Should We Raise Taxes to Balance the Budget?

with 3 Comments

Should We Raise Taxes to Balance the Budget?

The only two ways to balance the federal budget are to spend less or to collect more. Spending less is the preferred method, but that is just not happening. As a result, politics is pushing many in Congress to try to balance the budget by raising taxes.

The problem with raising the top marginal rate is that people will lose incentive to take on the challenge of starting and running a business. Every business venture needs a significant expected return on investment to justify the risks involved in investing. High taxes reduce the return on investment. This discourages entrepreneurs from attempting any additional business ventures that will push them into the higher tax brackets.

Some argue that America has one of the lowest tax rates in the developed world relative to many European countries and Japan. As a result, they claim we can afford to raise taxes. However, they must concede that America has also had one of the higher rates of growth of gross domestic product (GDP). The traditional 6.5% GDP growth has been dubbed the “American style of growth” as opposed to the current 2 to 3% European malaise.

Supply-side economists suggest that high top marginal tax rates are a major disincentive to GDP growth and consequently predictive of a country’s economic health. This would imply that low tax rates should be a priority in any country hoping to inspire productivity.

When the income of our clients is subject to a higher marginal rate, little can be done to safeguard their expected returns. Any new business ventures that will be subject to yet higher marginal tax rates will have a lower return on investment. Thus many highly productive clients decide to stop taking on new business ventures as they approach the higher tax brackets. Instead they opt for less risk, less taxes and less time spent working.

But unfortunately for the nation, highly productive people generate most of the nation’s employment, tax revenues and growth of GDP. If they stop being productive, all three suffer.

Because raising taxes diminishes productivity that in turn reduces tax revenue, raising taxes doesn’t help balancing the budget in the long run.

As a result, balancing the budget is a challenging political task. Liberals won’t let us spend less, and raising taxes is more likely to hurt than help us in the long run. The only choice left is to deficit spend.

Although deficit spending does have negative economic effects, they are not as severe as the unemployment and slower economic growth that result from a highly progressive tax structure.

The most obvious effect of deficit spending is the accompanying inflation. To understand where this inflation comes from, imagine how the government could solve its deficit problem.

One way is simply to add $17 trillion to the electronic version of the federal bank accounts, the equivalent of printing money. This solves the deficit without discouraging those who are highly productive but also massively devalues our currency. If the government did this, it would in effect just be taxing wealth held in dollars rather than productivity.

This effect discourages individuals from holding wealth in dollars. However, this change in behavior has a smaller negative effect on economic growth than individuals trying to avoid an income tax.

Because it is easier to guard wealthy clients against inflation than shield productive clients from excessive income taxes, an income tax is more economically destructive.

So it is not surprising that conservatives both want to balance the budget by reducing spending and yet prefer spending deficits to raising taxes. This perspective is in line with what supply-side economics suggests is best for a country’s long-term growth.

We would do well to keep supply-side economics in mind when addressing our current budget crisis. Low tax rates should be our first priority, with a balanced budget only our second. Taxes matter, and striving to keep them low is important. But if taxes must be raised, there are less economically destructive taxes than the top marginal income tax rate.

Photo by Madeleine_H and used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.

3 Responses

  1. Luis

    Here is a link explaining how tax cuts at top rates do not increase GDP as expected. The article is backed with official data in demonstrating its case.

    • Megan Russell

      Your article seems to say that tax cuts do not increase tax revenue and has little to do with tax cuts effect on GDP. The article you cite attacks the claim that “the near-doubling of revenues during Reagan’s two terms proves the value of tax cuts” and suggests that there is a correlation between “lower taxes and lower revenues, not higher revenues as suggested by supply-siders.”

      If you’re interested in debating the effect on tax revenue, here are three articles evaluating the effect of tax cuts on tax revenue:
      1. Should We Starve the Beast? shows that keeping revenue the same isn’t the goal of every tax cut. Sometimes, the goal of tax cuts is to reduce the size of government.
      2. On President Bush’s Economic Growth Tax Cut by Stephen Moore
      3. Lower Tax Rates Yielding More Tax Revenue by Daniel J. Mitchell on capital gains tax rates.
      He quotes the Wall Street Journal, which wrote, “CBO and Congress’s Joint Tax Committee originally estimated that reducing the capital gains rate to 15% from 20% would cost the Treasury $5.4 billion from 2003-2006. Whoops. Actual revenues exceeded expectations by 68%, creating a $133 billion revenue bonanza for the feds.”

      Regardless of the effect on tax revenue, there are several articles evaluating tax cuts at top rates effect on GDP both using the United States as well as other countries.

      My favorite example is the Heritage Foundation’s Index of Economic Freedom, which studies all the countries of the world, evaluating them on a wide variety of institutions that fiscally influence the nation. One of their factors is called Fiscal Freedom, which is “a measure of the tax burden imposed by government.”

      They as well as Organisation for Economic Co-operation and Development (OECD) found a “clear correlation between lower taxes and higher growth that data shows for the rich countries.” For poorer countries the correlation was not as clear, but Heritage analyst, Ambassador Terry Miller, evaluates just that in an article titled “To Render Unto Caesar: Tax Policy for Developing Countries.” He evaluates if the correlation between the tax burden and GDP growth rates holds for poorer African countries. He finds:

      The Heritage Foundation’s Index of Economic Freedom shows conclusively the link between economic freedom and economic growth. Vital components of the overall economic free­dom score are fiscal freedom, representing tax rates, and freedom from government, representing the percentage of economic activity for which the government is responsible.

      …Using our data from the Index of Economic Freedom, and excluding Equatorial Guinea and Chad, two countries whose high rates of oil-induced growth skew the results, we at The Heritage Foundation do find a clear correlation, but those of you who are statisticians can see from the low R-squared here that there is a lot more going on in the observed growth rates than just tax policy.

      Chart 3

      It appears that what government does and how it does it is far more significant than tax rates or the size of government in determining economic prosperity. On the other hand, higher government spending, while it might boost growth in the short run, seems to do so at the expense of long-term growth.

      He asked, based on the findings, what should these poor countries do? And answers:

      – Concentrate on what government should do rather than how big it should be. … It is not good public policy to tax the many to pay for benefits for the few.

      – Err on the side of too little taxation rather than too much. …

      – Pick a tax, any tax, and make adherence to it as simple and as widespread as possible. We’ve seen that every kind of tax poses problems of equity or efficiency, some more than others. We’ve also seen that there is no strong correlation between the amount of taxes and growth for poorer coun­tries. There is, however, a correlation between growth and tax friendliness–that is, the ease of compliance and simplicity. …A tax system that pro­motes the rule of law rather than evasion will have economic benefits far beyond any revenue that might be raised.

      All this would suggest that taxes are important factors of GDP growth rates, but that there are many institutional factors that play a role in this correlation. It is easy to see from this conclusion why the Index of Economic Freedom has ten factors instead of just one.

  2. Robert J. Castro

    There exists a third way. Increase the money multiplier | The only difference between BOOM ! & BUST !

    There should never e a need to increase the RATE of tax because it is imposed as a percentage of income. As an economy improves, unemployment declines, and incomes rise, a given RATE will supply the additional capital needed to carry the load…unless, of course. the mandate is to support a higher degree of Socialism (the antithesis of the American dream)…reward the underachievers at the expense of the overachievers. This is why ultimately, Socialism never works.