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Dear Dr. Dollar:

A Republican friend tells me that the huge new tax cuts will actually produce more revenue than the government would have collected before the cut, because once rich beneficiaries invest the money, they will pay taxes on every transaction. He suggested that the increase could be as much as 50% more than the originally scheduled revenues. Is this possible?
—Judith Walker, New York, N.Y.

This article is from the November/December 2003 issue of Dollars and Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org

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This article is from the November/December 2003 issue of Dollars & Sense magazine.

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Back in the 1970s, conservative economist Arthur Laffer proposed that high marginal tax rates discouraged people from earning additional income. By cutting taxes, especially on those with the highest incomes, Laffer argued, governments would spur individuals to work harder and invest more, stoking economic growth. Though the government would get a smaller bite from every dollar the economy generated, there would be so many more dollars to tax that government revenues would actually rise. Ronald Reagan invoked the “Laffer curve” in the 1980s, insisting he could cut taxes, hike defense spending, and still balance the budget.

Bush’s 2001 and 2003 tax packages are eerily reminiscent of the Reagan cuts. They reduce rates levied on ordinary income, with the largest rate cut going to the wealthiest taxpayers. They extend business tax write-offs and increase the child tax credit (though only for two years and only for families who earn enough to pay federal income taxes). They cut the tax on capital gains from 28% to 15%; dividend income, previously taxed at the same rate as ordinary income, now faces a top rate of 15%.

Citizens for Tax Justice estimates that two-thirds of the 2003 tax cut will accrue to the richest 10% of taxpayers. By 2006, the increased child credit will be phased out and nine out of ten taxpayers will find their taxes cut by less than $100. The top 1%, in contrast, will save an average $24,000 annually over the next four years, thanks to the 2003 cut alone.

Though inspired by the same “supply-side” vision that guided Reagan, Bush officials have not explicitly cited Laffer’s arguments in defense of their tax packages. Probably, they wish to avoid ridicule. After the Reagan tax cut, the U.S. economy sank into recession and federal tax collections dropped nearly 10%. The deficit soared and economic growth was tepid through much of Reagan’s presidency, despite sharp hikes in military spending. Some of the Republican faithful continue to argue that tax cuts will unleash enough growth to pay for themselves, but most are embarrassed to raise the now discredited Laffer curve.

The problem with your friend’s assertion is fairly simple. If the government cuts projected taxes by $1.5 trillion over the next decade, those dollars will recirculate through the economy. The $1.5 trillion tax cut becomes $1.5 trillion in taxable income and is itself taxed, as your friend suggests. But this would be just as true if, instead of cutting taxes, the government spent $1.5 trillion on highways or national defense or schools or, for that matter, if it trimmed $1.5 trillion from the tax liability of low- and middle-income households. All tax cuts become income, are re-spent, and taxed. That reality is already factored into everyone’s economic projections. But the new income, taxed at a lower rate, will generate lower overall tax collections.

To conclude that revenues will rise rather than fall following a tax cut, one must maintain that the tax cut causes the economy to grow faster than it would have otherwise—that cutting taxes on the upper crust stimulates enough additional growth to offset the lower tax rates, more growth than would be propelled by, say, building roads or reducing payroll taxes. Free-marketeers insist that this is indeed the case. Spend $1.5 trillion on highways and you get $1.5 trillion worth of highways. Give it to Wall Street and investors will develop new technologies, improve productivity, and spur the economy to new heights.

Critics of the Bush cuts contend, however, that faster growth arises from robust demand for goods and from solid, well-maintained public infrastructure. Give $1.5 to Wall Street and you get inflated stock prices and real estate bubbles. Give it to working families or state governments and you get crowded malls, ringing cash registers, and businesses busily investing to keep up with their customers.

Who is right? Die-hard supply-siders insist that the Reagan tax cuts worked as planned—the payoff just didn’t arrive until the mid-1990s! But the Bush administration’s own budget office is predicting sizable deficits for the next several years. Maybe, like your friend, they believe the tax cuts will pay for themselves—but they’re not banking on it.

Ellen Frank teaches economics at Emmanuel College and is a member of the Dollars & Sense collective.

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