Reaganomics essay

In the absence of a "tooth fairy" resources spent by the government are the total tax burden on the economy's productive sector. Wether government spending constitutes much needed public services, transfer payments, pure waste, or even worse; these resources must come from the economy's workers and producers. As such, they comprise a major part of the wedge driven between payments made for factor services and payments received by the factors themselves. Taken alone, increases in this wedge per se raise wages paid for factor services, lower wages received by factors and thereby lower the demand for and the supply of productive factor inputs. Output falls. The Roth-Kemp bill does nothing directly to impact this aggregate wedge. To stop here however would miss not only the essence of the Roth-Kemp bill, but much of the lessons from the history of taxation. Output depends as much on the constellation of individual factor tax rates as it does on the overall tax burden. If one productive factor is faced with exceptionally burdensome tax rates it will withdraw from the market place. Its departure from the market place will lower output by its production potential and, in turn, reduce the production potential of all other factors with which it is complementary. High productivity and high wages for truck drivers require the exist- ence of trucks for the drivers to drive. If trucks are taxed excessively their num- bers will decline as will the wages and productivity of truck drivers. Output will be impacted doubly. In the limiting case when all returns to trucks are confiscated none will exist and wages accruing to truck drivers will be zero. Output, too, will 131 be zero though there no taxes on the earnings of truck drivers. Tax receipts will also be zero. As a pedagogic device, imagine that we reduce all tax rates in the sample by one-half. The earnings of truck drivers remain untaxed but now earnings accruing to trucks are taxed at 50 percent instead of the previous 100 percent. Savers who either abstain from consumption or work harder can now obtain an after tax rate of return by accumulating trucks. There will be more trucks, higher wages, more output and tax receipts will rise. The increase in tax receipts results ex- clusively from the increase in production and the lowering of tax rates. The Roth-Kemp bill, armed with the experience of similar, but far more ex- treme, measures carried out by President Kennedy in the early sixties, addresses the current counter productive constellation of individual factor tax rates. By partially redressing the counter productive structure of current tax rates it most likely will lead to a substantial increase in output and, in the course of very few years, will probably reduce the size of goverment deficits from what they otherwise would have been. Net revenues could well expand even though income tax rates at each and every bracket are reduced. Part of the effect on the deficit, of course, will occur because higher output means less unemployment, less poverty and therefore lower total spending on unemployment benefits and poverty programs. In this sense, the Roth-Kemp bill actually reduces government spending and the overall wedge, albeit indirectly. People don't work and save to pay taxes. They basically work and save in order to acquire after-tax income. It is the after-tax incentive that drives production, savings and employment. In a Newsweek column several years ago Milton Friedman illustrated the sharp increase in the progressivity of personal income taxes resulting from an across-the-board income tax surcharge. The Roth-Kemp hill. as the earlier Kennedy tax rate cuts, is precisely a negative income tax surcharge. Its effects will be to lower the progressive nature of income taxes. The Roth-Kemp bill will increase those incentives the most where the incidence of taxation is currently the highest. Using the Kennedy income tax rate by way of illustration, when Kennedy came in to office Federal personal income tax rates ranged from 20 percent in the lowest brackets to 91 percent in the highest bracket. A worker in the lowest bracket who earned $1 on the margin paid 20 cents in taxes and his incentive was 80 cents. In the highest bracket one dollar of marginal earnings yielder 91 cents in taxes and an incentive of 9 cents. By cutting tax rates across-the-board by about 30 percent the lowest bracket after the Kennedy tax cut was 14 percent and the highest bracket 70 percent. The incentive effects however were radically different for the two extremes. The incentive in the lowest bracket was raised from SO cents on the dollar to 86 cents or an increase of 7'2 percent. In the highest bracket where the cut was 23 percent as opposed to 30 percent the incentive was raised from 9 cents on the dollar to 30 cents or an increase in incentive of 2.33 percent. The Kennedy era is an excellent example of the type of impact a Roth-Kemp bill could have. While occurring at different times the Kennedy tax program included an across-the-board cut in personal income tax rates. The corporate tax rate was reduced from 52 percent to 48 percent, depreciable lives for legal purposes were shortened and the investment-tax credit was instituted. In addition. major tax rate