that level, no one would work at all. So, despite the 100 percent tax rate, nothing is collected.

If you move a little to the left on the curve, such as with the 91 percent top income tax rate in America before 1964, then some taxes are collected. But for wealthy people, the main activity is finding ways to avoid taxes. The Beatles actually recorded a song, “Taxman,” attacking Britain’s 95 percent tax rate of 1966. After that, some of the Beatles, the Rolling Stones and other wealthy Britons left for lower-tax countries. The government of Britain then got little in taxation from them, despite the 95 percent rate.

In the middle of the Laffer Curve is the area that optimizes both tax rates and the collection of tax revenues. This can only be discovered through empirical observation of how taxes actually operate in a country or state. According to Laffer, ideally all federal taxes should be replaced with a 15 percent flat income tax and a 3 percent Value Added Tax. And for California he calls for replacing all state taxes with a flat income tax of between 6.4 and 6.9 percent, as I detailed in an article here on CalWatchDog.com.

The point is that taxes, at some level, actually become so high that they reduce revenue. Which means that cutting them would raise revenue – a seeming paradox, but one that was just explained. For further confirmation, consider what would happen if California quadrupled its income tax rates – raising the current top rate of 10.55 percent to  42.2 percent. That would be higher even than the current top federal rate of 35 percent.

Would you get four times as much revenue for the California treasury? If you answered “No,” then you are at least a little bit of a supply-sider.

Of course, supply-siders concede that, if you cut taxes too much, revenues will also decrease. That’s shown on the left side of the Laffer Curve. In that case, you will have to run deficits or cut spending. (Deficits also can result if spending increases faster than revenues.)

If an optimal tax rate is achieved, then the economy will grow faster, bringing up the tax base along with it. So long as the tax base rises, then tax revenues also will increase, even though tax rates remain low. For example, a 1 percent tax on a $1 million economy would produce $10,000 in revenue. If that’s a rate that allows the doubling of an economy in 10 years, then the economy would grow to $2 million; and tax revenues would grow apace, to $20,000. Even though the tax rate remained exactly the same, at 1 percent.

So, the supply-siders’ message on tax rates is simple: If you want to increase tax revenues, implement an optimal tax rate. That may mean raising the rate, or cutting it. In modern times, it usually means cutting it.

Historical examples

The CBP study includes several historical examples, both national and state. It contends:

National data point to a similar conclusion. Average annual growth in inflation-adjusted gross domestic product (GDP) – the value of all goods and services produced in the US – was weaker in the seven years following the massive federal tax cuts enacted in 1981 and 2001 than the significant federal tax increases enacted in 1993.

The footnote cites “Michael Ettlinger and John Irons, Take a Walk on the Supply Side: Tax Cuts on Profits, Savings, and the Wealthy Fail To Spur Economic Growth (Center for American Progress and Economic Policy Institute: September 2008).” The footnote says that the seven-year periods under review are optimal “because it was the longest period of time possible that would not overlap one of the other tax changes examined.”

But the data set is flawed. Although the Reagan tax cuts were enacted in 1981, they were fully implemented only in 1983. The first two years, 1981 and 1982, were at Jimmy Carter-level taxation. Laffer actually explained what happened in a June 6, 2010 article in the Wall Street Journal:

In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.

But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don’t work until they take effect.

In the event, the economy didn’t stop growing until President George H.W. Bush increased taxes in 1990.

As to President Clinton, the CPB is not factoring that, although Clinton raised taxes in 1993, he cut taxes a roughly equivalent amount in 1997 and 2000, as explained here. Both were capital gains tax cuts. The cut in 1997 dropped the top capital gains tax rate from 28 percent to 20 percent. That spurred the dot-com boom, much as a similar capital gains tax cut in 1978 spurred the early microcomputer boom for Apple, Intel and hundreds of other companies.

But will they stay?

