Progressive Tax Codes and Economic Growth: Fairness versus Efficiency (part 2 of 3)

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by Victor A. Canto, La Jolla Economics (Guest Contributor)

Progressivity and Economic Growth is a Tax Collector’s Best Friend

A summary of the tax brackets and the marginal tax rate for each bracket during the last decade each time we had a major revision in the definition of adjusted gross income is reported in Table 2. The highest and lowest tax rates have declined slightly over the time period. Now using the information combined with the data presented in Table 1, we can document the effects of bracket creep associated with the nominal GDP growth that has occurred during this time (i.e. the beta revenue elasticity in excess of 1). Bracket creep generated by the fluctuations of growth resulted in fluctuations in tax revenue collections in excess of the magnitude of the growth in the tax base, adjusted gross income.

Information on the distribution of returns, adjusted gross income and tax revenues across the different tax brackets is reported in Table 3. Looking across the table we can see that over the last decade the distribution of returns filed, the distribution of adjusted gross income and that of the tax revenues collections in the lowest and highest bracket has not changed much (see columns 2 through 4). For example the bottom bracket accounts for approximately 70 percent of the total returns, about a third of the adjusted gross income and less than a quarter of the tax revenues collections. The highest two tax brackets account for about 5 percent of the returns filed, about 20% to 25% of the adjusted gross income and up to 45% of the tax revenues collected. So in effect, the data replicates much of the information reported in the press about tax revenues collected from filers in the top 5% of the distribution as well as those on the bottom bracket.

One interesting detail evident from the data in Table 3 is the downward migration of people previously in the 28% tax bracket to the 25% tax bracket. A similar pattern can also be observed for the distribution of adjusted gross income (column 3). Looking at the data, it is apparent that given the positive GDP growth during the time in question such a shift is the result of the Bush tax rate cuts.

Looking at the tax revenues, we also see a different pattern. The share of the taxes paid by the two highest brackets steadily increases while that of the lower bracket steadily decreases. Notice also how the bulk of the taxes collected in the middle bracket move up to the next highest bracket. If that is not bracket creep we don’t know what is. Adding the top three brackets shows that a little over more than the top 5% of taxpayers account for better than 50% of tax revenues. Again if that is not progressivity, we don’t know what is.

A Rising Stock Market is also a Tax Collector’s Friend

Just as periods of fast economic growth lead to bracket creep and revenue gains above GDP growth rates, so do periods of rising stock markets. As shown in Table 4, periods of above average growth and a rising stock market lead to an abundance of capital gains while periods of declining stocks markets and slow economic growth lead to a shortage of capital gains. Notice that in a year following a strong stock market, the number of capital gains related returns and the taxes generated by capital gains as a percent of all returns rises dramatically. During years of single digit gains, years associated with strong economic growth also show that capital gains account for a significant, almost double digit share of the number of returns. Finally, years with little or no capital gains are associated with double digit declines in the market the prior year. The sole exception of this seems to be the year 2003. But recall that this was the year of the Bush tax rate cuts when capital gains and dividend tax rates were lowered to 15%. The lower rate on dividends reduced the need to create capital gains in order to reduce the tax liability of share holders. Dividends were taxed at the ordinary income rate prior to 2003. The reduction in both capital gains and dividends eased the unlocking of unrealized gains. The data for 2003 show that tax rate changes do alter economic behavior. At the very least they change the timing of capital gains realizations.

The Downside of Progressivity

Bracket creep affects every component of tax revenues. For example, the number of tax returns with adjusted gross income and/or capital gains are not invariant to the economic conditions. During periods of fast growth more people will have to report taxable income and capital gains, thus, moving from the non-tax rolls to the taxable income rolls, an extreme version of bracket creep while during periods of economic slowdowns and market declines, the opposite is true. Fluctuations in the stock market also have a visible impact on tax revenue collections.

In conclusion, prosperity and good times are one easy way to generate tax revenues. During the good times when GDP growth rates are high and positive, progressivity is great. Revenue elasticity or revenue beta in excess of one means that revenues grow faster than the overall economy’s growth. However, there is a downside to the high beta/elasticity of tax revenues. During economic and market slowdowns, revenues will decline faster than the economy. Bracket creep, like leverage works both ways. Tax payers creep up to higher brackets during periods of rapid growth and creep down during periods of economic decline.

