Kentucky Republican Senator Rand Paul wants to create a flat tax of 14.5% that he says will reduce government revenues by trillions of dollars, but magically lead to greater tax revenues in the future fueled by economic growth.
His plan, which he outlined in a Wall Street Journal opinion piece that has been reprinted on many other news websites, is based on the old Laffer Curve myth that proposes that lowering tax rates always leads to economic growth, which then always produces greater tax revenues. Laffer Curve theory has been around for ages but is associated with right-wing economist Arthur Laffer who supposedly drew it on a paper cocktail napkin for some government luminaries during the 1970’s. When I interviewed Laffer in 1981 for a television news report, he denied the myth.
Now Paul does not mention the Laffer Curve by name, but he is proposing the same twisted reasoning—lowering tax rates will lead to economic growth which will lead to higher tax revenues.
Paul’s premise comes up short in the reality department. Since the birth of the industrial revolution, our economy has thrived most when tax rates have been relatively high, such as after World War II and during the Clinton years (when compared to the eras immediately before and after Clinton).
Paul’s program consists of two changes to the current tax code: 1) Establish a flat tax of 14.5% that’s the same for every tax-paying entity (personal or business) and every kind of income (earned or investment); note that included are payments for Social Security and Medicare, which fulfills the conservative dream of comingling Social Security funds with the general budget, the first step in making major benefit cuts. 2) End all deductions, except for mortgages and charities.
The first idea ignores decades of data to build its case on the disproved notion that if you cut taxes on the wealthy, they will invest more in the economy, thereby creating more jobs. In a sense, it’s an operation of the false theory of supply-side economics, which essentially says that if you make it and put it up for sale, they will buy it. But the experience since the turn of the century has been that the wealthy and corporations have been afraid to invest (create more supply) because the market isn’t there. The low tax regime has therefore led to the wealthy piling up more wealth and to a precipitous increase in the values of assets that the wealthy tend to own such as luxury goods, real estate and fine art. Supply side economics never works because the so-called job creators who should create the additional supply believe at heart in investing based on predicted demand.
Now if we had not lowered tax rates on the wealthy during the Reagan years and under Bush II, the money that rich folk gleaned from tax cuts would instead be in the government coffers. One thing the government likes to do is spend money, and that helps the economy. Government outlays create demand, whether it’s for new government employees, from companies and individuals to perform services from the government or from payments to the poor and middle class, which they then mostly spend (as opposed to the rich, who mostly save after a certain point).
So much then for Paul’s argument that the flat tax will unleash economic activity. More than likely, it will lead to a cut in government services, which will lead to a shrinking of the economy.
The mechanism of the progressive tax, by which people are taxed at higher rates for income earned above certain thresholds, is a prime tool for increasing income and wealth equality because the wealthy don’t just pay more, they pay a higher percentage of their additional income in taxes. That higher percentage also reflects the fact that the wealthy derive more protection and services from government than the poor and middle class do. They have more property under government protection. The regulation and protection of markets benefits their interests more than the interests of the poor. The roads government builds conveys the cars of both the rich and poor, but it also conveys everyone’s cars to stores and businesses, all owned by the rich either directly or through financial instruments. The rich are far more likely to enjoy the luxury boxes in ballparks built with taxpayer money. Thus the progressive income tax makes the best tax system both for public policy reasons and to finance the many things that 21st century government does, Instead of establishing a flat tax, we need to raise marginal tax rates on the wealthy.
In theory the second Paul idea—to end deductions—is a good one because it simplifies paying taxes, but it may not work in practice. Here’s why: For the most part, tax breaks serve as incentives for people to act in certain ways—buy houses, invest in new businesses, install solar equipment, send their children to college. Each of these tax breaks also helps one part of the economy. For decades, for example, the oil depletion allowance has helped the fossil fuels industry, while the mortgage deduction has artificially boosted the residential real estate industry. Tax policy can also discourage actions, such as our high taxes on cigarettes. Notice that I don’t include gas as a high-tax item because our taxes on gasoline are very low compared to other industrialized nations.
If we give up tax incentives and disincentives, we lose the possibility to implement social and economic policy through taxes, eventually leading to more extensive regulation as the only other means to manage the economy and guide private activity. So while the idea of making the tax system less complicated sounds great in theory, in practice it wouldn’t work because we need tax policy to help manage a sophisticated economy and complex society.
Paul is right that our tax system has to change, but those changes should lead to higher rates of taxation on the wealthy and greater immediate revenues:
- We should increase the tax rates on incremental income (income above certain amounts).
- We should take the cap off the maximum salary subject to the Social Security tax.
- We should end the special treatment of capital gains taxes, or failing that, redefine capital gains to include only direct investments that benefit a business, which means no stock or bond bought or sold on a secondary market.
- We should end the carried-interest loophole that enables hedge fund manages to shield billions of dollars of income from taxes each year.
- We should take from the French and add a small annual tax on wealth above a certain level, maybe $5 million for an individual.
- Finally, we should assess a very stiff tax on all inheritances above a certain amount, again, say $5 million.
In other words, instead of lowering taxes on the wealthy, as Paul wants to do, we should raise them back to the level before the Reagan years. That’s a program that will lead to an economic growth spurt.