The Laffer curve stands for the proposition that in some cases (not all) revenues can be increased by reducing tax rates. This generally results when tax rates are so high and discouraging so much productive activity as a result that the rates are actually generating less revenue that they would if they were lower.
This has been demonstrated in the real world with capital gains taxes in recent decades. Since the 1960s, capital gains taxes have been cut 3 times and raised 3 times. Every time they have been cut, capital gains revenues have actually increased. Every time they have been raised, capital gains revenues have fallen.
Professor Laffer often explains this effect by saying that there are two rates when the revenues raised are always zero, a 0% tax rate and a 100% tax rate. But today I am going to explain a new breakthrough for the Laffer curve. I am going to explain how we can increase total federal income tax revenues with a zero percent federal income tax rate for a majority of Americans.
To see this, let’s start with where we are today with the federal income tax. According to the latest official data from the Congressional Budget Office (CBO), the top 1% of income earners pay 39% of all federal income taxes, while earning 19% of pretax income. The top 5% of income earners pay 61% of all federal income taxes, while earning 32% of pretax income. The top 10% of income earners pay 73% of all federal income taxes, while earning 42% of pretax income.
This has been the result of Reagan Republican supply-side tax policy from 1981 to 2007 (abandoned by Bush Treasury Secretary Hank Paulson in 2008, then economic policy guru for the administration). Reagan and his supply-siders cut tax rates for these upper income workers sharply during those years. The top federal income tax rate was 70% when Reagan entered office. It was 28% when he left in 1989. Blunders led by Bush I economic policy architect Richard Darman and by President Clinton and his economic policy team raised the top rate back up to 39%. But Bush II, originally committed to supply-side economics, reduced the top rate back to 35%, amidst much howling and braying by the Left.
The data above shows an enormous Laffer curve effect among the top income earners in response to these lower tax rates over the last 30 years. The much lower rates provided powerful incentives for these upper income earners to produce more because they were allowed to keep a much higher percentage of what they produced as a result. These upper income earners produced so much more that they actually ended up paying a higher nominal amount of taxes, even though those taxes were a lower percentage of their incomes.
Now let’s look at the other end of the income scale. According to the latest official CBO data, the bottom 40% of income earners don’t pay any federal income taxes as a group on net. Because of refundable income tax credits in the tax code, they actually receive payments from the income tax code on net equal to 3.6% of all federal income taxes. “Refundable” means if you don’t have enough income tax liability to receive the full amount of a credit, the government will send you a check for the difference. For example, suppose you have 3 children and consequently are entitled to $3,000 in federal child tax credits against your income taxes. But suppose you otherwise only owe $800 in federal income taxes. Because the federal child tax credit is refundable, you not only do not have to pay the $800, you actually get a check from the federal government for $2,200.
The middle 20% of income earners, the true middle class, pay only 4.4% of all federal income taxes, while earning 13.4% of pretax income. If you combine this middle 20% with the bottom 40%, then the bottom 60% of income earners together as a group on net pay only 0.8% of all federal income taxes. (The bottom 40% receive 3.6% of all federal income taxes while the middle 20% pay 4.4%, leaving the bottom 60% altogether paying only 0.8% on net).
This was also the result of Reagan Republican tax policy. Reagan actually proposed the first major refundable income tax credit, the Earned Income Tax Credit (EITC), in his historic 1972 testimony before the Senate Finance Committee. In that testimony, Reagan was leading the eventually successful fight against President Nixon’s proposed guaranteed national income, the Family Assistance Plan (FAP), which would have been a socialist nightmare. With his enormously successful welfare reforms in California in mind, Reagan called instead for focusing welfare assistance on the lowest income truly needy. He also called for workfare, requiring work in return for welfare for the able-bodied. Reagan also proposed the EITC to offset the burden of Social Security payroll taxes on the poor. After Nixon’s FAP was defeated, Reagan’s California welfare guru, Robert Carleson, was appointed national welfare commissioner, where he spread the Reagan welfare reforms to other states across the country.
