Tax Policy to Support a Growing U.S. Economy in a Competitive Global Marketplace
Volume 1, Issue 4, June / July 2006


First Appeared in the June 23rd Edition of National Review Online Financial

If the American people knew the price of government, they would purchase a lot less of it. But until the Treasury's fledgling Dynamic Analysis Division (DAD) came along, government officials were very successful in keeping that information secret, both from themselves ("we'd rather not know") and from the voters ("they'd revolt if they knew").

The secret is beginning to leak out - but only barely. Voters are still being misled and government is still taxing and spending on the false assumptions that $1 spent on a bridge-to-nowhere costs $1 in tax revenue, and that $1 in government tax revenue costs the private economy only $1.

In fact, the cost to the private sector of providing the government an additional $1 in tax revenue is about $2.50, and in some circumstances much more. Even academics on the left now acknowledge that taxes adversely affect economic performance and, therefore, when taxes go up, it is not just the private sector's after-tax income that goes down; its pre-tax income suffers as well.

Thus, when the question is, "How much does it cost the private sector to provide government with another $1 in tax revenue?", the answer is $1 plus the amount by which people's incomes in the future are smaller than they otherwise would be, but for the negative effects that the tax increase has on economic growth.

The amount of future pre-tax income that the private sector loses when government raises taxes varies, depending partly on whether the extra tax is on labor income or capital. Both respond to tax changes: declining when taxes go up and rebounding when taxes are reduced. But capital is particularly sensitive to taxes.

The table below, based on our model, illustrates a range of results when the government attempts to raise an additional $1.

The mainstream story is told by line (c), where the government undertakes to raise $1 in additional tax revenue by an across-the-board rate increase calculated on a static basis to produce that result. It indeed does collect an additional $1 - in a mindless bookkeeping sense - but the economy responds negatively to higher taxes and, as a result, pre-tax incomes (and tax collections) are less than they otherwise would be. On net, the government ends up having collected only $0.68, as shown in column (1). The government "lost" this $0.32 because taxpayers lost $1.07 of pre-tax income that otherwise would have been produced and which would have been taxed at an assumed average marginal rate of 30 percent ($1.07 x .30 = $0.32).

Up to this point in the story, the total cost to the private sector is $1.75 ($0.68 + 1.07), but the government has on net collected only $0.68 in tax. The government can continue to raise tax rates and ultimately net an additional $0.32, as shown in column (5), but that will cost the private sector another $0.50 in lost income, thereby bringing the total cost up to $2.57 per $1 of tax revenue.

The story in line (c) about an across-the-board tax increase on both labor and capital is consistent with recent work by Martin Feldstein at Harvard as well as a recent paper by Gregory Mankiw, the former Bush administration advisor who is also at Harvard. Mankiw also recently performed a groundbreaking analysis of the economic response to a change in taxes solely on capital. His results are consistent with the additional story illustrated in line (d), where the total cost is $4.33 for $1 of additional tax revenue from capital. Mankiw also estimated the economic response from a tax change solely on labor income. Line (a) illustrates the result in the case of a $1 tax increase. The total cost is $1.68.

Line (b) is consistent with the Congressional Budget Office's estimate of the short-term economic response to an across-the-board tax change and line (c) is consistent with CBO's estimate of the long-term response.

By anybody's reasonable estimate, the bottom-line results are clear. The cost of an additional $1 in taxes and spending is much more than $1 - most probably $2 to $3 - and the real burden of taxes on the American people (counting lost income) is much greater than the government admits.

If taxes were both reduced and reformed (so that the drag on economic performance per $1 of tax would be less), the economy would be larger, government would be smaller, and everyone would be better off.

CSTR is a nonprofit organization whose purpose is to evaluate and develop in full operational detail all options for fundamentally restructuring the American tax system.

The Honorable Bill Frenzel and the Honorable Murray Weidenbaum are co-chairmen and Ernest S. Christian is the Executive Director.


