Escaping the Static Trap

Writing in the Wall Street Journal, Harvard professor Martin Feldstein, who chaired Ronald Reagan’s Council of Economic Advisors, looks back at the Tax Reform Act of 1986 to draw an important lesson about the limits of “static” analysis:

The Tax Reform Act of 1986, enacted 25 years ago last Friday, showed how a tax reform that includes lower rates can change incentives in a way that grows the tax base and produces extra revenue. The 1986 agreement between President Ronald Reagan and House Speaker Tip O’Neill reduced the top marginal tax rate to 28% from 50%. A conservative Republican and a liberal Democrat could agree to a dramatic reduction in top rates because the legislation also eliminated a wide variety of tax loopholes.

A traditional “static” analysis that ignores the response of taxpayers to lower tax rates indicated that those combined tax changes would leave total revenue unchanged at each income level. But the actual experience after 1986 showed an enormous rise in the taxes paid, particularly by those who experienced the greatest reductions in marginal tax rates.

Feldstein analyzed thousands of tax returns from before and after the Tax Reform Act to calculate the effect marginal tax reductions had on both individual taxable income and federal revenue.  In the upper tax brackets, the increase in taxable income correlated almost precisely with the increase in net income brought about by tax rate reductions.  In other words, lowering tax rates increased taxable income with great efficiency, offsetting much of the government’s lost tax revenue.  Feldstein explains how this works:

This dramatic increase in taxable income reflected three favorable effects of the lower marginal tax rates. The greater net reward for extra effort and extra risk-taking led to increases in earnings, in entrepreneurial activity, in the expansion of small businesses, etc. Lower marginal tax rates also caused individuals to shift some of their compensation from untaxed fringe benefits and other perquisites to taxable earnings. Taxpayers also reduced spending on tax-deductible forms of consumption.

These benefits became less pronounced in lower tax brackets, which is not surprising, since lower income levels have fewer options for responding to changes in marginal tax rates, and engage in less deliberate tax avoidance behavior.  In total, Feldstein concludes that “a 10% across-the-board reduction in all federal tax rates would reduce revenue by about 60% of what a static analysis would imply.”

That’s an astonishing margin of error for the method Big Government uses to predict its own future.  When static models say a tax cut along the lines of Feldstein’s model would “cost” the government $500 billion on lost revenue, for example, the real number is closer to $300 billion.  And yet, the wildly inflated “loss” projections of static analysis are routinely cited as arguments against tax cuts.

The reverse is also true: tax increases never bring in the windfall projected for the Treasury, because the higher income brackets engage in behaviors that allow them to legally avoid paying elevated rates.  At the extremes, they simply stop earning marginal dollars that the government plans to seize fifty, sixty, or seventy cents from.

This is also a powerful argument against collapsing the tax base… which is a major goal of the Left.  As the tax burden is shifted onto a smaller and smaller minority of Americans, and “progressive” rates climb for the upper brackets, Uncle Sam finds himself trying to grab water with his fists, and it trickles through his fingers.  The failure of tax-and-spend policies becomes a self-perpetuating cycle of decline: tax increases never bring in the money they were supposed to, spending programs always cost far more than their proponents will admit, and the rising deficit becomes the fault of evil rich people who refuse to pay their fair share.

On and on this goes, until we reach the point where our Gross Domestic Product begins to collapse.  The power of those marginal dollars – the dollars evil “millionaires” don’t need, according to class warriors – should not be underestimated.  Those are the dollars Americans risk in the pursuit of reward.  Pick your favorite Obama “green energy” disaster to see what happens when corrupt politicians and blind ideologues seize that money to spend as they see fit. 

Truly dramatic tax reforms, in which rates are lowered, rules are simplified, and the tax base is broadened, would produce a fantastic surge in private-sector growth.  Even a radically smaller percentage of such a rapidly growing economy could fill the Treasury with cash.  But the static mindset essentially presumes decline and failure.  We can’t take a chance on the possibility of dramatic growth in a prosperous American future!  Not when we’ve got over three trillion dollars in spending, for both individual and corporate welfare, to cover!  Better to pump another pint of blood out of the sleeping American giant, and try not to worry about its disturbing heart murmurs.

Of course, the decline of national productivity as statist rigor mortis sets in causes unemployment to rise… creating political demand for more welfare spending… which produces mounting pressure for more tax increases, the only solution static analysts will accept, even though they have always been wrong, and always will be.

Static analysis is a Big Government mousetrap, in which tax increases are oversold, and tax cuts are briskly dismissed as unthinkable.  The economic damage from government bloat is concealed, while the dynamic power of liberty is treated like a fairy tale.  Heads we lose, tails Big Government wins.  Twenty-five years ago, Reagan’s Tax Reform Act proved static analysis is rubbish… but we’re still surrounded by rubbish.  In fact, we’re about to suffocate beneath it.

The American people have a dramatic choice to make in the next election: live within the static trap until we die, or junk our unsustainable government and its death-spiral tax system, and start believing in ourselves for a change.