The Federal government appears headed to bankruptcy based on the Congressional Budget Office’s forecasts. Mathematically both reducing spending and increasing taxes can reduce deficits. But can Uncle Sam collect more tax revenue?
Federal tax revenues have remained within about two points of the post-World War II average of 17.4 percent of GDP. S. T. Karnick argues in a Heartland Institute policy analysis (where I am a policy advisor) that this reflects an “Iron Law” of U.S. public finance.
Economic theory clearly demonstrates a limit to tax revenue. As Mr. Karnick observes, if you tax anything you get less of it. How much revenue would a 100 percent income tax raise? The logic of the Laffer Curve, a key element of supply side economics, is unassailable.
This might seem preposterous. The top Federal individual income tax rate, now 37 percent, was 91 percent after World War II until the Kennedy tax cuts and 70 percent before being lowered under President Reagan. Furthermore, eight Organization of Economic Cooperation and Development (OECD) countries exceed forty percent of GDP in taxes, led by France at 43.8 percent.
The question, however, is whether we collect more revenue. As Mr. Karnick notes, those higher past rates did not and the consistency of Federal tax revenue has persisted, “since World War II, no matter what the tax rates have been and what is taxed.”
Taxes could rise as a percentage due to lower GDP, not more revenue. If higher tax rates reduced GDP, the current $5 trillion tax revenue could become 25 percent of GDP instead of 18 percent.
We should closely scrutinize impossibility claims like the Iron Law. I will compare tax revenue per capita across states and nations. Differences should show the potential to collect more taxes.
Economists typically combine state and local taxes due to variations in local government taxation. Nineteen states collected between $4,000 and $5,000 in taxes per capita in 2022, including Alabama. But four states exceeded $9,000, led by Connecticut at $10,364.
Internationally I compare total government revenues due to differences in federalism. The OECD reports U.S. taxes at 25.2 percent of GDP in 2023, or $20,600 per capita. Sixteen nations collect more per capita, including Denmark ($31,900), Norway ($41,500), and Luxembourg ($56,800).
If collecting more tax revenue is possible, why does Federal tax revenue remain near 17.4 percent? For one, the U.S. does not impose a value added tax, like most European nations.
Mr. Karnick offers several reasons for American tax exceptionalism. For one, features of the income tax limit revenue; the 91 percent tax rate, for instance, applied only to incomes over $2 million in today’s dollars. The tax code has always allowed numerous shelters.
This should surprise no one. Politicians want to win votes without losing others’ support. Deceptive appearances allow this. High tax rates appear to soak the rich while the wealthy, who know they will not pay much, protest modestly.
The progressivity of the income tax, which means that the average tax rate increases with income, is another factor. The marginal tax rate rises across tax brackets from 10% to 37%, creating progressivity.
But the low rates in the first brackets needed for progressivity tax this portion of high-income households’ earnings lightly. Raising the top marginal tax rate, currently applied at $609,000, runs into the teeth of the Laffer Curve.
Americans strongly oppose being taxed more. Mr. Karnick quotes the Wall Street Journal’s Richard Rubin who observes that, “income taxes on the overwhelming majority of Americans can go down but never up.” Tax cuts under Presidents Reagan and Trump further entrench the ceiling.
The Iron Law worsens deficits in two ways. The first is directly by limiting revenue. But as Mr. Karnick observes, the Iron Law ensures that increased spending will be financed by borrowing, not taxes.
The United States is likely not above its revenue maximizing tax level. But given Americans’ tax hostility and our progressive income tax, significant near-term tax revenue increases seem unlikely. Only spending cuts and economic growth through deregulation can contain budget deficits today.
Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.
Daniel Sutter is Affiliated Senior Scholar at the Mercatus Center and Professor of Economics at the Manuel H. Johnson Center for Political Economy at Troy University.
