Spooked by the Obvious

Article excerpt


If you suddenly learned the government had reduced taxes on interest, dividends and capital gains, would you save and invest more or less? Most people would say more, because saving and investing would be more profitable with lower tax rates. As obvious as this seems, much of the Washington establishment is shocked the deficit is falling rapidly due to surging tax revenues, despite the "massive" Bush tax cuts.

The Washington establishment was shocked back in the late 1970s when, as a result of the capital-gains rate tax cut, tax revenues went up rather than down. They were shocked again in the mid-1980s when revenues surged despite the "massive" Reagan tax rate cuts. They were again shocked in the early 1990s when new tax revenues did not pour in after the Bush 41 tax rate increase. In the mid-1990s, they were also shocked when the Republican Congress forced President Clinton to cut the capital-gains tax rate, and revenues soared, leading to an unanticipated budget surplus.

Many in the political and bureaucratic class, not only in Washington, but in most world governments, are rather simple-minded on economics. They tend to think if they just increase tax rates they will get more money to spend. They rarely think about the behavioral responses of people and companies to changes in tax rates, and how the sum of these individual behavioral responses will affect the whole economy.

The issue of correctly forecasting changes in tax revenue receipts as a result of changes in tax rates and policies will become critically important again at the end of next month when the President's Tax Reform Commission is due to give its report. The commission was charged with recommending "revenue neutral" tax changes. In simple language, that means any new or revised tax system they devise should produce the same revenue as the current system.

This may sound simple but, in fact, no one knows how much revenue the current tax system will produce in future years, let alone some new system. Long-range forecasts are notoriously unreliable because they require knowing future rates of economic growth and inflation and understanding how people will alter behaviors because of any tax system changes.

To illustrate, let's start with a simple, true proposition: Normally, the higher something is priced, the less it will be demanded. …