reductions were carried out under the Kennedy round tariff cuts. From 1961 through 1966 real GNP grew on average at a 5.4 percent annual rate. Unemployment rates fell from 6.7 percent in 1961 (5.5 percent in 1962) to 3.8 percent in 1966. Capacity utilization as measured by the Federal Reserve Board rose from 77.3 percent in 1961 to 91.1 percent in 1966. Annual inflation averaged 2.1 percent, 1.6 percent and 1.1 percent for the GNP price deflator, consumer price index and wholesale price index respectively. For some, the behavior of stock prices is perhaps the best indicator of the era's growth. The ratio of the S+P 500 to GNP went from .1104 in 1960 to .1154 in 1967. The low was the 1960 ratio but peaked at .1281 in 1965. Over the 1961-66 period stock prices rose at an annual rate of 5.5 percent and from 1960 through 1967 at an annual rate of 7.8 percent. During the 1961-1966 period Federal spending rose at a rate lower than GNP growth, 6.2 percent versus 7.5 percent. As a consequence the overall federal wedge fell from 18.75 percent in 1961 to 17.62 percent in 1966. The deficit on the Federal level fell consistently from the $3.1 billion level in 1961 to a surplus of $1.4 bil- 132 lion in 1965 and literal balance in 1966. Defense spending increases during this era were less than non-defense increases. While the prognosis of dire consequences were the range in the early 1960's they didn't materialize. In many ways the situation is similar today. Unemployment is high, currently sitting a little above 6.0 percent. Federal spending, or the aggregate wedge, stands about 22.6 percent and S & P stock prices relative to GNP are at .045, close to their all-time low. Inflation is far higher today, run- ning at rates well over 6 percent. The federal deficit in the most recent period is about $45 billion. While the Federal tax code on the surface appears less distortive today than at the beginning of the Kennedy era other changes have occurred that could even result in more distortions. Additional changes have also occurred that make marginal tax rates relative to average rates even higher now than before. The institution and expansion of State and local taxes, the systematic reduction of real exemptions and credits combined with the highly distortive effects of inflation on the incidence of tax rates on real earnings have resulted in widely divergent marginal tax rates on different factors of production. The effects on incentives of the current structure of taxes are quite conceivably greater today than they were prior to the Kennedy cuts. An across-the-board tax rate cut, as shown earlier, increases incentives the most where the incidence of the tax structure is most restrictive. Without a great deal more specific knowledge the Roth-Kemp bill would be a good first step in an overall tax reform package. It would go a long way in reorienting incentives with market contributions. The Roth-Kemp bill by no means ends the need for tax reform and tax rate reductions. Additional legislation such as the Steiger-Hansen bill and the Stockman bill would be complementary with the Roth-Kemp bill. Looking out into the future, indexation legislation such as former Senator Taft's bill and legislation proposing full integration of the corporate tax structure with personal income taxes are desirable. Even more distant would be some proposal for the substitution of a value added tax for other far less efficient taxes. Social Security tax and benefit reforms are also badly needed. In analyzing the Roth-Kemp bill it is important to recognize that the bill is o beginning to a meaningful tax reform, not an end. The need for other legisla- tion does not mitigate the need for Roth-Kemp now. The best cannot be allowed to be the enemy of the good. The Roth-Kemp bill should also have a good effect on inflation. Inflation is primarily a Consequence of too much money chasing too few goods. Excessive money growth has long been recognized as a cause of inflation. It is equally as true, however, that too few goods will also cause prices to rise. To put this relationship into clear focus, one need only to imagine the following: What would happen to prices in the United States if output were reduced to, say, the output level of Luxembourg and the amount of money stayed un- changed? Prices would skyrocket, not fall. Higher unemployment means lower output. As such, high unemployment is, by itself, a cause of high prices. High prices and rapid inflation increase the prospects for high unemployment. With progressive income tax schedules, high price levels raise tax rates for each level of production. Rapid increases in prices result in firms underdepreciating their plant and equipment and also under-valuing their cost-ofgoods sold. Pretax profits are overstated. This results in higher tax rates for businesses for each level of output. The increase in tax rates that result from higher prices and inflation reduce output directly and cause unemployment. Fortunately, this view has two highly attractive characteristics. First and foremost, this view is supported by a large body of experience. Secondly, the policy implications offer some hope to a world badly afflicted with economic malaise. The Roth-Kemp bill would start the process in the correct direction.