Jul 22, 2020

Proposed Tax Increases Will Not Reduce the Deficit

Higher taxes generally lead to even more spending and less economic growth
Veronique de Rugy Senior Research Fellow , Jack Salmon Staff Writer

This is the second in a series of three articles on the wrong way to reduce the growing federal debt. The first piece in this series is on the fallacy that low interest rates will allow the federal government to continue to safely accumulate high levels of debt.

In light of multitrillion-dollar deficits and dwindling future growth prospects, some policymakers are proposing to increase taxes to drive up revenues in the coming decade in an attempt to reduce the deficit—currently more than $20 trillion and growing. One such proposal comes from presidential candidate Joe Biden, who pledges to reverse aspects of the Tax Cuts and Jobs Act of 2017, including reinstating the 39.6 percent top rate of income tax, raising corporate income taxes from 21 to 28 percent, and increasing payroll taxes while lifting the payroll tax cap. However, empirical research and countless real-world examples demonstrate that attempts to reduce fiscal deficits by raising taxes almost always fail because they lead to increased government spending by a factor that outweighs growth in revenues.

In the 1990s, economists Richard Vedder, Christopher Frenze, and Lowell Gallaway conducted a study on the relationship between taxes and deficits based on an analysis of budget data from 1947 to 1990. The study became known as the “$1.59 study” because the authors concluded that every $1.00 in new taxes generated $1.59 in new government spending. In 2010, Vedder and Stephen Moore made revisions to the study on the basis of updated data through 2009 and found that each dollar of new tax revenue was associated with $1.17 in new spending. The authors observed different time periods and used different data and control variables, but their model revealed the same result every time: though the amount of new spending varied, higher tax collection always resulted in higher spending that exceeded growth in revenues.

In assessing this pattern, economist Jeffrey Miron examined the results of long-run tax increases on government spending levels. Using regression data from a 2007 study by Christina and David Romer, Miron demonstrates the cumulative impact of a tax increase totaling 1 percent of GDP on total expenditure and finds that this tax increase is associated with a 5 percent increase in government spending. In the long term, the increase in spending is about twice the initial increase in taxes; the author hypothesizes that this may result from the government underestimating the costs of its new programs.

These tax and deficit studies indicate that plans to raise taxes in the coming months will not have the desired effect of reducing deficits but will more likely inflate government spending levels. Some analyses of Biden’s plan to raise taxes estimate that it will raise $3.1 trillion in additional revenue over the 10-year budget window 2021 to 2030, while other models have projected $3.2 trillion in additional revenue. Not surprisingly, the spending proposals announced during the same 10-year budget period are estimated to cost as much as $8.475 trillion in additional government spending. Given these proposals to increase government spending by more than double the expected revenue gains from taxes, it is easy to see why tax increases do not reduce budget deficits.

Another reason tax increases don’t reduce deficits is that they are harmful to economic growth, employment levels, and wage growth. This growth slowdown ultimately means the actual revenue yield from tax increases is significantly lower than the expected revenue yield. In a literature review of 26 peer-reviewed journal articles, all but three find a negative effect of taxes on growth, with taxes on corporate and personal income being particularly harmful to economic growth. So, not only do tax increases encourage higher levels of government spending, but they also shrink the tax base by stifling economic growth, productivity, and wage growth.

The inability of governments to reduce fiscal deficits primarily through raising taxes has long been acknowledged by the academic literature. As early as 1995, the late Harvard economist Alberto Alesina and his coauthors concluded that attempts to reduce the deficit by means of raising taxes almost always resulted in failure. In a new Mercatus study, we review the literature on past attempts to reduce the deficit and find that efforts that focus primarily on reducing government expenditures are notably more successful at lowering debt levels than efforts that focus on tax-based adjustments. More specifically, we find that past efforts to reduce fiscal deficits that succeeded focused around two-thirds of tax and spending adjustments on spending reductions, while efforts that primarily focused adjustments on tax increases caused deep and long-lasting negative shocks to economic output and did not result in significant deficit reduction.

Recent proposals to raise taxes will be ineffective at reducing the US fiscal deficit and will more likely grow the deficit through two main channels: (1) encouraging more federal spending and (2) lowering economic output and employment levels. Such an approach will lead to a smaller tax base, reduced productivity, diminished wage growth, and a subsequent worsening in fiscal condition. Rather than proposing tax hikes, policymakers should look to spending restraint as the most effective and responsible method of reducing our fiscal deficit. If we are to avoid the harmful economic effects of a high debt burden in the coming decade, then we must look to broad-based spending reductions, effective fiscal rules, and strict oversight of the budgetary process.

Photo credit: Nora Carol Photography/Getty Images

Support Mercatus

Your support allows us to continue bridging the gap between academic ideas and real-world policy solutions.Donate