If you wish to support CSTR's tax reform research efforts, please send a tax deductible contribution to CSTR-TRI at:

800 Connecticut Ave, NW
Suite 705
Washington, DC 20006



On Tuesday, August 1st, Secretary of the Treasury Henry M. Paulson delivered his first public address at Columbia University in New York City. Secretary Paulson's remarks addressed the current state of the economy with a particular emphasis on the long-term challenges facing the United States.

In a recent Washington Post article entitled "Oregon Senator Wants to Take On the Burden of Fixing the Tax Code," columnist Jeffrey H. Birnbaum describes Senator Ron Wyden's (D-OR) effort to rewrite the tax code.

In a speech before the National Economists Club on July 27th, Deputy Assistant Secretary for Tax Analysis Robert Carroll provided significant insight into Treasury's efforts on dynamic analysis. In addition, Carroll outlined key components of Treasury's dynamic analysis of permanent extension of the President's tax relief.




At the joint CSTR/Heritage Seminar on July 18th, Congressman Paul Ryan (R-WI), a leading member of the Ways and Means Committee, emphasized the importance of his Legislative Line-Item Veto Bill (H.R. 4890), which passed the House in mid-June. Furthermore, in his view, budget and spending reform ought to be paired with tax reform aimed at enhancing economic growth.

The Legislative Line-Item Veto Bill would permit the president to place a temporary hold on wasteful spending projects or "tax pork" in bills he signs into law. The president would have a limited amount of time to request rescission on these items. Within 14 legislative days of receiving the president's request, Congress would then be required to have an up-or-down vote without amendment on whether to rescind the appropriated funding. Thus, an extra layer of accountability, fiscal discipline and transparency would be added to the spending process.

Insofar as concerns tax reform, Congressman Ryan said that Congress should begin addressing this issue as soon as possible, beginning in 2007, instead of waiting until the end of the decade when the Bush tax cuts and other pro-growth tax policies expire. He is right: overtaxing and overspending are two sides of the same coin; both come at great cost to the private economy ($2 to $3 dollars or more for each $1 of federal taxing and spending); and before either the budget process or the tax code can be reformed the voters must decide how much government they really want and how high a price they are willing to pay for it.

Congressman Ryan's call for a realistic "in-public-view" restraint on federal spending in combination with growth-oriented tax reform is a good example of the kind of new out-of-the-box thinking which is greatly needed and for which he is becoming well-known.

"Line-item pork parer," By Paul Ryan, appeared in The Washington Times on June 22, 2006



Senator Gregg, Chairman of the Budget Committee, recently introduced a far-reaching budget reform bill, the purpose of which is to force action on many of the important fiscal issues Congress would rather sidestep. The "Stop Over-Spending Act of 2006" or the SOS Act, creates mechanisms to control government spending, reduce the deficit, and reduce the unfunded promises in the country's largest entitlement programs.

The bill includes deficit targets, discretionary spending caps and limits on emergency spending, a Medicare trigger that would require that any new mandatory spending be offset once Medicare becomes too large a drain on the rest of the budget, biennial budgeting, line-item rescission, reforms to the budget resolution and reconciliation processes, and two new commissions-one to address entitlements and one to review government spending.

The line-item veto would shift some power from Congress to the President; commissions shift power away from elected officials to outside experts; and triggers rely on defaults to replace the proactive type of decision-making one would hope to see demonstrated by Congress. But the fact is that Congress has not been willing to make hard choices.

Given where we are in the business cycle and the forthcoming baby boom retirement-which starts in less than two years-a good case can be made for deficit reduction goals more aggressive than those in Senator Gregg's bill.



CSTR and the Center for Data Analysis at the Heritage Foundation are jointly hosting a "People Who Make A Difference" luncheon series. Important opinion leaders and decision makers will meet in roundtable discussions to analyze policy issues. Some of these meetings will be videotaped and broadcast via the internet by the Heritage Foundation.


