Retirement and Social Security Reform
The Fiscal Bottom Line
Wall Street Journal
April 16, 2007
By Ernest S. Christian and William E. Frenzel
Just because something is simple and makes sense
does not mean it isn't true -- even in Washington. Consider
the proposition that tax cuts are good and tax increases are
Tax cuts are good because they stimulate economic growth,
making people better off by several multiples of the amount
of revenue the government loses. A good rule of thumb is that
a $1 tax cut induces $1 to $2 of additional economic growth.
Conversely, tax increases are bad because they impair economic
growth, making people worse off by several multiples of the
extra amount of tax revenue the government collects. Generally
speaking, each additional $1 of tax revenue costs the economy
not only the $1 of tax but an additional $1 to $2 in lost
So why not cut taxes and spending? There is plenty of room
for reducing the nearly $3 trillion federal budget, without
cutting anything even resembling muscle and sinew. Another
good rule of thumb (attributed to Milton Friedman) is that
the government usually spends $3 to do a $1 job.
Imagine if all tax increases became the last instead of the
first resort, to be used only after every ounce of political
spoils, patronage, waste and just plain silliness had been
squeezed out of the federal budget? And imagine -- if you
can -- a government that keeps its hand out of your pocket,
its nose out of your business, and does its own assigned tasks
with cost-effective competence.
Nevertheless, just because something makes sense does not
mean it will carry the day -- especially not in Washington.
Consider the two versions of the truth that may be drawn from
a recent study by Gregory Mankiw, an economist at Harvard.
Reduced to its essence, Mr. Mankiw concluded that a $1 tax
cut on dividends would reduce government revenue collections
by about 50 cents, after taking into account taxes on $2 of
additional economic growth induced by the tax cut. A $1 tax
cut from an across-the-board rate reduction would cost the
IRS about 77 cents, after taking into account taxes on the
95 cents of additional economic growth induced by the tax
To the champions of bigger government, the important truth
of the Mankiw study was that the amount of tax on induced
economic growth was insufficient to make up for all of the
revenues lost to the Treasury from the original tax cut. Ergo,
the government has less money to spend. Ergo, tax cuts are
To those of us who prefer economic growth over government
growth, the Mankiw study confirmed a different truth. If Congress
is willing to forego 50 cents of revenue, the economy would
grow and people would have $2 more income. If given the choice,
most people would take the $2.
Now apply the conclusions of the Mankiw study in reverse --
to tax increases. The results illuminate the high costs of
providing the government with an additional $1 to spend. A
purported $1 tax increase on dividends only nets the Treasury
50 cents -- but costs Americans $2 in lost income, plus 50
cents in tax. When a higher rate is levied on all forms of
income, an attempted $1 tax increase yields only 77 cents
-- but costs Americans 95 cents in lost income plus 77 cents
in tax. If the government were to kick up the tax increases
enough to collect a full additional $1, the cost to the public
would be between $2.25 and $5, counting both tax paid and
income lost. A May 2006 study by Harvard's Martin Feldstein,
"The Effect of Taxes on Efficiency and Growth,"
confirms the disproportionately large economic losses associated
with tax increases.
The economic losses that result from increased taxes fall
mainly on low- and middle-income earners in the form of salary
increases not obtained and jobs not gotten (or lost); and
this burden applies irrespective of whether those who lose
out pay or do not pay income taxes. The regressive nature
of the adverse economic fallout from high taxes cannot be
avoided by concentrating those taxes on ostensibly rich capitalists.
In fact, Mr. Mankiw's study confirms that concentrating taxes
on capital exacerbates the damage to the economy.
Unfortunately, the new party in power in Congress has threatened
to impose higher tax rates on dividends, capital gains and
the incomes of upper-bracket taxpayers in general. They will
tell the public that they are raising $50 billion of revenue
from the malefactors of great wealth and that they will spend
this money wisely.
A decent respect for the truth would, however, require them
to warn the American people about the most likely results
of the tax increase. The higher tax rates will cost them about
$60 billion in lost incomes and jobs. Because of that economic
damage, the revenue yield from the tax increase will be only
about $33 billion, not $50 billion. And at the margin, the
entire $33 billion will be spent on perks, pork, patronage
and other waste.
Mr. Christian, an attorney, was a deputy assistant secretary
of Treasury in the Ford administration. Mr. Frenzel is a former
Republican congressman from Minnesota who served on the Ways
and Means and Budget Committees.