Tax Cuts For The Rich: How Effective Are They?

September 19, 2010: One of the issues that has garnered a great deal of attention in the run up to the November election is tax cuts. Specifically, whether the so-called "Bush tax cuts" for the top 3 percent of Americans should be extended beyond this year. If no legislation is passed, the tax cuts are due to expire on December 31, 2010.

The main argument being presented by those in favor of extending the tax cuts for those in the top income bracket is that if their tax rates were allowed to rise, their level of consumption of would drop, hurting the economy. A seemingly logical argument on its face, and may have a small amount of truth to it. But the evidence of how the rich have reacted to tax cuts and increases in the past tell a different story.

Studies seem to indicate that the wealthy do the exact opposite of what you might think they would do when presented with a tax increase, this according to Moody’s Analytics Inc.

When tax legislation was signed by Clinton in 1993 -- raising the top tax rate to 39.6 percent from 31 percent -- the saving rate fell from 12.1 percent in the second quarter to 9.5 percent in the first quarter of 1994. The Standard & Poor’s 500 Index rose 1.9 percent from July through September, after little change the previous three months.

When the first Bush tax cuts were signed into law in June 2001, pushing the top rate down to 35 percent, the wealthy boosted savings. The saving rate climbed to 2.8 percent in the first quarter of 2002 from minus 2 percent in the second quarter of 2001. The increased savings coincided with a 1.1 percent decline in the S&P 500 index. (source)

What does this all mean? In short, when taxes are raised on the wealthy, they decide to spend their money rather than save it, and vice versa. And since consumption is the most significant contributor to our economy, higher taxes on the wealthy has a much greater chance of spurring the economy than lower taxes.

Moody's also found that making the "Bush tax cuts" permanent would return a mere 29 cents of economic growth for each dollar the government spent on the tax breaks. This is behind 11 other stimulus provisions that the government can take to boost economic growth.

(Note: The chief economist of Moody's is Mark Zandi, an economic advisor to John McCain during his 2008 presidential run and someone who the Obama administration used to help shape their stimulus package. So he, and the company that he helped co-found, are very much in the middle of the political spectrum.)

In addition to the analysis that Moody's provides, the Congressional Budget Office rated the tax cuts for the wealthy, and found that it was the least helpful of 11 forms of economic stimulus they evaluated.

Another argument presented in favor of extending the tax cuts for the wealthy is that failing to do so would be detrimental to small businesses. But the evidence provided by the IRS shows that very few small businesses would be affected.

Internal Revenue Service statistics indicate that only 3 percent of small businesses would be subject to the higher tax, and many studies of previous tax increases suggest that it would have minimal impact on hiring.

According to the Joint Committee on Taxation, 97 percent of all businesses owners do not earn enough to be subject to the higher rates, which would be levied on income of over $200,000 for individuals and $250,000 for families. (source)

And even the 3 percent number is probably too high.

Even among the 750,000 businesses that would be subjected to the higher rates in 2011, many are sole proprietors — a classification so amorphous it can include everyone from corporate executives who earn income on rental property to entertainers, hedge fund managers and investment bankers. (source)

Finally, something that is important to MajorityVoteRules.Org, is the sentiment of the public. As of the time of this article, six different national public opinion polls show that a solid majority of Americans support ending tax cuts for the rich.

We have just presented information that makes a strong case for the "Bush tax cuts" for the top earning income bracket to expire at the end of the year. But ultimately the position of MVR.Org is the one that the voters take. If our constituents believe that there is a case to be made for extending these tax cuts (most likely believing a tax increase right now would negatively impact consumption) and want their congressional representatives to vote as such, then that is the position we support as well.

P.S. - It is also worth pointing out that the "Bush tax cuts" are primarily responsible for the massive deficit we now have. Remember, tax cuts without spending cuts increases the debt.

** Added September 27 **

A Quinnipiac University poll this year showed nearly two-thirds of those with household incomes of more than $250,000 a year support raising their own taxes to reduce the federal deficit. (source)

** Added November 17 **

For historical perspective, it is worth pointing out that the top marginal tax rate under President Dwight Eisenhower, a Republican, was 91% between 1956-1960. In other words, the very wealthy only kept 9% of what they made (over $10 million, which is an important point). Under President Richard Nixon (Republican), the wealthy only kept 30%, while under the Ronald Reagan, another Republican, it was an even split. For a neat graphical look at the top marginal tax rate over the past 100 years, check this out. You can get the hard numbers for this time period here.

** Added November 18 **

Sometimes the debate over an issue comes down to a simple question. This is one of them. The New York Times' David Leonhardt asks the rhetorical question that is really the only question that matters in this debate: 'Were the Bush Tax Cuts Good for Growth?'

Those tax cuts passed in 2001 amid big promises about what they would do for the economy. What followed? The decade with the slowest average annual growth since World War II. Amazingly, that statement is true even if you forget about the Great Recession and simply look at 2001-7.

The competition for slowest growth is not even close, either. Growth from 2001 to 2007 averaged 2.39 percent a year (and growth from 2001 through the third quarter of 2010 averaged 1.66 percent). The decade with the second-worst showing for growth was 1971 to 1980 — the dreaded 1970s — but it still had 3.21 percent average growth. (source)

Here is a graph showing the growth of GDP since 1961. The evidence is in and it's pretty clear that the tax policies of the last decade, in comparison to previous decades, did not work.

GDP Graph

~ MVR.org