The CBP study contends:

Even if reducing taxes boosts economic growth, at least some of that growth is likely to occur in other states or countries. This means that only part of each dollar of revenues California would lose due to a tax cut would be returned to the state’s economy. For example, if California cut corporate income taxes:

• Businesses would likely use some of the additional money freed up by the tax cut to buy supplies or equipment made in other states or countries;

• Companies might expand operations outside of California, in which case the jobs created as a result of California’s tax cut would accrue in other regions of the US or the world….

This is an oddly protectionist view coming at a time when neither major party, nor any major economic theory (such as those mentioned above), is protectionist. All understand that prosperity depends on each area optimizing its own “comparative advantage.”

But the real question is: Will companies continue to put up with continuous high taxes, or move to areas with lower taxes, such as the zero-state-income-tax states of Texas, Nevada and Washington.

I talked to Joe Vranich, the Business Relocation Coach, whose Web site lists firms that are exiting California. He wrote there on July 15:

In the last two days California has lost three company headquarters – Globalstar, Inc. will depart Milpitas for Louisiana, eEye of Irvine will move to Arizona, and TriZetto Group will leave Newport Beach for Colorado – which means this year we are seeing a stunning increase in company disinvestments in California.

In just the first half of the year, there have been 84 such events, nearly double what occurred through all of 2009. An “event” includes instances where companies have closed factories down, moved their headquarters or facilities to another state or country, or targeted locations elsewhere as better places to grow and therefore sent billions of dollars in capital out of state or out of the country.

Would tax cuts help stanch the hemorrhaging of businesses and jobs from California? “Tax cuts would help businesses as they compete against lower-taxed companies in other states and other nations,” he told me.

Would tax cuts encourage businesses to stay here? “Absolutely. We ought to look at cuts across the board from corporate income taxes to the gasoline tax to inventory taxes and let’s be sure to reduce the awful city tax rates in places like Los Angeles, a city run so badly that I’ve heard business people refer to it as a banana republic.”

But, he added, it’s not just taxes, but “other factors are at play, too. Besides taxes are quality of life issues like good schools, good roads and low crime — California no longer wins any prizes on those scores. And for every safe community there is, like Irvine, there are huge swaths of unsafe territories like big sections of Los Angeles.”

A similar view came from Jonathan Williams, director of the Tax and Fiscal Policy Task Force at the American Legislative Exchange Council. I reviewed the group’s study, Rich States, Poor States: The ALEC-Laffer Economic Competitiveness Index, back in April. He told me of the CBP study:

I did have a chance to read their (flawed) analysis. They do admit that California has high costs of doing business within the state, but they attempt to rationalize it with the stale arguments that high government spending somehow makes up for it. Basically they are saying taxes don’t matter. If that were true, states could double taxes without consequence, if they “invest” the revenue into services. However, this view is totally detached from history. Our “Rich States, Poor States” publication clearly lays out how much taxes matter. Today’s growth states have competitive tax rates. Unless California legislators are comfortable with an unemployment rate near Michigan’s, they need to reform their tax system so that it will foster competitiveness and job creation.

You can have the best roads and a well-funded education system, but if a state neglects their business tax climate, those well educated residents will use the well paved roads and leave the state in search of jobs.

California’s tax increases – and cuts

The CBP study wrote:

In the debate around how to spur California’s economy in the early 1990s, tax-cut proponents argued that traditional “static” analyses – which look at only the direct revenue impact of tax changes – were inadequate and that a “dynamic” approach, incorporating the effects of tax cuts on the broader economy, was needed. In response, California enacted legislation requiring the Department of Finance (DOF) to conduct dynamic revenue analyses to evaluate proposed tax policy changes with significant direct revenue impacts….

The DOF’s dynamic analyses provided “no evidence … that tax rate reductions … can in general ‘pay for themselves,’ as some parties in the past claimed.” (12) Instead, the DOF found that tax cuts would only modestly offset a portion of their direct revenue loss.