As President, Reagan cut federal income tax rates for everyone across the board, including those at the low and middle-income levels. He indexed income tax rates for inflation, so that inflation would no longer drive low and moderate-income workers into higher rate brackets. He doubled the personal exemption, which helps lower income workers the most. Subsequently, the Republican majority Congress led by former House Speaker Newt Gingrich adopted a child tax credit of $500 that President Bush later doubled and made refundable, which again helped low and moderate income workers the most. President Bush also reduced the bottom tax rate by 33% to 10%, while reducing the top tax rate by only 13%. President Clinton contributed to this by expanding the EITC in 1993.
The end result of this is that the Republicans, primarily, abolished federal income taxes for what some call the working class, and almost abolished federal income taxes for the middle class, as the numbers discussed above show.
Last year, on the campaign trail, Obama told Joe the Plumber, “We’ve cut taxes a lot for folks like me who make a lot more than 250, but we haven’t given a break to folks who make less.” Obama repeated over and over during the campaign that the Republicans cut taxes only for the rich, while jilting the middle class. This was our first indication that Obama is not living in the real world, and that he has trouble telling the truth. Dangerous for America to have a President like that.
With the reality as described by the numbers above, which are for 2006, we can now see that Obama’s campaign theme of cutting income taxes for the middle class was a cynical manipulation of voters. Reagan and the Republicans had already cut income taxes for the middle class and working people to little or nothing. You can’t cut federal income taxes more for people who are already paying little or nothing.
As President, Obama’s tax policy involves adding or expanding still more refundable tax credits to the code, shoveling still more tax revenues to favored constituencies. As a result, he is mangling the income tax code into a socialist redistribution system, rather than a revenue-raising system. Obama has already expanded the EITC still further, and adopted a new, refundable, $400 per worker income tax credit, both of which were in his February stimulus package, among still more in the process of adoption. Those additional tax credits have probably now eliminated all federal income taxes completely for the bottom 60% as a group on net.
Many conservatives are deeply troubled by this. They fear that with the bottom 60% of income earners paying nothing in federal income taxes, this majority will see no reason not to vote for limitless spending burdens. But it would be politically disastrous for conservatives to campaign on increasing taxes on the bottom 60% because that is good tax and social policy. Steve Lonegan recently demonstrated this in the New Jersey gubernatorial primary, where he campaigned on a 3% state flat tax. This would be very good tax policy, but it would have resulted in a slight increase in state income taxes, about $300 per year on average, for the bottom half of income earners in New Jersey, who essentially pay no state income taxes now. His opponent Chris Christie pounded away in advertising on that point, and won easily. And this was in a Republican primary.
The top advocates of a flat tax like Steve Forbes and Dick Armey recognize this political reality. That is why their flat tax proposals always included generous personal exemptions of $10,000 to $12,000 per person that still left the bottom 60% paying little or nothing. Moreover, as a lifetime taxpayer advocate, I find it difficult to see a majority of Americans exempt from federal income taxes as a real problem. But I do not favor sending them money on net from the top 40% through refundable income tax credits.
I think there is a better way for conservatives, taking advantage of the current situation. First, I think conservatives and Republicans should trumpet and take credit for the fact that they basically abolished federal income taxes for what is termed the working class, and virtually abolished them for the middle class. We should trumpet that in particular to counter the liberal-left Democrat libel that Republicans only cut taxes for the rich, while dissing the middle class and working people.
Secondly, conservatives and Republicans should advance tax reform that builds on that achievement, creating ideal overall tax policy. That tax reform would involve a 0% federal income tax rate for the bottom 60% of income earners. But, in return, the reform would abolish all refundable income tax credits because the income tax code should be focused on raising revenues efficiently, not robbing the top 40% to actually send what is effectively welfare to the bottom 60%. Given current realities, such reforms would probably be revenue neutral at least, or quite possibly actually increase overall revenues, while leaving a majority of Americans with a 0% federal income tax rate. Hence, a new breakthrough for the Laffer curve.
