Physicist Niels Bohr once quipped that, “Prediction is very difficult, especially about the future.” Just several months ago, the prediction was that the federal budget deficit for this year would be $423 billion dollars. A surge in economic growth increased revenues so that the deficit has dropped $127 billion to $296 billion. In other words, the deficit estimate was 30% too high, which is a measure of the accuracy of the science of economic prediction. President Bush claims that his tax cuts were responsible for the increase in economic growth. The results mitigate the Democrats critique that tax rates are too low.
Democrats argue that federal revenues are just passing the point where they were in 2001.However, in 2001 the economy was entering a recession and the attack on September 11, 2001 added to negative economic growth. The tax cuts did not begin their impact until 2002, so the effect of the 2001 recession and September 11 on tax revenues would have occurred whether or not the tax cuts were implemented.
Whether one accepts Bushs argument or not, the logic behind the Laffer curve, named after economist Arthur Laffer, is inexorable. At a 0% tax rate, government would receive no revenue. At a confiscatory 100% tax rate, there would be such a distinctive to engage in economic activity, that the tax revenue would also be zero. At some tax rate in between, the government maximizes its revenue.
Tax rates also affect private income. There must be some government revenue to provide for a government that can at police economic transactions. Others argue that investment in education by government also increases private income. In any case, a 0% tax rate would not maximize private income. But certainly a rate that maximizes private income would be at a tax rate lower than the rate at which government income is maximized.
Indeed, the two functions can be coupled so that at some intermediate tax rate, the sum of private and government income is maximized. Whether a people select a tax rate that maximizes private income, government income, or the sum of the two is in part at matter of philosophy. Indeed, there are some on the Left who would raise income taxes on the wealthy in a punitive effort to reduce income disparity; even it meant that net tax revenues would be lower.
In addition, the optimum tax rate also depends on the economic distribution of the tax. The poor who are barely managing will continue to work quite hard in spite of high tax rates because they do not have the luxury of living on less. The rich, on the other hand, could decide to eschew the additional work or risk required to earn more income at lower rates of return. Changes in the rate of capital gains also affect the economy in a different way than the taxes on regular income.
The disappointing part is that politicians do not argue about what the optimum tax rate is. For Republicans, the tax rates are always too high. For Democrats, taxes are always too low. When President Ronald Reagan followed President Jimmy Carter into office in 1980, the highest marginal income tax rates were 70%. Reagan persuaded Congress to reduce the highest marginal rate to 28%. When President George Bush followed President Clinton, the highest marginal rates were in 39.5%. The Bush tax plan reduced the highest rate to 35%. Surely, the simulative effect of the Reagan tax cut would have been substantially larger than that associated with Bushs tax cut. Is the tax rate that maximized federal income 28%, 35%, 39.5%, or 70%? Are we close to revenue maximizing rate now? At what rates are private income or the sum of private and public income maximized? What is the optimum mix of income, sales, and other taxes? These real questions are lost in the political noise.