The Alternatives to a Revenue Shortfall

Market declines and economic recession is one way to rapidly extinguish government revenue collections. And this brings us to the very critical issues of how to manage the volatility of revenues and how to determine the long term spending levels consistent with the tax revenue stream.

Spending alternatives: One possibility to consider is a balanced budget at all times. The downside of this alternative is that it ties spending to revenue collections and will result in a high beta spending strategy. Spending will increase as a share of GDP during periods of economic growth and will shrink during periods of economic slowdown. Clearly for Keynesians this will be an unacceptable spending policy. In order to manage the economy’s aggregate demand and to stabilize it along the long term “full potential output” trend, they would advocate the opposite: Higher spending during slowdowns and lower spending during faster growth periods. Keynesians argue for a negative beta or at the very least a beta lower than 1 for the public spending policy in relation to GDP growth. The benefit of such a policy is that according to Keynesians, such a policy stabilizes the economy’s aggregate demand, something economists of other persuasions dispute.

Revenue Alternatives: As already mentioned under a progressive tax code, tax revenues have a beta greater than one with respect to GDP growth. The high beta leads to higher volatility with respect to economic growth and governments have to decide how to deal with the volatility. The reason for this, as we already mentioned is that it impacts the level and timing of government spending. No matter what one calls it, the only way to stabilize revenues relative to the economy is to effectively reduce the beta of tax revenues. Borrowing ideas from investment management we come up with ways to deal with the issue. One possibility is to “index” revenues to the economy. This is easily accomplished by adopting a flat or proportional tax. Clearly under such a scheme, revenues would grow at the same rate as the economy. The strategy could be set to generate the desired level of long run or net present value revenues needed to finance the net present value of spending. The one advantage of this approach is that it minimizes the marginal tax rate, something that supply-siders care a lot about. The reason is that they view tax rates as distortions that alter incentives and economic behavior. Depending on the magnitude of the substitution effects generated by the distorting tax rates, the impact on the economy could be significant. The magnitude of substitution effects is a big point of contention between supply-siders and Keynesians.

Another possible way to effectively reduce the beta of revenue collections is to take money off the table during periods of exceptional returns and save them for the periods when returns are below average. The parallel here would be to set up a rainy day fund. In theory, the rainy day fund would work. A rainy day fund would effectively lower the beta of the revenues available for current expenditures.

If We Know the Solution, How Come We Fail to Implement it Correctly?

The previous paragraphs illustrate the key elements of a sound fiscal policy. First, the government has to somehow determine the economy long term and the net present value of tax revenues collection and use that to determine the level of spending and taxation. Different schools of thoughts have different views about the role of government and the disincentives of tax rates. These views would disagree as to what constitutes an appropriate level of spending and taxation, not on the desirability of the optimization process outlined in this paragraph. In other words, the level of spending/taxation is a political decision left to the electorate. The government also needs to determine how it will vary spending levels during economic cycles. Will it increase spending during slowdowns? If so, by how much? The budget constraints dictate that the net present value of spending and revenues match up.

In theory, the process works very nicely. However, the experience of state and federal governments shows that this is not the case. For example, even states with rainy day funds have gotten into financial trouble. So have states with spending limitations and balanced budget mandates. All of this suggests that states have systematic biases that lead them to underestimate their spending and to overestimate their revenues. We attribute these systematic forecasting errors to the myopic behavior of politicians.