With the explicit 0% tax rate for the bottom 60% framing the issue, abolishing the refundable tax credits that actually ship money to lower income earners through the tax code would become politically viable. Few Americans today understand or would support the idea that the income tax code should be paying rather than taxing some favored portion of the public. Arguing that we should use the tax code to pay rather than tax some Americans would not be an appealing political rally cry.
Such tax reform can and should be combined with overall welfare reform based on work that would ensure an adequate safety net for the poor. The hugely successful 1996 welfare reforms changed just one program, the old Aid to Families with Dependent Children (AFDC). We need to extend those reforms to the other 85 federal means-tested welfare programs, including Medicaid and food stamps, which I will discuss further in future columns. Considering the raging success of the 1996 AFDC reforms, such further reform should result in huge overall savings.
Moreover, with no possible concern that an income tax system with a 0% tax rate for the bottom 60% could be unfair to those low and moderate income earners, we should then be free to adopt sound tax policy for the top 40%, who earn 75% of total income. The new reform should propose taxing all of the income of those top 40% once with a 15% flat tax. That would be close enough to revenue neutral on a dynamic basis because of the enormously positive resulting pro-growth effects.
The usual arguments against a flat tax is that it would be unfair for lower income workers to pay the same tax rate as upper income workers. That argument reflects a distorted notion of fairness, which would best be served by the same rate for all. Under a pure flat tax, if A earns 10 times as much as B, A pays 10 times as much as B, which is perfect fairness. Under a progressive income tax with higher rates for upper income workers, if A earns 10 times as much as B, A pays much more than 10 times as much as B, which is not fair.
Nevertheless, this argument would not even apply to our reform because the bottom 60% would enjoy a 0% tax rate.
This is also the way to eliminate the distorting tax preference for employer-provided health insurance, rather than by adopting still more refundable tax credits as some conservatives are advocating now. For the bottom 60%, there would no longer be any health insurance tax preference, and for the rest the favoritism would be reduced to a minimal 15%. Or the tax exclusion for employer-provided health benefits could be eliminated altogether, affecting only the top 40%, in return for the 15% rate. The economic distortions caused by every other tax preference in the code would be minimized or eliminated entirely through the reform in this same way.
Contrary to the fears of conservatives, this tax system would sharply limit the size of government. No politician would dare suggest imposing income taxes anew on the bottom 60%. While the last two Democrat Presidents won by running on a tax cut for the middle class, that game would be over. Instead conservatives can argue for middle income and working class votes to protect the 0% tax rate from big government liberals. And as the Obama Administration will soon learn, higher income earners have flexibility in their taxable income, and increasing revenues by raising taxes on them is not easy.
I would also extend the 15% tax rate to business and investment income across the board. I would reduce the current, crippling, uncompetitive 35% federal corporate income tax rate to 15%. While under pure tax reform, the capital gains tax should be abolished because it involves multiple taxation of capital, we could live with a 15% capital gains rate for both individuals and corporations (current corporate cap gains rate is 35%). The same is true for the tax on dividends: we could live with a 15% rate there also. These low tax rates would produce surging tax revenues from the resulting surging economic growth.
We should combine all this with a long-term agenda of eventually replacing the entire payroll tax with personal savings and investment accounts that would ultimately take the responsibility of paying all the benefits currently financed by the payroll tax. Another long-term project is to extend the policy of no state income tax now enjoyed in 9 states to every state. That could be covered financially by a cap on the growth of state spending and some higher sales taxes.
This is the long-term, free-market tax agenda for conservatives. While most of us are sickened by the current far left domination of the federal government, and too many state and local governments, conservatives are poised for a huge political resurgence. We should have an agenda in mind for when that occurs.