Dissecting The Demagoguery About 'Tax Cuts For The Rich'

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    Testimony before the Senate Finance Committee from one of my favorite thinkers:

    Dissecting The Demagoguery About 'Tax Cuts For The Rich'

    By THOMAS SOWELL Posted 07/18/2011 06:20 PM ET

    Democrats' insistence that the "rich" pay more in taxes is rivaled only by Republicans' apparent inability or unwillingness to engage them on this specific issue. In the following excerpt from testimony submitted to the Senate Finance Committee, economist Thomas Sowell attempts to fill that void.

    At various time and places, particular individuals have argued that existing tax rates are so high that the government could collect more tax revenues if it lowered those tax rates, because the changed incentives would lead to more economic activity, resulting in more tax revenues out of rising incomes, even though the tax rate was lowered.

    This is clearly a testable hypothesis that people might argue for or against on either empirical or analytical grounds. But that is seldom what happens.

    Even when the particular tax-cut proposal is to cut tax rates in all income brackets, including reducing tax rates by a higher percentage in the lower-income brackets than in the upper-income brackets, such proposals have nevertheless often been characterized by their opponents as "tax cuts for the rich" because the total amount of money saved by someone in the upper-income brackets is often larger than the total amount of money saved by someone in the lower brackets.

    Moreover, the reasons for proposing such tax cuts are verbally transformed from those of the advocates — namely, changing economic behavior in ways that generate more output, income and resulting higher tax revenues — to a very different theory attributed to the advocates by the opponents, namely "the trickle-down theory."

    "Trickle down" is not an economic theory.

    No such theory has been found in even the most voluminous and learned histories of economic theories, including J.A. Schumpeter's monumental 1,260-page "History of Economic Analysis." Yet this nonexistent theory has become the object of denunciations from the pages of the New York Times and the Washington Post to the political arena, and has been repeated as far away as India.

    It is a classic example of arguing against a caricature instead of confronting the argument actually made.

    While arguments for cuts in high tax rates have often been made by free-market economists or conservatives in the American sense, such arguments have also sometimes been made by people who were neither, including John Maynard Keynes and President John F. Kennedy, who in fact got tax rates cut during his administration.

    But the claim that these are "tax cuts for the rich," based on "trickle-down theory," also has a long pedigree.

    President Franklin D. Roosevelt's speech writer, Samuel Rosenman, referred to "the philosophy that had prevailed in Washington since 1921, that the object of government was to provide prosperity for those who lived and worked at the top of the economic pyramid, in the belief that prosperity would trickle down to the bottom of the heap and benefit all."

    The same theme was repeated in the election campaign of 2008, when presidential candidate Barack Obama attacked what he called "the economic philosophy" which "says we should give more and more to those with the most and hope that prosperity trickles down to everyone else."

    When Rosenman referred to what had been happening "since 1921," he was referring to the series of tax-rate reductions advocated by Secretary of the Treasury Andrew Mellon and enacted into law by Congress during the decade of the 1920s. But the actual arguments advocated by Secretary Mellon had nothing to do with a "trickle-down theory."

    High rates drive taxpayers into shelters.

    Mellon pointed out that, under the high income-tax rates at the end of the Woodrow Wilson administration in 1921, vast sums of money had been put into tax shelters such as tax-exempt municipal bonds instead of being invested in the private economy, where this money would create more output, incomes and jobs — thereby producing higher tax revenues for the federal government.

    It was an argument that would be made at various times over the years by others — and repeatedly evaded by attacks on a "trickle-down theory" found only in the rhetoric of opponents.

    The actual results of the cuts in tax rates in the 1920s were very similar to the results of later tax-rate cuts during the Kennedy, Reagan and George. W. Bush administrations — namely, rising output, rising employment to produce that output, rising incomes as a result and rising tax revenues for the government because of the rising incomes, though the tax rates had been lowered.

    Another consequence was that people in higher-income brackets paid not only a larger total amount of taxes, but a higher percentage of all taxes, after what were called "tax cuts for the rich." It was not simply that their incomes rose, but that this was not taxable income, since the lower tax rates made it profitable to get higher returns outside of tax shelters.

    The facts are unmistakably plain, for those who bother to check the facts. In 1921, when the tax rate on people making over $100,000 a year was 73%, the federal government collected a little over $700 million in income taxes, of which 30% was paid by those making over $100,000.

    Revenue spiked as tax rates were slashed.

    By 1929, after a series of tax-rate reductions had cut the tax rate to 24% on those making over $100,000, the federal government collected more than a billion dollars in income taxes, of which 65% was collected from those making over $100,000.

    There is nothing mysterious about this. Under the sharply rising tax rates during the Wilson administration, fewer and fewer people reported high taxable incomes, whether by putting their money into tax-exempt securities or by any of the other ways of rearranging their financial affairs to minimize their tax liability.

    Under Wilson's escalating income-tax rates to pay for the high costs of the First World War, the number of people reporting taxable incomes of more than $300,000 — a huge sum in the money of that era — declined from well over a thousand in 1916 to fewer than three hundred in 1921. The total amount of taxable income earned by people making over $300,000 declined by more than four-fifths in those years.

    Secretary Mellon estimated in 1923 that the money invested in tax-exempt securities had tripled in a decade, and was now almost three times the size of the federal government's annual budget and nearly half as large as the national debt. "The man of large income has tended more and more to invest his capital in such a way that the tax collector cannot touch it," he pointed out.

    Getting that money moved out of tax shelters was the whole point of Mellon's tax-cutting proposals. He also said: "It is incredible that a system of taxation which permits a man with an income of $1,000,000 a year to pay not one cent to the support of his government should remain unaltered."

    Capital won't work for inferior returns.

    He added: "Just as labor cannot be forced to work against its will, so it can be taken for granted that capital will not work unless the return is worthwhile. It will continue to retire into the shelter of tax-exempt bonds, which offer both security and immunity from the tax collector."

    In other words, high tax rates that many people avoid paying do not necessarily bring in as much revenue to the government as lower tax rates that more people are in fact paying, when these lower rates make it safe to invest their money where they can get a higher rate of return in the economy than where they can get a higher rate of return in the economy than they get from tax-exempt securities.

    The facts are plain: There were 206 people who reported annual taxable incomes of one million dollars or more in 1916. But as tax rates rose, that number fell to 21 by 1921. After a series of tax-rate cuts in the 1920s, the number of individuals reporting taxable incomes of a million dollars or more rose again, to 207 by 1925.

    As output surged, joblessness plunged.

    It should not be surprising that the government collected more tax revenue under these conditions. Nor is it surprising that, with increased economic activity resulting from more investment in the private economy, the annual unemployment rate from 1925 through 1928 ranged from a high of 4.2% to a low of 1.8%.

    The point here is not simply that the weight of evidence is one side of the argument rather than the other but, more fundamentally, that there was no serious engagement with the arguments actually advanced but instead an evasion of those arguments by depicting them as simply a way of transferring tax burdens from the rich to other taxpayers.


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