Upcoming CSTR Seminar Dates:

Tuesday, October 10, 2006

Tuesday, November 14, 2006

(The current goals would allow Congress to increase the deficit in each of the next three years before requiring deficit reduction in 2010 compared to the CBO current baseline.) The ongoing abuses to emergency spending must be addressed and the limits on emergency spending in the SOS Act would ratchet down the amount of emergency spending permitted to historical levels. The Medicare trigger would importantly focus attention on the growing costs of Medicare and halt all new direct spending until the program's growing claim on budgetary resources had been addressed. (Ultimately, controlling the costs of Medicare and Medicaid will require more comprehensive reform.)

All of these components serve important purposes and help focus political and national attention on getting control of fiscal imbalances. Senator Gregg should be commended for developing bold enforcement measures that help force action and serve as a check against fiscally irresponsible actions.

Maya MacGuineas is the President of the Committee for a Responsible Federal Budget. She received her Master in Public Policy from the John F. Kennedy School of Government at Harvard University.

"Stop Federal Overspending" by Senator Judd Gregg appeared in The Washington Times on June 21, 2006.


Dr. Edward Lazear and Dr. Douglas Holtz-Eakin spoke at the CSTR/Heritage Seminar on July 18th. Dr. Lazear, who is Chairman of the President's Council of Economic Advisors and was a member of the President's Advisory Panel on Federal Tax Reform, explained the contribution made by the Bush tax cuts to the sustained level of high economic growth presently being experienced. Dr. Holtz-Eakin, former Director of the Congressional Budget Office and the newly-appointed Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volker Chair in International Economics at the Council on Foreign Relations, led a discussion about tax and spending policies. Both speakers received high praise from the more than fifty tax and economic policy experts who attended the seminar.


"What Is Really Happening to Government Revenues:
Long-Run Forecasts Show Sharp Rise in Tax Burden"

By Daniel J. Mitchell, Ph.D. and Stuart M. Butler, Ph.D.
The Heritage Foundation
July 28, 2006

"Updated Long-Term Projections for Social Security"
Congressional Budget Office
June 2006

"Empowering Citizens to Monitor Federal Spending"
By Chris Edwards
Cato Institute
July 2006

"Spending Restraint Measures Before The Senate"
By Stephen J. Entin
Congressional Advisory #206
June 23, 2006

"The Effect of Taxes on Efficiency and Growth"
A Working Paper
By Martin Feldstein
National Bureau of Economic Research
May 2006

"The Macroeconomist as Scientist and Engineer"
By N. Gregory Mankiw
Harvard University
May 2006

"Fiscal Year 2007: Mid-Session Review"
Office of Management and Budget
July 2006

"A Dynamic Analysis of Permanent Extension of the President's Tax Relief"
Dynamic Analysis Division
United States Treasury Department
July 2006


“What’s a Treasury Secretary to Do? -- An Agenda for Henry Paulson, Here and Abroad”
By C. Fred Bergsten
The Washington Post
June 26, 2006

“Dynamic Analysis”
By Robert Carroll and N. Gregory Mankiw
The Wall Street Journal
July 26, 2006

“The Private-Sector Cost of $1 in Government Tax Revenue”
By Ernest S. Christian and Gary A. Robbins
Tax Notes
June 26, 2006

“A Dubious Deal For Reduction In Entitlements”
By Ernest S. Christian and Gary A. Robbins
Investor’s Business Daily
June 30, 2006

“Mushrooming Muni Bonds”
By Chris Edwards
Investor’s Business Daily
July 7, 2006

“Why a Higher Minimum Wage Is Bad Economic Policy”
By Kevin A. Hassett
Bloomberg Wire
July 10, 2006

“Supply Side: Don’t Know Much About History…”
By Stephen Moore
The Wall Street Journal
June 12, 2006

“Renaming the ‘Laffer Curve’”
By Alan Reynolds
Human Events Online
June 11, 2006

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