Former Treasury Secretary Robert Rubin wrote a tedious essay in The Wall Street Journal that wisely advised "putting aside ideology in favor of facts and analysis." Unfortunately, he proceeded to instruct us that "serious policy advocates" have to agree about this, and "mainstream economists" already agree about that. Such descriptions are ideological, designed to thwart disagreement by intimidating anyone who might dare be tempted by heresy.
Rubin identified the unserious heretics as a group of nameless supply-side theoreticians who allegedly made wildly incorrect predictions about lower tax rates in 2003 and also about higher tax rates in 1993:
"The proponents of supply-side theory who assert that tax cuts will wholly — or even significantly — pay for themselves (through increased growth and federal tax revenues), appear to be no more accurate now than they were in the ’90s. Then, they argued that tax increases included in our plan to address fiscal deficits were likely to lead to massive job loss, but what followed instead was the longest economic expansion in our history."
No supply-side economist argued that the higher tax rates of 1993 "were likely to lead to massive job loss." If anyone made such a forecast, it proves they did not even understand the difference between supply and demand. If steeper tax rates on spouses of high-income individuals discouraged them from seeking employment, the unemployment rate might go down.
No supply-side economist asserted that any and all tax cuts will pay for themselves. My Wall Street Journal response to President Bush’s initial 2001 tax bill said it was mostly a demand-side effort to reduce revenue (particularly the rebated 10 percent tax rate) with minimal impact on marginal incentives.
On the other hand, quite a few academic economists — Larry Lindsay, Dan Feenberg and James Poterba, Martin Feldstein and others — have observed that reducing the highest marginal tax rates soon resulted in larger tax receipts. This is partly a matter of supply-side effects on labor effort and entrepreneurship, and partly a matter of reduced incentive to avoid taxes.
At least 13 studies found that reducing the capital gains tax rate results in more gains being realized and therefore more taxes paid. Even before Congress was contemplating reducing the top tax on dividends from 35 percent to 15 percent, I argued that this, too, would increase tax revenues. Investors in high tax brackets are now far more willing to hold dividend-paying stocks in taxable accounts (rather than retirement accounts), and firms have responded by paying more dividends.
So, what actually happened after tax rates on dividends and capital gains were reduced to 15 percent in 2003? An IRS report "Individual Income Tax Returns 2003" says: "Income items that increased appreciably included net capital gains and dividends, which increased 23.3 percent and 11.5 percent, respectively. … This was the first increase in dividends since 2000, and it coincided with reduced tax rates for certain qualified dividends."
Once the 2004 figures become available, it will then be even clearer that cutting the tax rates on dividends and capital gains accounts for much of the big surge in tax revenues that still baffles Rubin and his mainstream band.
What about the Clinton years? That "longest expansion" began in April 1991 — nearly two years before President Clinton took office. The economy grew by 3.3 percent in 1992, which candidate Clinton (who had some animosity toward 1942) described as "the worst economy in 50 years."
After 1992, it is absolutely critical to distinguish between President Clinton’s first term, when the economy grew by only 3.2 percent a year, and his second term, when the economy accelerated to a 4.2 percent pace. In 1997, the Republican Congress shoved the top capital gains tax back down to 20 percent — something supply-side heretics had been promoting since 1978, at home and abroad.
The following table divides 1988-2000 into four periods, based on the timing of changes in top tax rates on capital gains and other income. The last column uses Treasury Department data to identify "other" individual tax receipts (other than taxes on capital gains) as a percentage of GDP:
Individual Tax Rates and Revenues
Years —- Top Tax on Capital Gains —- Top Tax on Salaries — Capital Gains Tax Receipts Percent of GDP —- Other Tax Receipts Percent of GDP
1988-1990 —- 28 —- 28 —- 0.6 —- 7.5
1990-1991 —- 28 —- 31 —- 0.4 —- 7.3
1993-1996 —- 28 — 39.6 —- 0.6 —- 7.4
1997-2000 —- 20 —- 39.6 —- 1.1 —- 8.5
While the top tax rate on salaries and dividends was 28 percent, it brought in 7.5 percent of GDP. After President Clinton added the 36 percent and 39.6 percent tax brackets in 1993, the income tax (aside from capital gains) brought in only 7.4 percent of GDP for four years.
Revenues from the 28 percent capital gains tax were no better from 1993 to 1996 than they were from 1988 to 1990. The popularization of the Internet in 1996, and the related euphoria over dotcom and telecom stocks, would have generated big capital gains anyway. But the lower capital gains tax after 1996 was capitalized in higher stock prices, and it facilitated more frequent trading.
Revenues from the "other" portion of income tax revenues after 1996 were mainly due to capital gains. Such big employers as Ford, Southwest Air, Microsoft, AOL, Intel and Sun were doling out stock options to mid-level employees in the ’90s, options that became more valuable than anyone had expected. Gains from cashing-in those stock options were taxed at ordinary income tax rates, creating a temporary windfall for governments, too. The increase in tax revenues and economic growth after tax rates were increased in 1993 did not occur until 1997, and that was because the tax on capital gains was cut.
What actual (rather than imaginary) supply-side economists said about tax rates, economic growth and tax revenues in 1993 and 2003 is quite consistent with the facts, if not with mainstream ideology.