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  • What Are Economists Really Saying About Tax Rate Increases?

    Beware of comparing apples to oranges when it comes to tax rate studies.

    On Friday, Representative Pete Sessions (R–TX) and House Speaker John Boehner (R–OH) ran afoul of Glenn Kessler’s “Fact Checker” blog regarding a study of President Obama’s proposed tax increase. Before deciding on a tax change, policymakers are wise to look at the economic impacts of the change.

    Two Studies

    In fact, two studies released this year predict that raising tax rates on high-income families and small businesses would hurt the economy. The tax rate increase was proposed by President Obama and involves raising the top two marginal tax rates to 39.6 percent and 36 percent, respectively.

    The first of the two studies was performed by Ernst and Young, a large consultancy, for a group of clients representing small businesses. They used Ernst and Young’s proprietary macroeconomic model to evaluate the long-run economic cost of the proposed tax increase, along with tax increases on dividends and capital gains.

    The second study was performed by the Congressional Budget Office (CBO) and focuses on the short-term impact of the tax increase on high-income taxpayers. The CBO report must be read carefully, since the baseline is current law, in which tax rates will rise across the board.

    Jobs Impact

    The Ernst and Young study predicts that the tax increases will slow investment, resulting in slower growth in employment and wages. Compared to their model’s baseline predictions, the higher-tax economy would have 0.33 percentage point lower employment after 10 years and would asymptotically approach 0.5 percentage point lower employment. In terms of today’s population, that would be 710,000 fewer people holding jobs. In addition, real wages for those with jobs would decrease by 1.8 percent on average.

    Because the effects take place over time, they may seem small in any given year, but they build. Long-run models don’t focus on the timing with which effects come into play. However, based on their 10-year figure, a back-of-the-envelope calculation shows that the model probably predicts more than 2.6 million job-years lost in the first decade. If strong effects of the tax increase are felt immediately, as the second study suggests, then the lost job-years in the first decade might be around 3.4 million.

    The CBO report estimates that a year from now, the economy will have 200,000 fewer jobs with President Obama’s tax increase than under an extension of current tax rates.

    How does the 200,000 job loss predicted by CBO compare to the 710,000 job loss in the Ernst and Young study? Like apples to oranges. Not only are the time frames different, but the key economic mechanisms in each study are different. Nonetheless, despite asking different questions, the two studies get the same answer: Higher taxes slow job growth.

    What Happens to All That Money?

    One of Kessler’s criticisms is that the Ernst and Young study assumes that the additional revenue from the tax increase would be used to fund more government spending, not to reduce the deficit. This is a reasonable assumption—after all, Harvard economist Alberto Alesina and his co-authors have shown that increasing taxes to decrease the deficit rarely works, and the President has promised lots of new federal spending in his second term. And if the Ernst and Young model is similar to others in the industry, the assumption that new taxes are used to fund government spending mitigates the predicted job losses. Thus, the “710,000 jobs lost” is smaller than it would be if the new taxes went entirely to deficit reduction.

    Are These Numbers Big or Small?

    Kessler seems to imply that the economic costs predicted by the Ernst and Young study are small. So let’s compare the economic costs to the revenue that the new taxes might yield. According to the left-leaning Tax Policy Center, such a tax increase would bring in $440 billion over 10 years, even if the economy were unaffected. If the tax increases result in a loss of 3 million jobs over the same 10 years, that would be one job lost for every $150,000 in revenue. In addition, wages, investment, and gross domestic product (GDP) would also be lower. That’s a pretty pricey tax increase.

    Will the Tax Increases Make a Dent in the Debt?

    Kessler correctly points out that high debt can slow economic growth, as recent scholarship has shown. Will the revenue gains from higher tax rates outweigh the revenue losses from lower wages and lower employment? And is this an efficient way to slow the growth of the national debt?

    The Ernst and Young study predicts that long-run GDP with the higher tax rates would be 1.3 percent smaller. If that 1.3 percent of lost GDP had been taxed at 20 percent (a conservative guess), then the loss of tax revenues from smaller GDP would be about the same size as the static revenue gains estimated by the Tax Policy Center.

    Without modeling all these components together in the same framework, one cannot be certain how to relate them, but the best evidence is that the costs of the tax increase are large compared to its benefits.

