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Occasional Common Sense

Sowell, And How Changing Tax Rates Affects Incentives

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Last week Thomas Sowell, who’s about as died-in-the-wool a supply-sider as there is, landed a three-part article in Investor’s Business Daily (which makes the WSJ editorial board  look like neutral observers).   In the series Sowell argues that liberals and historians, and in particular liberal historians, haven’t properly described the motivations, actions, impacts, and results of the 1920s tax cuts implemented on the advice of then-Treasury secretary Mellon.

As part of this article, Sowell sets up equivalences between the 1920s tax cuts, the 1963 Kennedy tax cut, the 1982 Reagan tax cut, and the 2001-3 Bush (43) tax cuts.  His argument relies on these equivalences to assert that the impacts of the Bush tax cuts were similar to those of prior cuts.

To understand why this isn’t true, first we need to look at the impacts of the various tax cuts on the taxpayers affected.

Year

Before

After

1921-5

73%

25%

1963-5

91%

70%

1981-2

70%

50%

1986-8

50%

28%

2000-3

39.6%

35%

Top marginal rate data from http://www.taxfoundation.org/publications/show/151.html.

The Coolidge cuts were enormous by any stretch of the imagination.  But look at the Kennedy cut: the portion of a taxable dollar collected by the government declined by 23%.  Sounds pretty significant.  But remember, the key to the argument here is the changing incentive of taxpayers.  The actor here is not the government; the government is passive, collecting tax revenue due to the actions of others.  To assess the impact on incentives, look at the same data by the change in after-tax returns on taxable investment income:

Year

Before

After

After-Tax Income Change

1921-5

27%

75%

178.0%

1963-5

9%

30%

233.0%

1981-2

30%

50%

67.0%

1986-8

50%

72%

44.0%

2000-3

60.4%

65%

7.6%

So the first two tax cuts were enormous, when looked at in terms of what they meant to affected taxpayers’ after-tax income — the Kennedy tax cut actually provided the largest incentive change.  And the two Reagan cuts, while not of the same scale as the Coolidge and Kennedy cuts, were still quite sizable.

The Bush tax cuts?  Not so much.

Sowell’s central argument about the reason why revenues increased dramatically following the Coolidge cuts has to do with tax avoidance.  As taxes increase, taxpayers have more incentive to take economic actions not based on the merits of the investment, but on the total after-tax return.  Sowell says that tax rates were so high that rather than deploy their riches to investments that the marketplace valued more highly (indicated by higher returns), the wealthy parked their money in tax-free municipal bonds.  Here’s why.

Let’s assume tax-free municipal bonds pay 4%, for an after-tax return of 4%.  The following table shows how much a taxable investment would have to pay to give an equivalent after-tax yield:

Tax Cut

Before Cut Rate

After-tax ROI

Pre-tax ROI

After Cut Rate

After-tax ROI

Pre-tax ROI

Baseline

0.0%

4.0%

4.0%

4.0%

4.0%

4.0%

1921-5

73.0%

4.0%

14.8%

25.0%

4.0%

5.3%

1963-5

91.0%

4.0%

44.0%

70.0%

4.0%

13.3%

1981-2

70.0%

4.0%

13.3%

50.0%

4.0%

8.0%

1986-8

50%

4.0%

8.0%

28.0%

4.0%

5.6%

2000-3

39.6%

4.0%

6.6%

35%

4.0%

6.2%

Look at the “1921-5” line.  In 1920, an investment taxed at 73% would have had to pay 14.8% — 3.7 times as much — to achieve the 4% rate of return of a tax-free municipal bond.  Factor in a risk premium, and Sowell’s argument that the rich were parked in munis makes perfect sense.  After the Coolidge cuts to 25%, a taxable investment only had to pay 5.3% to match munis.  So the wealthy moved money into taxable investments, which meant a more efficient allocation of capital into more profitable investments, and everybody benefited.

Now look at the 1963 line, which compares the top rates before and after the Kennedy cut.  With the top rate at 91%, a taxable investment would have had to return 11x as much as a tax-free bond to break even!  Sowell’s argument makes even more sense.

But a funny thing happens on the way to “lower is always better.”  Yes, Reagan’s two tax cuts dropped the top rate from 70% to 28% (though the 28% top rate clearly wasn’t bringing in sufficient revenue), which dropped the needed taxable return from 3.3x the tax-free rate to 1.4x.   But Bush’s tax cuts?  From 1.65x to 1.55x.  Not a very big change when we’re talking about tax avoidance — it’s highly dubious that this change provided sufficient incentive for people to shift into taxable investments.

In terms of incentives, Sowell’s assertion that the “cuts in tax rates in the 1920s were very similar to the results of later tax-rate cuts during the Kennedy, Reagan and George. W. Bush administration” doesn’t hold true.  Let’s see about revenue. Says Sowell:  Following the Bush tax cuts, we had “rising output, rising employment to produce that output, rising incomes as a result and rising tax revenues for the government because of the rising incomes.”

Rising output?  Following the Bush tax cuts, the economy grew slower than during any other non-recession timeframe since 1962.  In the 3 years following 2001, the economy grew 2.6% per year, and for the 3 years following the 2003 cuts, it grew 3.1% per year.  Compare this against the 3 years following the Clinton tax increase of 1993, when the economy grew by more than 3.4% per year.  Sowell’s argument that the economy grew due to the Bush tax cut is unconvincing.

Rising employment?  In 2001, civilian employment as a percentage of non-institutional population was 63.7%.  By 2003, it had fallen to 62.3%, and in 2006 it had regained ground to 63.1%.  Again, compare to 1993: the labor participation rate of 61.7% increased steadily following the Clinton tax cuts, reaching an all-time high of 64.4% in 2000.   Sowell’s argument that employment rose in response to the Bush tax cuts is, again, unconvincing.

Rising incomes?  The median household income statistics kept by the Census bureau are pretty good for this.  In 2001, the median household income in the country was $51,161 (all figures in this paragraph are 2009 inflation-adjusted dollars).  By 2003, it had dropped to $50,519.  Three years later, it had climbed to $51,278 — a 0.23% increase in five years.  In 1993, median household income was $45,665.  In 3 years, it had climbed to $48,315 (5.8% increase) and in 5 years it had climbed to $51,100 (11.9% increase).  Yet again, Sowell’s argument is left wanting.

Rising tax revenues?  Even the Heritage Foundation doesn’t claim that tax revenues were higher following the Bush tax cuts than they would have been without them.  Even Mankiw, Bush’s chief economic advisor, doesn’t claim this.  Nobody with any economic credentials whatsoever believes that this is the case with tax rates where they stand today (as opposed to those of 1920 or 1960).  And yet partisans like Sowell continue to shovel this into the public sphere as if the idea had merit.

In both economics and punditry, incentives matter.  The incentive for anti-tax zealots to be less than forthright about this stuff is clear.

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Tax Cut

Before Rate

After-tax ROI

Pre-tax ROI

After Rate

After-tax ROI

Pre-tax ROI

1921-5

0.0%

4.0%

4.0%

4.0%

4.0%

4.0%

1963-5

73.0%

4.0%

14.8%

25.0%

4.0%

5.3%

1981-2

91.0%

4.0%

44.0%

70.0%

4.0%

13.3%

1986-8

70.0%

4.0%

13.3%

50.0%

4.0%

8.0%

2000-3

50%

4.0%

8.0%

28.0%

4.0%

5.6%

39.6%

4.0%

6.6%

35%

4.0%

6.2%

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Written by David Clayton

July 23, 2011 at 11:08 pm

Posted in Debunkery, Punditry

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