Real Reductions In Deficit Must Be From Spending Cuts Not Tax Hikes

Introduction

Politicians and economists alike love to hypothesize that an increase in tax revenue would lead towards the reduction in budget deficits;  some examples of this are Bernie Sanders  wanting to increase taxes in order to balance the budget (while simultaneously redirect spending from defense to welfare) or Hillary Clinton wanting to increase taxes on upper income earners  in order to “balance the budget”.

However, what about economists? What would they say about the budget deficit and how to reduce it?

According to Neo-Keynesian economists like Paul Krugman, raising taxes on budget deficits is the right choice so long as the economy is not weak. However, in this article, we’ll explore why raising taxes in order to reduce the budget deficit is essentially a policy doomed to fail.

Raising Taxes, or Cutting Spending?

In theory, raising tax revenues would have the ability to reduce the budget deficit. By reducing the budget deficit, we decrease the burden of debt placed on the US public, therefore, by that logic, we should raise taxes on the rich (as seen by examples above). However, there are two issues with this position.

For example, let’s look at the latest Federal Income Tax Data from 2014.

In 2014, the budget deficit was 491.296 Billion US Dollars (2016 inflation adjusted). Now looking at the data below, amongst the different types of taxpayers.

Top 1% Top 5% Top 10% Top 25% Top 50%
Number of Returns 1,395,620 6,978,102 13,956,203 34,890,509 69,781,017
Adjusted Gross Income (Millions) 2,025,423.02 3,539,100.58 4,646,745.42 6,782,727.22 8,733,571.83
Income Tax Paid (Million) 550,137.70 835,540.39 987,583.55 1,209,158.34 1,355,105.42
Effective Tax Rate 27.16% 23.61% 21.25% 17.83% 15.52%

 

In 2014, the top 1% paid 550.138 Billion USD in taxes. This translates into an effective tax rate of 27.16%.

Now, assuming that no one in the top 1% gets disincentive to work, or have incentives to find loopholes, and other factors with tax increase. What happens if we place the remainder of the burden on the top 1%?

This would mean that the top 1% would have an effective tax rate of 51.42%. An increase by 24.26%. If we include changes in behavior, it is highly likely that the total tax revenue raised by the 1% would decrease or would be less than the anticipated 491 Billion USD anticipated in being raised.

Now, the second issue with raising tax revenues in order to cover the deficit is that raising revenue does not cover deficits, raising revenues only incentives government officials to spend more rather than to actually reduce the deficit.

If we look at the real deficits according to a percentage of total revenue raised, we find that no real statistical relationship exists from 1947 to 2016 (removing years of 2010 to 2013 as outliers) when revenues are raised in order to cover those deficits.

However, what about in terms of real deficits to real GDP? Furthermore, no real statistical relationship exists when looking at real deficits as a percentage of GDP and total real revenues.

Which then brings us to our next question, what about the relationship between revenue and spending?

When we test these two together, we get that for every dollar of additional revenue raised, another 1.12USD in real terms is spent (with a standard error of +/- 1.16%, and T-Ratio of 39.34).

This means that a deficit of 0.12USD (12 cents) arises for every dollar raised.

So, if we take the example above of essentially completely putting the burden of the deficit on the top 1%, what would happen to the following years? The likely result is that a new deficit would arise rather than the budget being balanced.

In Relation to Donald Trump’s Tax Plan

When looking at Donald Trump’s recent tax plan, it is difficult to evaluate if taxes for individuals will be cut or not.

However, we do know that corporate tax rates will be cut.

Let’s take the theory of Laffer Curve. The Laffer Curve states that a certain tax rate would induce the highest amount of tax paid in terms of total revenue. Although the Laffer curve is not accurate (due to other issues arising with it), let’s assume that in this scenario it is.

Donald Trump essentially cuts taxes, which moves the effective tax rate towards the optimal tax rate needed for the highest amount of revenue which can possibly be raised. Now, we know that a higher degree of tax revenue would result in the likelihood of higher spending and would not bridge the deficit created. However, Donald Trump has also proposed a spending cut as well, of effectively 3.561 Trillion USD over 10 years (this is less economic savings) or essentially 356.10 Billion USD per year.

Now, taking into consideration the scenario that Donald Trump’s new tax-plan sees an effective tax cut (resulting in raising total revenue and therefore raising total spending), thus what would need to happen is that the spending cuts must outweigh the new spending (from the extra revenue created) to truly reduce the deficit or bring it towards a surplus.

Conclusion

In conclusion, when analyzing the so called proposed need of increasing tax revenues, the cruel reality is that it induces congress to spend an additional 1.12 USD per 1 USD raised.

This means that if we raise revenue by 1USD, an additional budget deficit of 0.12USD would be the result. Therefore, the most realistic result is that a spending cut is needed to balance the budget, rather than an increase in revenues by either tax cut (Laffer curve, debatable if it works), or by increasing taxes on the wealthy.

When considering the recent attempts by the White House to cut taxes, we may see an increase in real total revenue, and therefore an increase in real spending as a whole above the amount being raised.

Furthermore, Donald Trump’s administration have also proposed a spending cut, the spending cut is the right direction towards reducing the deficit. When taking into consideration how a reduction in deficits could have positive impacts on the economy (freeing up resources for private sector to utilize). Donald Trump’s proposal is a step in the right direction towards truly reducing the deficit.

However, as we know, these are all proposals, and have not realistically been passed through Congress.

Therefore, the clear majority of so called tax-cuts, or spending cuts could still be confined as mere speculation rather than concrete policies.

 

Calculation Disclaimer

All data was obtained on US Government spending from 1947 to 2016 can be found here.

All Revenues of the same time period can be found here.

All figures are adjusted for inflation using inflation figures from here.

Econometric calculations (of spending for additional revenue raised) were done using Gretl. Econometric calculations (used to calculate revenue relationships towards deficits) were done using Gretl.

All above calculations may have errors, however, the author has taken great care to make sure that all data are in real terms and that sampling and non-sampling errors are minimized.

 

Image: Art Laffer/Onward State

This post was written by Baland Rabayah.

The views expressed here belong to the author and do not necessarily reflect our views and opinions.

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baland.rabayah@beinglibertarian.email'

Baland Rabayah

Baland Rabayah is a student of accounting and finance at Bangor University and is also pursuing a Graduate Diploma in Economics at the University of London. Baland holds a Diploma in Accounting and Finance from the Bahrain Institute of Banking and Finance. He plans to pursue to continue his studies by doing a master's in economic history and a PhD in Economics. Baland follows a mixture of Chicagoan and Austrian principles in economics, with his influences being Murray Rothbard, Ludwig von Mises, Friedrich Hayek, George Selgin, Lawrence H. White, Peter G. Klein, Ronald Coase, and Milton Friedman. He is currently part of the Being Libertarian Merchandise Project’s management, and runs his own investments. Baland is also the former CEO of MoreTech Bahrain, a start-up company which attempted to launch Bahrain's and the Middle East's first flagship smartphone. He is a racing enthusiast, and regularly races professionally in Bahrain's SWS races.

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