The Real Problem with Taxes

It is not just tax rates but tax complexity and regulatory compliance costs that affect the economy. 

Taxes, too little?  Too much?  Is that even the question?

The fact is that Uncle Sam's take this year will be the lowest since 1950, when the Korean War was just getting under way.  This fact is not in dispute.  The question is what to make of it.

Recently (5/31/11), Bruce Bartlett, in a NYT article, argued that taxes are too low by historical standards.  This certainly seems to undercut the Republican argument that taxes need to be cut to stimulate the economy.  The argument is basically that stimulating the economy will result in an increase in jobs and ultimately an increase in tax revenues.  The increase in tax revenues together with cuts in government spending will bend the deficit trend line and begin to reduce the national debt. 

Bartlett defines the tax rate in its "broadest" sense as total revenues divided by GDP.  Using that metric, there is no question that Bartlett is right.  Federal taxes are at their lowest level in more than 60 years.  The Congressional Budget Office estimated that federal taxes would consume just 14.8 percent of G.D.P. this year.  The last year in which revenues were lower was 1950, according to the Office of Management and Budget.

Note that the tax rate is defined in terms of tax revenues -- how much the government takes in.  There is a difference between the (statutory) tax rate and what the government takes in.  As Thomas Sowell recently pointed out in an article in the Washington Examiner, there is no automatic correlation between the two.  Higher tax rates do not automatically been higher tax revenues and lower do not mean less. 

History has shown repeatedly, under administrations of both political parties, that there is no automatic correlation between tax rates and tax revenues. When the tax rate on the highest incomes was 73 percent in 1921, that brought in less tax revenue than after the tax rate was cut to 24 percent in 1925.

Defining the tax rate in terms of tax revenues, as Bartlett does, just obfuscates the problem of getting a handle on the relationship between the two.  Moreover, the relationship needs to be discussed in the context of another seemingly antithetical fact.  Corporate tax rates in the U.S, with the possible exception of Japan, are the highest in the industrial world.  Naturally the Democratic argument for raising taxes to reduce the deficit is founded on the tax revenue fact and the Republican argument is founded on the corporate tax rate fact.  The puzzle is putting the two together. 

One way of disentangling or deciphering the relationship is to use the distinctions that economist have developed regarding corporate taxes.  We learn that there is a difference between the statutory tax rate and the effective tax rate.  In simplest terms the statutory corporate tax rate is the tax rate corporations are supposed to pay on their pre-tax profit before their tax experts play with the tax code to garner exemptions and loopholes.  The effective tax rate is what the corporation actually pays after their accountants play with the tax code.  (GM paid no corporate income taxes last year nor did Exxon.)

James Boyd gives an excellent account of the divergence between the statutory and effective tax rates. 

Congress has created a labyrinth of tax credits and arcane accounting rules that results in a lower effective tax rate for corporations in this country than in most other nations. Actual taxes paid by Fortune 500 companies show an effective tax rate of less than half the statutory rate. From 1998 through 2005, two out of three U.S corporations paid no federal income taxes. For the most recent year, General electric paid zero. ExxonMobil paid a significant amount but not in the U.S; their U.S. tax bill was zero. Chevron also paid out a lot of money in taxes-in other countries. Their U.S. tax bill was $200 million on sales of $172 billion. Bank of America paid zero. Citigroup paid zero. Valero paid zero.

But there is also a strange disconnect between corporate profit and the basically Republican argument that an increase in corporate coffers results in expansion and jobs.  Corporations are sitting on mountains of cash but are not creating jobs.

There is no compelling evidence that if tax rates were lowered, U.S. corporations would hire more people. If they did decide to spend the extra money to expand and hire new people, they might well do that in another country. It would be their money and they could spend it anywhere they like. Or they could just keep it and not spend it at all. After all, that is what they have chosen with recent earnings. Corporations currently have $1.5 trillion in extra cash and they have shown no inclination to use any of that to hire more people.

How does that factor in the discussion?  So far the question has been about the justification for tax decreases versus tax increases.  Time to ask the Herman Cain question: "Are we working on the right problem?"

Is the problem all the  chicanery and special deals and exemptions and waivers that have resulted in a "corporate welfare state" -- especially for large corporation with special ties to the government?  A relationship that has created a Rube Goldberg tax scheme and frozen corporate decision making?  Do corporations focus on making a better cheaper product (or services) and thereby expand and grow?  Or do they focus on beating the tax code?  This is, in Darwinian terms, a case of double adaptation.  Corporations are not focusing just on economic realities but economic realities as filtered though the labyrinthine tax code.  Instead of deploying capital to expand and create jobs on the basis of potential profits (economic realities) they are focusing on the tax consequence of  any decision to deploy capital.

A second problem is another labyrinth problem and double adaptation problem.  Along with the tax labyrinth is the regulatory labyrinth.

Government red tape is strangling business.  Red-tape compliance is costing U.S. businesses $1.75 trillion!  That is more than government revenues.  It is more than the GDP of India.  Get rid of the excessive red tape that is strangling U.S business, large and small.  Get rid of compliance costs that strangle U.S. business.  That in itself would get the economy going, create jobs, accelerate growth, and grow our way out of tax-and-spend stagnation and crippling debt.

The cost of regulatory compliance has not gone unnoticed in the recent discussion of our economy's woes.  The Obama administration has made Cass Sunstein its purported de-regulator in chief.  Sunstein has recently written an article In WSJ touting a potential 2 billion in savings that his efforts to prune the regulatory mess will bring.  Touting 2 billion "potentially saved" in the face of a 1.75 trillion problem is like the captain of the Titanic patting himself on the back for handing out buckets to the passengers.

If we don't tackle the real problems holding the economy back we won't get the economy going up to its potential.