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February 15, 2005

Why Social Security Reform Can’t Include Tax Increases (or, Why Liberals Hate the Laffer Curve)

“It is difficult to get a man to understand something when his salary depends upon his not understanding it” — Upton Sinclair

Democrat politicians are still going on Sunday television talk shows to advocate that Social Security’s $3.7 trillion “unfunded obligation” be closed by repealing “Bush’s tax cuts for the rich”. There is one tiny problem with what these Liberals are proposing: when those tax cuts became effective, Federal Revenues went up, not down.

Let’s look at the actual impact on Federal Revenues of the 2003 tax cut.



Full size image

As can be seen in the above graph, Federal revenues began a dangerous decline in the last year of the Clinton administration and fell for three straight fiscal years. When “Bush’s tax cuts for the rich” took effect, Federal Revenues began growing again and are just now surpassing their pre-tax-cut peak.

So, how is it possible that cutting tax rates can result in higher tax revenues? And why is this something that no Democrat can see, even when the evidence is right in front of their faces?

The answer is simple: above some optimum tax rate, every tax becomes counterproductive. When sketched as a graph on a cocktail napkin, this economic truth is known as “the Laffer Curve”.

If you think about it, the Laffer Curve is just common sense. Taxes discourage (which is one reason we tax things like cigarettes so heavily). Whenever you tax something, you get less of it. An economist would state this as, “The higher the tax rate, the lower the tax base.” As you increase the tax rate, there comes a point where the tax base falls so much that the higher tax rate actually generates less revenue for the government.

The Bush 2003 tax cuts reduced the maximum income tax rate on ordinary income from 40% to 35%, the maximum income tax rate on corporate dividends from 40% to 15% and the capital gains tax rate from 20% to 15%. The reason that Federal revenues went up rather than down after these tax cuts is because the previous tax rates were above the optimum rates. That is, they were “on the wrong side of the Laffer Curve.” Indeed, economic studies show that top marginal income tax rates are still too high. The best estimates are that tax revenues would be maximized by a top income tax rate of no more than 25%.

Repealing the 2003 tax cuts would make Federal Revenues go down, not up. This would not help Social Security, Medicare, or anything else. Benefits must be paid with tax dollars, not tax rates.

It takes about two minutes of “Googling” to find out that the big tax rate cuts of the past 100 years (under President Harding in the 1920s, Kennedy in the 1960s, Reagan in the 1980s and Bush in 2003) have produced higher economic growth and higher government revenues. So, why don’t the Liberal “talking heads” on the Sunday TV know this? And why are they advocating tax rate increases that will lead to lower government revenues?

There are two answers to this:

1. Denial. The Liberals (desperately) don’t want the Laffer Curve to be true, so they pretend it isn’t true and depend upon the Republicans (“the Stupid Party”) to be too stupid to articulate clearly and forcefully that the Laffer Curve is true.


2. Malevolence. Just as the Republicans are “the Stupid Party”, Democrats (at least post-1965) are “the Evil Party”. At some level, the Liberals know that higher tax rates mean lower economic growth and lower tax revenues, but this is the outcome they secretly want. A weaker private economy and more people in need translate into more votes for Democrats and greater relative status and income (and therefore happiness) for the academics and government employees who compose the core of the (post-1965) Democratic Party.

So, the reasons that Social Security reform cannot include tax increases are as follows:

1. Tax rates for the highest income earners are still above the optimum level and raising them will result in lower economic growth and lower tax revenues. Eliminating the so-called “cap” (the maximum amount of wages subject to Social Security taxes) would constitute a huge increase in the top marginal tax rate and would therefore also reduce government revenues.


2. While it would be possible to squeeze more tax revenue out of middle- and lower-income workers, it would be wrong to do so—they are already struggling financially in today’s economy.

While Social Security reform cannot and must not include tax increases, there is an opportunity to increase economic growth and government revenues by cutting effective marginal tax rates. This is why there must be no “phase-ins” and no “caps” on the 4% of wages that workers should be able to put in their Personal Social Security Accounts. With Personal Accounts with no “phase-ins” and no “caps”, Social Security Reform will act as a 4 percentage-point cut in marginal tax rates on everyone making less than $90,000 per year. This would give a significant boost to economic growth and, over time, Federal revenues.

Posted by Louis Woodhill at February 15, 2005 3:00 PM | Print

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