Worst Argument Of the Day

Justin Fox at Time has squirted out an impressively useless rebuttal to supply-side economic theory.

The official word on whether capital gains tax cuts increase revenue (it's no)

The Congressional Budget Office issued a report Friday on Sources of the Growth and Decline in Individual Income Tax Revenues Since 1994. The gist of it was that the big gains in federal tax revenue from 1994-2000 had very little to do with changes in the tax code, while about half of the decline in tax revenue (as a share of GDP) between 2000 to 2004 was the result of the Bush-administration tax cuts.

You may already be feeling woozy from the illogic and that's normal.  Let's just concentrate on the last half of that last sentence and read it again slowly (take a drink of water first if your head is still swimmy from last time).

...about half of the decline in tax revenue (as a share of GDP) between 2000 to 2004 was the result of the Bush-administration tax cuts.

And therein, Fox assures us, is proof that capital gains tax cuts officially do not increase tax revenues.  You may have noticed the bolding in that second go-round.  These phrases are central to Fox's piffle.

Alert readers, keen fiscal policy observers, and anyone with Wikipedia access can attest that the Bush tax cuts, EGTRRA  and JGTRRA, were enacted in 2001 and 2003.  While the first round did address capital gains in a limited way (it reduced the rate on stocks held for 5+ years from 10% to 8%), it was much more significantly a package of income tax cuts.  It was the second round of tax cuts, enacted in May 2003, that really slashed capital gains taxes (and ushered in a 4+ year bull market and the longest period of unbroken job creation in recorded history).

Fox is disavowing the idea that reductions in capital gains tax rates can fuel so much investment and business activity that incomes and gains increase enough to offset the lower rates levied on them, thus raising revenues.  And Fox is leaning on the fact that revenues (as a share of GDP) decreased from 2000-2004.  But the primary capital gains tax cut wasn't enacted until 2003.  What's more, the tax cut did not apply to investments held for less than one year.  So any new investments made after the enactment couldn't be sold (and no corresponding gains could be realized or taxed) until May of 2004, if they were wanted to make use of the tax cut.

Looking at the 2000-2004 window to judge the effect of a policy whose earliest material impact couldn't begin to be measured until mid-2004 is a genuine head-scratcher.  I know, I know, you'd feel more satisfied if you could see a little uptick in 2004.  And I'm loathe to disappoint you, if you've already read this far.

That chart is right there in the paper Fox cites.  I'm not sure how he missed it.  It's true, you see, that tax liabilities declined (as a share of GDP) from 2000-2004, but that cleverly ignores the fact that they began increasing once the capital gains tax cut was enacted.

But asinine time window selection isn't the only fatal failing of the argument.  Recall the other half of Fox's troublesome phrase: as a share of GDP.  The Laffer Curve doesn't predict that lowering tax rates will raise taxes as a percent of GDP.  In fact, a tax cut - almost by definition - is precisely the opposite, a reduction of tax revenues as a share of GDP.  Supply-side theory argues that absolute revenues will rise, even if you reduce the ratio of taxes/gains or taxes/income.  And that's pretty much the whole point of the theory and the school of economic policy built around it.  (Not sure how Fox missed that either.  We know he's at least aware of Arthur Laffer - he graciously acknowledged him to be a "bona fide economist" in a similar "tax cuts don't increase revenues" piece a few months ago.)

Of course, that's also exactly what's happened.  Individual income tax revenues since 2004 have shot up more than $350 billion (a compound rate of 13% per year, or 44% cumulatively over those three years).

Empirically, it's generally a fool's errand to try either to prove or disprove (or at least to quantify) income's tax rate elasticity, 1) because there are too many factors you can't control for (exogenous macroeconomic changes, bubbles, wars, etc.), and 2) because it's hard to know where you're starting from on the Laffer Curve.  If you're already at the peak, then reducing tax rates won't increase revenues (of course, that doesn't mean it's not still a good idea - maximizing tax revenues certainly isn't equivalent to optimizing tax revenues).

Still, while even a well-reasoned argument for or against supply-side theory, based on a properly interpreted set of observations, is pointless enough to begin with, Fox has raised the exercise to a new level of fatuity by looking at irrelevant data and apparently failing to grasp the central thesis of the theory.  His rebuke was hardly the "official word" on whether capital gains tax cuts increase revenues, but it certainly was a singularly unsound one.