Opinion and Taxes and Economic Analysis

HICKS: Demagoguery and the truth about taxes

December 1, 2012

The popular media lately has been full of astonishing piffle with regard to taxation—so much so that a reasonably smart listener might suppose there was some magnificent disagreement among economists, like there is among lawyers in a court case. That is not the case.

We economists are in broad agreement about the facts of taxation. This does not mean we agree about policy, for there is more to any policy decision than the truths of taxation, but we should be mindful of demagoguery about taxes. This column will focus on known truths of taxation.

First, higher taxes on a good or service will lead to less of it being consumed and produced than would otherwise have been the case. So, a higher tax rate must lead to less economic activity, all things being equal.

Of course, all things are never equal. Oftentimes, taxes are cut when the economy is stalling or increased as it rebounds. To no surprise, it is common to have periods of increased tax rates alongside a booming economy. It actually requires statistical modeling to tease out the effect, so when you hear someone comparing tax rates and growth using one historical example, you may be certain they are either lying or have no idea what they are talking about (or both).

Second, the effects of tax-rate changes are nonlinear in the sense that a small tax increase causes less of a decline in economic activity than a big tax increase. Moreover, the rate of tax that matters most in dampening economic activity is that levied in the last dollar, not the first dollar earned. This is the higher marginal tax rate economists warn about.

These truths combine to explain many things, including the Laffer Curve—a hypothesized relationship between marginal tax rates and tax revenue. A staple of supply-side economics, this theory roughly suggests that too high a tax rate will dampen economic growth so much that overall tax revenue will decline.

The converse is also true: At some point, lowering tax rates will boost the economy so much that tax revenue actually increases. This is because there is both a mathematical relationship (higher rates lead to more revenue) and an economic relationship (higher tax rates lead to less economic activity).

While the existence of a Laffer Curve is largely accepted, the best evidence suggests that we are a long, long way from having tax rates that are high enough to feel the effect. A tax cut will almost certainly not increase tax revenue, while an increase will not grow revenue proportionately.

Debates about tax rates are appropriately political. Taxes influence decisions about how much we save, where we live, how many children to have, and how big a home to buy and what type of government we have.

But we should all understand the facts in the debate over taxes.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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