Taxes & GDP

David Ranson, the head of research for H.C. Wainright & Co. Economics, wrote in Monday's Wall Street Journal on the relationship between US GDP and tax revenues.

The graph from his article appears nearby. It shows real US tax receipts (Y axis) plotted against US GDP (X axis), with the dotted red line representing Y-values equal to 20% of the X-values at each point.

Ranson observes, in his editorial,

"The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth.

The nearby chart shows how tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution's W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP."

I confess to being completely surprised at the incredible consistency of this chart. There aren't the kind of significant swings above and below a regressed curve fitted through the actual data.

Rather, it's clear, assuming Ranson's numbers, as sources in his chart footer, are correct, that this relationship is very tight and dependable.

Why is this so? Ranson opines,

"What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue."

You can guess what the contemporary application of Ranson's version of "Hauser's Law" would be. Ranson considers current federal tax revenue and GDP projections,

"In this form, Hauser's Law provides a simple basis for testing the validity of any government's revenue projections. Today, since the economy already suffers from a large output gap that is expected to take many years to close, 18.3% must be a realistic upper limit on the ratio of budget revenues to GDP for years to come. Any major tax increase will reduce GDP and therefore revenues too.

But CBO projections based on the current budget show this ratio reaching 18.3% as early as 2013 and rising to 19.6% in 2020. Such numbers implicitly assume that the U.S. labor market will get back to sustainable "full employment" by 2013 and that GDP will exceed its potential thereafter. Not likely. When the projections are tempered by the constraints of Hauser's Law, it's clear that deficit spending will grow faster than the official estimates show."

What provides me with some odd comfort is that, no matter how heavily the government taxes us, jointly, we only pay up to about 18-19% of GDP. Thus, recent deficit-financed spending is not going to be repaid out of near-term taxes which rise precipitously.

Rather, it's pretty clear that the only way it will be repaid is through economic growth. And that's going to take a much different economic climate than our current federal government seems to be capable of delivering.