    Posted in Economics [slideshow_deploy]

    9 Responses to What Are Economists Really Saying About Tax Rate Increases?

    1. GrayArea says:

      Thanks for the post, maybe we could clarify something here. I was wondering why the tax cuts we have already made over the past decade aren't enough to create faster growth as it is. I mean, nobody can say that we didn't make deep cuts during the last administration, we clearly did. As a non-economist, it is interesting that I hear folks comparing this recovery unfavorably to the Reagan recovery (while we are comparing dissimilar fruits). Seems to me that our taxes are quite a bit lower now than they were in the 80s, so why doesn't that automatically mean that the conditions are better for faster growth?

      The models seem to say that tax hikes *always* reduce growth, and tax cuts *always* increase growth. Sure, conventional wisdom, everyone knows that, but is it really the case? If so, it leads to simplistic solutions to every economic problem – and the answer is always the same. The recipe is invariably for a steady dose of tax cuts that are administered in times of high economic growth and times of recession. There is no steady state; they have to keep going down because the last round of tax cuts, whenever they happened, will never be enough to save us from the economic challenges ahead.

      Oh boy, maybe I could be an economist, the job seems incredibly easy.

    2. Brian Cain says:

      Though this curve and its conclusions are widely agreed upon by economists (this is the Laffer curve drawn sideways because I think it is easier to visualize that way), it is universally maligned by media. However, it applies to the population and I believe it applies equally to corporations whereas raising the corporate tax rate can cause investment to go overseas. But the question continually being asked is where, on the curve, is the proper tax rate and could that rate be raised in order to squeeze a little more tax revenue out of people without tanking the economy?

    3. Brian Cain says:

      There is little doubt that lowering corporate tax rates in a geopolitically secure, developed nation with a clear regulatory structure and a strong capacity for consumption encourages foreign investment in that nation and increases capital spending among domestic companies, simply because there is more capital to spend. It would then follow that with such economic tailwinds, lowering the individual rate would also encourage small-business start-ups. Under such a scenario, government spending could continue without cuts until the economy starts humming, but this strategy would not as egregiously increase the deficit as precipitously as if money were spent willy-nilly on social programs, or if stimulus after stimulus were hurled at the economy in hopes of goosing job creation. And let's be honest with ourselves: our congress will never be able to get its act together to write a truly efficient stimulus act; the temptation for pork is far too great.

    4. Brian Cain says:

      If you follow this logic, it concludes that the most realistic way to sustainably create economic growth and slow deficit growth is by growing net exports through increased foreign investment and increased capital spending, and the way to do that is by lowering taxes.

      If you doubt that, think about this for a moment: compared to other countries around the world, the United States is the most secure in terms of geopolitical uncertainty. There is no risk of your investment being nationalized, there is infrastructure here that is second to none, there is a highly skilled workforce, and, increasingly, there is a secure supply of energy and associated petroleum-related feedstocks for manufacturing. Among the greatest deterrents to investment and economic growth in the American economy is the current tax rate structure. Lower it, and let the United States open for business.

    5. Blair Franconia, NH says:

      To paraphrase Bob Dylan, You don't need an economist to tell you which way the economy's going.

    6. Colin says:

      First, we had to recover from the real estate bubble and ensuing recession. Businesses by and large have recovered, but with increased regulatory pressures in the financial, energy, and healthcare fields and the added uncertainty surrounding Obamacare, businesses have been slow to expand and hire.
      As for federal tax receipts, the Treasury is nearly back to pre-recession levels; $2,449 billion collected in 2012 versus $2,568 billion in 2007.

    7. R Simons says:

      In response to GrayArea, the Bush tax cuts dramatically increased economic growth. Several years following the cuts, revenue to Government achieved its highest level ever. The recession caused by the home loan debacle (a result of massive Government meddling re: Community Reinvestment Act) thwarted that growth, but that does not suddenly turn economics on its ear and mean that now tax increases will result in growth.

    8. Bobbie says:

      It's ridiculous to increase the tax rate because of the lack of respect, the lack of control, the total advantage those in government possess. Stop adding to the problem and correct it!
      Sick of the narrow thinking to dump the consequences government causes to increase taxes.

    9. Bobbie says:

      More taxes on the provider means more taxes on everything means less food and less livelihood for everyone! Except Obama's favorites getting the more of everything off the backs of everyone else, laughing as cowards will, for now!

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