Under a myopic government which does not care about future governments, there will be a strong incentive to overestimate future revenues and underestimate the need for spending during future downturns. This, in effect, allows the current government to spend excessively and, thus, increase future deficits. There are several ways to deal with myopic behavior. Presumably that is what political parties do. Political parties may have horizons that go beyond those currently in office. In order to insure the survival of the party, they must insure that their legislators adhere to the long horizon view of the world or else they will face the wrath of the electorate. Another possibility is that voters take matters into their own hands and adopt legally binding mandates that limit government spending in some way such as through limits in spending, limits on taxes and/or balanced budget amendments. Unfortunately, politicians on both sides of the aisle have proven to be quite adept at circumventing these restrictions. They have used gimmicks such as excluding certain expenditures from the budget and in some cases have outright violated voter mandates. The have also directly attacked and tried to weaken voter mandated measures. Only when voters remain vigilant have these measures survived. Proposition 13, California’s property tax limitation is one example. The Howard Jarvis and Paul Gann Organizations have done a wonderful job of keeping the voters aware of politicians’ attempts to weaken the proposition. Jerry Brown, a California Democrat, also deserves a lot of credit for the success of Prop 13. He opposed it. However, when the voters approved it, he respected the wishes of the voters and facilitated the implementation of the constitutional amendment. That is what politicians are supposed to do, implement the will of the people, not circumvent them.

Unfortunately not all politicians are like Jerry Brown. Their myopic behavior leads them to systematically underestimate spending and overestimate revenues. That way they can spend more during their time in office and leave the problems to future generations of politicians. Hence it is the job of the legislature to keep in check the executive branch and, thus, effectively force them to have a longer horizon. But when that fails we know how that game has to end. At some point in time in the future, the government confronts large deficits. If the latter are unsustainable a political decision has to be made, should the government reduce spending or increase revenues (an euphemism for tax increases)? To us, the answers depend in large part on what the government had been doing. If it had been spending beyond the long term path, the obvious solution is to reduce spending. But, that is hard to do. The politicians would, in general, argue that a higher level of spending is now necessary, an investment in the future, and that tax rates would have to be increased in order to collect more revenues. That may very well be what the politicians do. But that is not their job. It is the people who determine how big a government they want. If the politicians do not satisfy the people’s desire for either a large or smaller government with corresponding smaller or larger tax rates, they should be thrown out of office. If unchecked, myopic politicians would follows a strategy guaranteed to end in financial crisis. The reason is simple. During good times, when revenues increase, the government will increase spending and during the bad times it will raise revenues to finance the spending. Such a strategy leads to ever increasing spending that is eventually unsustainable. California may be the poster child of such a strategy.

Farsighted Solutions

The outcome of a myopic process to a shortfall in revenues brought about by the onset of an economic recession is straightforward. Needless to say, most governments would follow an anti-cyclical spending policy, especially those of the Keynesian variety. Spending would tend to rise during hard times, thereby exacerbating the revenue shortfall and increasing the need to generate additional revenues. There are two possible ways to generate the desired revenues. One is to increase the tax base and the other is to collect more taxes out of the existing base.

However, if incentives matter, the higher the tax rates and the more progressive the tax code, the lower the economy’s growth rate and its tax base. In such a world, tax collectors aiming to maximize tax revenues have to balance out these two opposing effects. They need to take into account the feedback or interaction between the tax base, tax rates and the progressivity of the tax system. Needless to say, it is difficult to expand the tax base through short run growth. When it comes to increasing revenues, political considerations push the politicians in the direction of tax rate increases. In order to help the needy, they need to reduce taxes on the people hurting. The political calculus is simple; help the people in need and collect additional revenues. The desire to collect more revenue out of the existing tax base will lead to a higher and more progressive tax structure.

Critics of these policies argue that the higher tax rates will reduce incentives to work and produce, thus reducing the tax base. Hence, the higher tax rate collects more per dollar of income while at the same time reducing the number of dollars to be taxed. If the first effect dominates, revenues go up while output decrease. On the other hand, if the latter effect dominates, both revenues and output decline. There is no disagreement as to the impact on output. It is negative. The only disagreement is as to the impact of the higher tax rates on revenues. If the disincentive effects of a tax rate increase is sufficiently strong, a lower tax rate could increase incentives to produce and result in higher sustainable growth, and higher tax revenues in the long run.

These are two very different views. One approach argues for more government intervention and control of resources while the other argues for less government intrusion. The superiority of the alternatives in question depend in large part on the magnitude of the substitution effects generated by the government designed incentive/tax rate structure.

Victor A. Canto
La Jolla Economics
www.lajollaeconomics.com

Be on the lookout in the next few days for part 3 of Progressive Tax Codes and Economic Growth: Fairness versus Efficiency by Victor Canto of La Jolla Economics on ValueExpectations.com