next three years.18 In short, increasing taxes, rather than bringing in more money, cost the state money and reduced people’s incomes.
Update: It would seem that California politicians learned little from this experience. After getting out of this hole, politicians once again went on a spending spree as if nothing had happened. When the current economic down turn hit budget deficits once again soared, to become once again the largest in the country. Yet rather than the $8 billion deficit that they faced last time, this time the short fall exceeded $40 billion.19
Lessening The Burden
Now if increasing taxes can depress the economy thereby resulting in less tax revenues than expected, should not cutting taxes conversely stimulate the economy? If the economy is stimulated won’t that mean that the government will get more money in tax revenues than it had expected; that the tax cuts will not “cost” the government as much as predicted?k
The answer is yes and this also has many historical examples, such as the Kennedy tax cuts in the 1960s, the Reagan tax cuts in the 1980s, and more recently the Bush tax cuts that took effect in 2003. As a result of the Bush tax cuts, for example, by mid 2005 the economy had recovered such that revenues were 14 percent higher than what had been expected, while the budget deficit was reduced by nearly $100 billion more than had been projected.20
While it is not always the case, some tax cuts have resulted not only in more revenues than had been predicted but in actual increases over even the pre-tax cut projection. Part of the Bush tax cuts, involved cutting the capital gains tax from 20 percent to 15 percent. At the time the Congressional Budget Office (CBO) predicted this cut in the capital gains tax would correspondingly reduce the amount of money the government would receive. Without the tax cut, the CBO estimated that the government would receive $186 billion in revenues from capital gains taxes over three years.21 But when the tax cut was passed the CBO reduced this to $147 billion; a reduction of $39 billion dollars because of the lower rates.22
Once the tax cuts actually took effect the results were somewhat different. Rather than the reduction in revenues that the CBO had expected, revenues actually increased, not just over the $147 billion predicted following the tax cuts, but even over the $186 billion that had been predicted before the tax cuts were passed. By the time that the CBO finished its analysis of the results, the CBO noted that the actual revenues received from capital gains taxes over the three years following the tax cuts were $216 billion. This was $30 billion more than had been expected prior to the tax cuts and $69 billion more than expected as a result of the tax cuts.23 In this case cutting taxes actually resulted in more money.
Theoretical Limits
Now there is, at least in theory, a limit on a democratic government’s ability to raise taxes, and that is the people’s willingness to pay them. If taxes are increased too much, people will complain, politicians will get worried, and the new programs the taxes were supposed to pay for will be seen as unnecessary. At least this is the theory.
The Founding Fathers understood this well. One of the main issues that sparked the Revolution had been taxes, and the subject of taxation was a major concern for writers of the Constitution. Federalist Papers 30-36 were devoted to this subject. The subject of taxation deserved this much treatment, for as Hamilton observed early in Federalist #30 that,
Money is, with property, considered as the vital principle of the body politic; as that which sustains its life and motion and enables it to perform its most essential functions.24
Not only did they recognize it as a necessity, they also recognized its dangers. Madison noted that,
the apportionment of taxes on the various descriptions of property is an act which seems to require the most exact impartiality; yet there is, perhaps, no legislative act in which greater opportunity and temptation are given to a predominant party to trample on the rules of justice.25
Hamilton wrote on this subject that,
The ability of a country to pay taxes must always be proportioned in a great degree to the quantity of money in circulation and to the celerity with which it circulates.26
Then in a later Federalist paper Hamilton added,
There is no part of the administration of government that requires extensive information and a thorough knowledge of the principles of the political economy so much as the business of taxation. The man who understands those principles best will be least likely to resort to oppressive expedients, or to sacrifice any particular class of citizens to the procurement of revenue. It might be demonstrated that the most productive system of finance will always be the least burdensome.27
The concern was not just that taxation would become too burdensome on the economy, but that the burden would not be fairly distributed. “Every shilling with which they overburden the inferior number is a shilling saved to their own pockets.”28 The tax the Founding Fathers designed was an attempt to strike a balance between the needs of the government for revenue, and the dangers inherent in taxation.
A major change to this balance occurred during the early part of the 20th century, with the passage of the 16th amendment to the U.S. Constitution, which allowed for the progressive income tax system. The problem was further compounded when the collection of taxes was made much easier in 1943 with the establishment of the current income tax withholding system. The combination of these two changes has allowed government to tax at ever-growing rates while greatly reducing the opposition of those paying the taxes. The resulting effect on government’s ability to tax has been dramatic.
How Much Do We Even Pay?
The Federal Government’s budgeted spending for fiscal year 2008 was $2.9 trillion. This is such a large sum that for most people it is completely incomprehensible. It is just a number with no real meaning, other than that it is really, really big. When this is combined with increases due to inflation and growth in the population, it is hard to get an understanding of just how much government has grown.
To make matters even worse, the current tax code is extremely complex. So many things are taxed in so many ways, and there are so many exceptions, deductions, and credits that it is virtually impossible for anyone to know how much they actually pay in taxes even to the federal government, much less state, county, and city. Then there are the hidden taxes, taxes passed on to you in the cost of the goods and services you purchase such that it is virtually impossible to find out exactly what you pay in taxes even if you wanted to.
As a result of all of this complexity and confusion there is a real disconnect between what government spends and what we actually pay in taxes. For example, if the 2008 budget had been $2.8 or $3.0 trillion would you know what impact that would have had on your taxes? Would it have any at all? And yet that is a difference of $100 billion dollars.
In an attempt to try and get some sort of handle on this, every year for the last 30 years, an organization called the Tax Foundation has waded through state and local government economic reports to come up with its own summary on government spending and just how much it costs us. In order to put all this confusion into some sort of perspective, they have come up with a way of measuring this, which they call Tax Freedom Day.
Tax Freedom Day is calculated by taking government figures on income and taxes to determine what percentage of income on average that is taken by government to pay for all the programs it funds, and thus get one overall “effective tax rate.” This is then used to determine “Tax Freedom Day,” the day in the year on which you theoretically have earned enough money to pay all your taxes for that year, and thus the point at which you are free to start working for yourself, instead of for the government. Given the vast complexities of the tax system, this is not a good measure of any one person’s individual taxes, but it does give a good idea of the relationship between the taxes people pay and the spending that government does.
More importantly for the discussion here, it very clearly shows the overall trend in taxes from year to year, and from decade to decade; and the trend is both very clear and very worrisome. For the early part of the nation’s history, as the Tax Foundation Report notes,