The note No. 12 referenced was to  “Jon David Vasché, ‘Whatever Happened to Dynamic Revenue Analysis in California?’ (prepared for the Annual Revenue Estimation and Tax Research Conference, Federation of Tax Administrators: September 17-20, 2006), p. 12.” I dug out that report on the Internet. Vasché did find the conclusion quoted by CBP. But he also found:

California’s experience with dynamic revenue estimating yields a mixed picture. As noted in Figure 5, dynamic estimating has provided California with new and useful insights and qualitative information regarding how tax changes affect the state’s economy and the revenues that it produces. On the other hand, dynamic state revenue models inherently face many data and specification problems which make their quantitative outputs subject to limitation, some debate, and very sensitive to their underlying assumptions….

The CGE model’s results are very sensitive to the values used for many of the various elasticities contained in it, especially those relating to such things as population migration and trade flows. Because the true values of these elasticities are often not know with certainty, especially at the state level, educated guesses and assumptions about them often have to be made, and errors in this regard can significantly reduce the model’s reliability.

However, the key thing is that dynamic revenue estimating is done with a computer model. And that model, as Vasché points out, is done programmed with “educated guesses and assumptions.” Moreover, the estimating was mandated by state law only in 1994, and that law expired in 2000.

But we don’t need a computer model to see what happens. We have the actual history of tax cuts and increases in California.

Recent tax cuts and increases

The numbers are in Schedule 6 of the Governor’s Budget Summary 2010-11, Page Appendix 13.

In 1991, Gov. Pete Wilson increased taxes a then-record $7 billion. Here are the resulting tax revenues:

Revenues Fiscal Year

$42,026  –  1991-92
$40,946  –  1992-93
$40,095  –  1993-94
$42,710  –  1994-95
$46,296  –  1995-96

So, we see that, after the tax increases were imposed, state revenues dropped by $2 billion. It’s worth noting that this was a time when the country was recovering from the 1990-01 recession, so revenues should have increased. But California’s economy remained mired in a recession. As I have noted in a previous CalWatchDog.com piece, during this period of the Wilson tax increase, unemployment in California also shot up above the national average.

Clearly, the intended revenues didn’t arrive.

But let’s look at the other side of the equation in the CBP study: Do tax cuts increase revenues? I remember at the time in 1994, state Sen. Rob Hurtt predicted that, when the temporary Wilson tax increases ended in 1995, California would finally recover from the recession, and revenues would growth. (Unfortunately, Hurtt’s office told me that he no longer talks about politics.)

In the budget numbers just cited, look at fiscal 1994-95: revenues grew by a hearty $2.6 billion in one fiscal year, to $42.7 billion, as the tax increases faded away. The next year, fiscal 1995-96, saw revenues grow another $3.6 billion, to $46.3 billion.

Clearly, tax cuts increased revenues. And as I noted in the unemployment piece, the Jobs Gap with the rest of the nation also declined, as businesses expanded and hired new workers.

The 2009 tax increases

In February 2009, Gov. Arnold Schwarzenegger increased taxes a record $13 billion, supposedly to close the budget deficit of a record $42 billion. However, a year and a half later, the budget deficit remains at $19 billion. And the governor and Legislature are at an impasse about passing a budget for fiscal 2010-11, even though the fiscal year actually began on July 1.

Preliminary numbers from the governor’s May Revise of the budget show, however, that the tax increases have increased revenues, at least so far:

Revenues Fiscal Year

$82,722  –  2008-09
$86,521  –  2009-10
$91,451  –  2010-11 (projected)

So in that case, the CBP thesis may be partly right about increased revenues. But the budget remained unbalanced. The projected 2010-11 increase in revenue increases occur after the tax increases are anticipated to lapse. And California unemployment today remains 2.4 percentage points above the national average, indicating the state’s economy still is struggling.

The last number, for fiscal 2010-11, also is a projection for an economic future that assumes continued national economic recovery. If, as I warned in a previous CalWatchDog.com article, “Another economic dip coming?”, the recession returns, then all bets are off.

Moreover, at the national level, the end of many of President Bush’s tax cuts in 2011– meaning taxes will rise sharply – will be another test case of the CBP thesis. Again, if the national tax increases spark a return of recession, then national tax revenues will drop.

Next year will be more than interesting for both California and America.

John Seiler, an editorial writer with The Orange County Register for 19 years, is a reporter and analyst for CalWatchDog.com. His email: [email protected].