Will Higher Taxes Tank the Economy?

Will Higher Taxes Tank the Economy?

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The main sticking point in negotiations between Republicans and Democrats on deficit reduction measures to accompany a rise in the debt limit is whether higher revenues should make any contribution. A key Republican concern is that any tax increase would depress the economy.

Given the slow patch that the economy is going through, any realistic threat to growth is one that has to be taken seriously. But the Republican position that spending cuts are expansionary while tax increases are depressing is not logically consistent. Both spending cuts and tax increases affect the economy in roughly the same way in the short run – by reducing aggregate demand. Fiscal contraction, whether on the tax side or the spending side, will have a negative effect under current economic conditions.

Of course, it goes without saying that there will be different economic effects depending on how spending is cut or taxes are raised. But the first-order effect in either case will be to reduce national income and depress growth. In the longer run, some spending cuts could well be expansionary if they altered economic behavior in a positive direction. In general, subsidies are a bad idea because they distort economic decision making and reduce growth below what would occur in a free market environment.

But the same is true for tax subsidies. If someone pays lower taxes because they produce ethanol it is really no different than just getting a government check for doing the same thing. Yet many Republicans oppose abolishing tax-based subsidies because it would be an impermissible and economically depressing “tax increase,” while eliminating budget-based subsidies would be a beneficial “spending cut” that would be economically stimulating.

Economists have known for many years that many tax cuts are nothing more than spending by another name. They call such things “tax expenditures” and there are about $1 trillion worth in the tax code. Getting rid of many of them would have exactly the same economic benefits as reducing on-budget subsidies. Nevertheless, Republicans oppose eliminating tax expenditures unless other taxes are cut because any net tax increase would depress growth. The historical evidence, however, does not necessarily support this view.

Back in 1982, Ronald Reagan was persuaded that the deficit was such a severe impediment to growth that a tax increase to reduce it would be economically beneficial. Many in his party strenuously objected, citing research by Republican economists. For example, on August 12, 1982, U.S. Chamber of Commerce president Richard Lesher sent to Congress an analysis of the proposed tax increase. Said Lesher:

“If H.R. 4961 is passed in these troublesome economic times, we have no doubt that it will curb the economic recovery everyone wants. It will mean a lower cash flow as more businesses pay more taxes, with a depressing effect on stock prices. It will reduce incentives for the increased savings and investment so badly needed to improve productivity and create more jobs. It will mean higher prices for many products and services. It will increase government costs in caring for those who, because the economy is held down, cannot find employment.”

It would be hard to find an economic forecast that was more wrong in every respect. Looking at real gross domestic product, it grew 4.5 percent in 1983 and 7.2 percent in 1984 – an exceptionally strong performance. The stock market had one of its best years ever in 1983 – both the Dow Jones Industrial Average and the S&P 500 Index rose 35 percent. There was no increase in the rate of inflation, which was exactly the same in 1983 and 1984 as it was in 1982. The unemployment rate fell from 10.6 percent in December 1982 to 8.1 percent by December 1983 and 7.1 percent in December 1984.

The Chamber was not an outlier. Virtually every Republican economist made similar dire predictions. Economist Arthur Laffer told his clients on July 26, 1982, that the Tax Equity and Fiscal Responsibility Act, which raised taxes by about one percent of GDP, “will stifle economic recovery,” “retard economic growth,” and undercut “the economy’s ability to enter into a period of expansion.” On August 20, 1982, he told his clients that TEFRA “will tend to lengthen and deepen the recession.” Writing in the New York Times on September 12, 1982, economist Norman Ture said the administration’s claim that TEFRA would promote economic growth was “bizarre.” He said it would “weaken the impetus for economic growth” and make the economic recovery “less certain and less vigorous.”

Despite these erroneous predictions, Republican economists said pretty much the same thing when Bill Clinton proposed a tax increase in 1993. On April 12, 1993, the Republican members of the Joint Economic Committee predicted that the unemployment rate would be 0.3 percent higher in 1994 and 1995, 0.5 percent higher in 1996, and 0.6 percent higher in 1997. Real GDP growth would be 0.4 percent slower in 1994, 0.5 percent slower in 1995, 0.8 percent slower in 1996, and a full percentage point lower in 1997.

On August 20, 1993, Laffer told his clients, “Clinton’s tax bill will do about as much damage to the U.S. economy as could feasibly be done in the current political environment.” He said that interest rates would rise and the stock market would fall.

Once again, it would be hard to find a forecast that was more completely wrong. The unemployment rate fell from 7.1 percent in January 1993 to 5.4 percent by December 1994. Real GDP growth rose from 2.9 percent in 1993 to 4.1 percent in 1994. Stock prices rose and interest rates fell. More importantly, the 1993 tax increase and accompanying spending controls, which were opposed by every Republican in Congress, laid the foundation for the phenomenal growth of the late 1990s that actually produced budget surpluses before Republican tax cuts in the 2000s dissipated them.

Despite these facts, it is Republican dogma that tax increases are so offensive that they are willing to walk away from trillions of dollars of spending cuts that the Obama administration has agreed to and risk defaulting on the national debt just to prevent so much as $1 of tax increase from being enacted. While obviously any tax increase needs to be carefully considered, there is no doubt that closing loopholes and eliminating many tax subsidies would have the same effect as cutting spending. If Republicans believe that cutting spending is stimulative, they can’t logically oppose cuts in spending through the tax code.