Ask yourself a simple question: when the price of something – anything – goes up, do you buy more? Or do you buy less? If the filets at the grocery store – the ones you buy once a month for that great Sunday dinner – go from 10.99 per pound to 12.99 per pound, are you going to buy more of those steaks? Or is it possible that you will either ask the butcher for smaller steaks, or switch to rib-eyes, at only 9.99 per pound?
This sort of fundamental concept is necessary to understand why things rarely work the way Congress wants. If a grocery store raises prices of their prime cuts of beef, as a general rule they will sell fewer of those steaks. And when government raises taxes, in the end they will get less revenue.
Now, this isn’t absolutely true, that is, true in all cases. Take the case of a new society, formed out of the wilderness. Every family is responsible for its own security, and people live on a barter system. Then, a society is formed. Some sort of money is created and a small tax is levied to pay for certain services – basic security being the fundamental collective service of all societies, followed by other, basic services (security, governance (setting and maintaining standards for trade and ownership), money supplies and support to trade, infrastructure). The result is that the basic step from living as isolated families to living in a society and paying even a modest tax results in a very short time in a huge increase in economic activity as individuals are free to concentrate their efforts on their particular trade and not have to protect themselves and do all the other things that are provided by even the most basic of societies.
So, the difference between zero tax, with the government having no assets to provide for a basic society, and a society taxed at just a few percent, is massive. The few percent tax will provide enough assets to allow for a range of basic services and overall productivity soars. Now, here’s the important point: as productivity soars, the amount of revenue from taxes also continues to grow.
Simple numbers will suffice: during the first year of taxation there will essentially be no revenue. Money is just starting to circulate, there is no banking system, hence the money supply will actually under-represent the amount of economic activity.
After a couple of years the money is now widely circulated, banks have been established and people are now using money instead of a barter system and the money begins to multiply (I deposit money, the bank loans it out, others spend that money on capital investments, etc.) And so, a 5% tax in year 2 or 3 yields substantially less then a 5% tax or even a 3% tax in year 6 or 7. The economy grows so revenue increases despite tax rates remaining flat or even declining.
Now, let’s jump ahead and imagine a situation in which the rich society, with a tax of let us say 5%, is suddenly seized by a mad king, who inherits the kingdom after his father dies suddenly. The mad king wants more money to build more castles and so he raises the tax rate to 100%. What will happen? The answer is simple: everyone would stop working. What happens if the tax rate is 95%? A few people would work; many - most - would not. And total government revenue would be well below what it was when the tax rate was at 5%.
Now, it is apparent to event the most casual observer that there is a ‘boiling frog’ solution to part of this problem; that is, like boiling the frog, don’t throw the taxpayer in boiling water (high taxes), rather put him into nice, comfortable situation (warm water – low taxes) and slowly turn up the tax rate (heat up the water). Eventually, the government gets what it wants: very high tax rates. Unfortunately, it will also, eventually kill the taxpayer, just as surely it will kill the frog. The only difference is that the death is very gradual, rather than sudden.
It is also apparent that, if the government wanted to maximize revenue, it would play at reducing taxes until it found the ‘sweet spot’ where economic activity and hence total tax revenue is maximized. Estimates from a wide range of economists – led by Milton Friedman – have estimated that the ‘magic number’ is somewhere in the range of 15 percent total taxes for the society. Let me repeat that, the federal government would maximize its total tax revenue if the total tax rate on the country were approximately 15%.
Friedman argued, as have many others, that by reducing the tax rate the overall real economic activity in the nation would increase – the economy would grow – faster than the tax rate was shrinking. In short, lowering the tax rate would result in an increase in total tax revenue. (Think of WalMart: they lower the prices on everything and they have huge amounts of revenue AND profits).
Has this been tried? Yes. President Kennedy tried it, President Reagan tried it, and President Bush tried it. In all three cases the economy grew and government tax revenues increased, even as tax rates decreased. It has also been tried with equal success in other countries, Chile for example.
There are those who will respond that this didn’t happen under Reagan or Bush, but the numbers tell a different story. In fact, the deficits grew during the Reagan and Bush years because government spending actually grew faster than the economy, and the economy was growing very fast indeed. (Only during the period of 1994 to 1999 when the then Speaker of the House insisted on fiscal discipline did federal government spending, though it continued to increase very year, slow below the rate of growth of the economy.)
What does this mean? It means that if the federal government were interested in increasing tax revenue as its primary goal, it would further cut taxes. If it has other interests, such as gaining greater control over the economy (and increasing the number of people who are on the public dole and hence can be manipulated), irrespective of the total revenue, it will continue to raise taxes.
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