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Will Higher Tax Rates Balance the Budget?

As the U.S. debt and deficit grows, some politicians and economists have called for higher tax rates in order to balance the budget. The question becomes: when the government raises taxes, does it actually collect a larger portion of the US economy?

Professor Antony Davies examines 50 years of economic data and finds that regardless of tax rates, the percentage of GDP that the government collects has remained relatively constant.  In other words, no matter how high government sets tax rates, the government gets about the same portion. According to Davies, if we’re concerned about balancing the budget, we should worry less about raising tax revenue and more about growing the economy.  The recipe for growth? Lower tax rates and a simplified tax code.

Will Higher Tax Rates Balance the Budget?

For more than a half century, the total amount of money that federal government has collected from all sources has increased. But that isn’t surprising because over the past 50 years the economy has grown, the population has grown, and prices have risen. A more useful way to examine federal tax revenue is to look at it as a fraction of GDP, the size of the economy. In other words, each year the government takes a slice of the economy for itself. How big is that slice? Over the past half century the government slice of the economic pie has been a pretty constant 18 percent.

In the face of budget deficits, some politicians and economists call for higher tax rates as a necessary measure for raising needed revenue. The important question is, historically, how has the government slice of the economic pie changed as tax rates have changed. In the 1950s and 1960s the top income tax rate, that’s the income tax paid by the richest Americans, was 90 percent. The top income tax rate fell in the 1960s, but was at least 50 percent all the way up to 1986. Throughout this period, the government’s revenue was almost 17 percent of GDP. In 1987 the government lowered the top marginal income tax rate to 39 percent, then later to 28 percent, then back up to 40 percent, then down again to 35 percent, where it is today. Throughout this period the government’s revenue was just under 18 percent of GDP. It didn’t matter whether tax rates on the rich were high or low. The government slice of the economic pie stayed about the same.

Of course, the top income tax rate only applies to the richest Americans. Let’s look at the average marginal rate. This is the income tax rate that applied to the average American. It appears that significant changes in income tax rates have little effect on the slice of the economic pie the government collects as tax revenue. Let’s look at some other taxes.

The capital gains tax is a tax on the sale of assets. If you buy an asset, for example a share of stock, and then later sell it for a higher price, you pay a capital gains tax on the profit you make from the sale. It didn’t matter whether capital gains tax rates were high or low. The government slice of the economic pie remained at 17–18 percent. Similarly, it didn’t matter whether corporate tax rates were high or low. The government’s slice of the economic pie stayed about the same.

The lesson here is that if we are concerned about balancing the budget we need to design our tax policy not to raise revenue, but to grow the economic pie as quickly as possible. The larger the economic pie grows the more tax revenue the government gets, because 18 percent of a big pie is a lot more revenue that 18 percent of a small pie. The recipe for the big pie is simple: lower tax rates and a simplified tax code.

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