Higher Tax Rates Won't Support Entitlement State
The fiscal cliff negotiations seem to be foundering on Barack Obama’s insistence on higher tax rates on high earners and House Republican leaders' insistence on opposing them. The president believes he has a mandate from voters for his position, and House Republicans believe they have a mandate from voters for theirs.
The real argument here is over the size and scope of government. Under Barack Obama, federal outlays – the technical term for federal spending – have increased to 24 and 25 percent of gross domestic product.
That’s a higher level of federal spending than in any year since 1946, when we were demobilizing after World War II. And the Obama budgets envision federal spending to continue at such levels more or less indefinitely.
This is an inevitable result, some Obama backers argue, of our aging population. Spending for entitlement programs for the elderly – Social Security and Medicare – are on a rising trajectory, and so the federal government simply must absorb a higher percentage of the economy than in the last two-thirds of a century.
Let’s adjust the trajectory, House Republicans argue, by reforming the entitlements. Obama has given lip service to this idea – but has offered no specifics.
He seems to be paying attention to those Democrats who oppose any changes in entitlements. Just raise taxes, they seem to say, and entitlements can keep rising as scheduled.
The problem is that, as historian Paul Rahe wrote earlier this year, “we no longer have the resources to support the entitlement state. We can certainly raise taxes, as President Obama and the Democrats intend to do, but that does not mean that in the long run we will take in more revenue – and it is massively increased revenue that the entitlement state needs.”
Rahe seems to have history on his side. To see why, take a look at the Economic Report of the President 2012, Appendix B, Table B-79, on page 412, which shows federal receipts – the technical term for revenues – and outlays as a percentage of gross domestic product for every year from 1939 to 2011, with estimates for 2012 and 2013.
Over that period of nearly three-quarters of a century, federal receipts have never exceeded 20.9 percent of gross domestic product. That was the number for the war year 1944.
The highest number since was the 20.6 percent of GDP in 2000, the climax of the dotcom boom. In the Obama years, federal receipts have hovered at 15 percent of GDP.
That’s just because tax rates are too low, Obama backers reply. Just raise the rates on high earners, and the problem will be solved.
Actually, high earners don’t make enough money to close the current budget deficit. You’d need to raise taxes on middle-income earners too.
But we have had higher income tax rates in most of the years since World War II. What history and Table B-79 show is that even much higher rates – like the 91 percent marginal rate on top earners imposed from the 1940s to the 1960s – have never produced federal receipts higher than 20 percent of GDP.
Why is that? As the late Jack Kemp liked to say, when you tax something, you get less of it. When the government took 91 percent of what the law defined as adjusted gross income over a certain amount, not many people had adjusted gross income over that amount.
According to a Congressional Research Service study, the effective income tax rate on the top 0.01 percent of earners in the days of nominal 91 percent tax rates was only 45 percent. Others have pegged it at 31 percent.
In the 1970s, when the top rate on wage and salary income was 50 percent and 70 percent on investment income, high earners spent much of their time and energy seeking tax shelters. The animal spirits of capitalists, to use John Maynard Keynes' term, were directed less at productive investment and more at tax avoidance.
But don’t European nations extract more in taxes from their citizens? Yes, but through consumption taxes like the value-added tax. But those taxes tend to be regressive, and in this country sales taxes have been the province of states and localities.
Barack Obama and the Democrats may well get higher tax rates. But it’s not likely that high tax rates can ever generate enough revenue to fund unreformed entitlement programs.
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