Since World War II, Congress has passed and presidents have signed more than 30 major changes to the tax code. These changes have had a dramatic impact on the U.S. economy and, one would expect, on government revenues. Except in reality, they have not. A recent study by the R Street Institute found that demand for government spending drives tax policy, not the other way around. This conclusion has important implications for the carbon tax debate.
There have been numerous tax rate changes in the past 70 years, with the marginal income tax rate falling from a high of over 90 percent in the 1950s to as low as 28 percent in the late 1980s. Yet during this entire time period, federal tax revenue has stayed in a fairly narrow band when measured as a percentage of gross domestic product, never rising above 20 percent or falling much below 15 percent between 1950 and 2018.
This phenomenon, which keeps federal revenues within a relatively narrow band, is known as Hauser’s Law, named after its discoverer, investment analyst Kurt Hauser. The paradox that surrounds the law is likely to become more prominent as the issue of deficits and spending is set to return to Washington. With Congress now split between political parties and a presidential election less than two years away, Democrats will surely blame the increased deficit on Donald Trump, while the Democratic Party’s penchant for spending on social programs gives Republicans ample opportunity to place blame on it.
What the R Street study found is that the belief that any kind of new taxation introduces even greater government spending is based on very little actual evidence. Instead, Hauser’s Law provides evidence that certain kinds of tax swaps, such as exchanging an income tax for a carbon tax, may actually increase the rate of economic growth without increasing taxes’ share of the overall economy. This means that taxing pollution more and taxing incomes and profits less could boost economic growth, keep spending from outstripping revenues, and help clean the environment.
The primary reason for the increase in government spending over the past century or so has been the stealthy structure of the modern income tax. When the 17th Amendment passed in 1913, the federal income tax started at a low rate that only applied to a small percentage of wealthy households and excluded large portions of the population. This made it possible to rapidly expand the tax to cover more individuals by simply lowering the income threshold (which was made easier for legislators after Congress declared war in 1917 and again in 1941). Before 1913, federal revenues made up only about 5 percent of America’s annual GDP, compared to last year’s level of just under 18 percent.
The relative imperviousness of the GDP-tax percent equilibrium since the late 1940s suggests that spending pressures drive taxes and not the other way around. This is important when considering whether to replace an income tax with other kinds of taxes, such as a carbon tax. Since the goal of a carbon tax is to discourage emissions, most carbon tax proposals apply the tax to almost all emissions from the beginning. This leaves no room for additional political exploitation or bracket creep as tax brackets remain unchanged to account for inflation.
Additionally, unlike revenue from income, sales or property taxes — which tend to increase over time at a constant tax rate — revenue from a carbon tax is likely to remain stable or fall gradually as emissions decline. This is because the taxation is on an item — pollution — that can be substituted quickly through changes in behavior and improvement in non-emitting energy technologies. And the higher the tax, the faster the fall in revenues. This means that distinguishing between tax structures and whether they boost or depress economic growth is important — and independent of government expenditures.
It’s not as though America’s budget problems are going away any time soon. As things currently stand, the U.S. national debt is $21 trillion and, thanks to the Trump tax cuts, the U.S. budget deficit is expected to increase from $665 billion in fiscal year 2017 to more than a trillion dollars per year by 2021, according to Politifact. Different tax regimes matter to the health of the republic in the 21st century. False assumptions on taxes and government spending should not be allowed to remain unquestioned for decades.
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