Budget Deals Are a Recipe for the Worst Kind of Tax Increases

November 13, 2018 by Dan Mitchell @ International Liberty

The most disturbing outcome of the recent mid-term election isn’t that Alexandria Ocasio-Cortez will be a Member of Congress. I actually look forward to that because of the humor value.

Instead, with the Democrats now controlling the House of Representatives, I’m more worried about Donald Trump getting tricked into a “budget summit” that inevitably would produce a deal with higher taxes and more spending. Just in case you think I’m being paranoid, here are some excerpts from a recent Politico report.

The dust has barely settled on the midterm elections, yet tax talk is already in the air thanks to President Donald Trump signaling openness to higher taxes, at least for some. …Trump said he’d be open to making an “adjustment” to recent corporate and upper-income tax cuts… Those off-the-cuff comments are sure to spark concerns among Republican leaders… Trump also suggested he could find common ground with Democrats on health care and infrastructure.

To be fair, Trump was only talking about higher taxes as an offset to a new middle-class tax package, but Democrats realize that getting Trump to acquiesce to a net tax hike would be of great political value.

And I fear they will be successful in any fiscal negotiations. Just look at how Trump got rolled on spending earlier this year (and that orgy of new spending took place when Democrats were in the minority).

I fear a deal in part because I object to higher taxes. But also because it’s quite likely that we’ll get the worst kind of tax hikes – i.e., class-warfare increases in tax rates or work, saving, investment, and entrepreneurship.

The political dynamic of budget deals is rather straightforward. So long as the debate is whether to raise taxes or not, the anti-tax crowd has the advantage since most Americans don’t want to give more of their money to politicians.

But if both parties agree with the notion that taxes should increase, then most Americans will – for reasons of self defense – want higher taxes on the rich (with “rich” defined as “making more money than me”). And those are the tax increases that do the most damage.

Interestingly, even economists from the International Monetary Fund agree with me about the negative consequences of higher tax rates. Here’s the abstract of a recent study.

This paper examines the macroeconomic effects of tax changes during fiscal consolidations. We build a new narrative dataset of tax changes during fiscal consolidation years, containing detailed information on the expected revenue impact, motivation, and announcement and implementation dates of nearly 2,500 tax measures across 10 OECD countries. We analyze the macroeconomic impact of tax changes, distinguishing between tax rate and tax base changes, and further separating between changes in personal income, corporate income, and value added tax. Our results suggest that base broadening during fiscal consolidations leads to smaller output and employment declines compared to rate hikes, even when distinguishing between tax types.

Here’s a bit of the theory from the report.

Tax-based fiscal consolidations are generally associated with large output declines, but their composition can matter. In particular, policy advice often assumes that measures to broaden the tax base by reducing exemptions and deductions are less harmful to economic activity during austerity. …base broadening often tends to make taxation across sectors, firms, or activities more homogeneous, contrary to rate increases. This helps re-allocate resources to those projects with the highest pre-tax return, thereby improving economic efficiency.

By the way, “base broadening” is the term for when politicians collect more revenue by repealing or limiting deductions, exemptions, exclusions, credits, and other tax preferences (“tax reform” is the term for when politicians repeal or limit preferences and use the money to finance lower tax rates).
Anyhow, here are some of the findings from the IMF study on the overall impact of tax increases.

The chart on the right shows that higher taxes lead to less economic output, which certainly is consistent with academic research.

And the chart on the left shows the revenue impact declining over time, presumably because of the Laffer Curve (further confirming that tax hikes are bad even if they generate some revenue).
But the main purpose of the study is to review the impact of different types of tax increases. Here’s what the authors found.

Our key finding is that tax base changes during consolidations appear to have a smaller impact on output and employment than tax rate changes of a similar size. We find a statistically significant one-year cumulative tax rate multiplier of about 1.2, rising to about 1.6 after two years. By contrast, the cumulative tax base multiplier is only 0.3 after one year, and 0.4 after two years, and these estimates are not statistically significant.

And here’s the chart comparing the very harmful impact of higher rates (on the left) with the relatively benign effect of base changes (on the right).



For what it’s worth, the economic people in the Trump Administration almost certainly understand that there shouldn’t be any tax increases. Moreover, they almost certainly agree with the findings from the IMF report that class-warfare-style tax increases do the most damage.

Sadly, politicians generally ignore advice from economists. So I fear that Trump’s spending splurge has set the stage for tax hikes. And I fear that he will acquiesce to very damaging tax hikes.

All of which will lead to predictably bad results.

P.S. A columnist for the New York Times accidentally admitted that the only budget summit that actually led to a balanced budget was the 1997 that lowered taxes.