Introduction to Tax Cuts and Budget Deficits…
Measuring the impacts of tax cuts is very complex. Perhaps the most difficult aspect is defining, “What is a tax cut or tax increase?” Since President Ronald Reagan took office in 1981 through the present, we have seen a plethora of tax machinations. Reagan is known as a tax cutter, yet he broadened the tax base by eliminating many deductions commonly used my most taxpayers. He also eliminated tax shelters and other tax loopholes while cutting the number of tax brackets . Reagan also increased Medicare and Social Security taxes and dramatically increased the IRS enforcement budget. All of these increased taxes for most United States citizens. President Bill Clinton raised taxes, but not uniformly for all income groups. Clinton also signed the General Agreement on Tariffs and Trade (GATT) which he labelled the biggest tax cut in history. Clinton cut the IRS budget which was in effect another tax cut. On top of all this, Reagan and other presidents enacted user fee increases, federal fuel and cigarette tax increases and a host of other fees which are all tax increases.
Because of these issues, one cannot simply analyze the effects of Reagan’s tax cuts or Clinton’s tax increases and get usable information. An alternative is to look at the broader picture. Whenever the federal budget is a deficit, that is actually a tax subsidy to all taxpayers. For example, the government borrowed $1.3 trillion in 2011 to cover the budget deficit. If the government had not borrowed that money, we would all have paid $1.3 trillion in more taxes. The budget deficit is in effect a tax cut. When there is a budget surplus, the government collected more taxes than needed in that particular year. That passes the test of looking and smelling like a tax increase.
In the following analysis, each year is analyzed separately. Budget deficits are a subsidy to tax payers and used as a starting point for calculating what is labelled as a tax cut. This is the primary assumption that drives this analysis. Readers that have a problem with this logic can change the title of this article to, “Budget Deficits, Not the Answer” and find that budget deficits are not associated in any way with faster growth or higher employment.
Analyzing the impact of the federal government’s ending balance on annual employment rates and Gross Domestic Product (GDP) is relatively simple. However, critics can justifiably point out that spending increases are part of a budget deficit. Spending increases do have impacts. These are analyzed in “Spending increases, Not the Answer” on this site. To cut the impact of spending increases in this analysis, the federal government’s spending change from the previous year is added to the Ending balance, thereby eliminating the spending increase from the budget deficit or surplus. (Throughout this analysis, Bureau of Economic Analysis (BEA) data is used. In the BEA tables, “Ending balance” is the net annual budget surplus or deficit).
One could argue this correction is not necessary. No effort is made to counter this argument. Not adjusting for spending changes will change the final numbers somewhat but the end conclusion is the same.
Another argument is that as employment rates drop, this lowers tax receipts and impacts the Ending balance. To alleviate this issue, a number of budget items were analyzed to determine which had statistically significant correlations to employment rates. For those that were statistically significant, such as Unemployment insurance, linear regressions were used to adjust those budget factors to the average unemployment rate over the period of the study. This eliminates most of the impact of higher unemployment rates on the Ending balance. The same was also done with the analysis of the impacts of tax cuts on economic growth measured by Gross Domestic Product (GDP).
More detail is available in the Appendix. The bottom line of this introduction is that Tax cuts in this analysis are the federal government’s Ending balance adjusted by the change in government spending from the previous year. Further adjustments are made on budget items affected by Employment rate.
All of these adjustments are made in the interest of making this analysis as accurate as possible. Unfortunately, the adjustments add a great deal of complexity and to some may make the analysis actually lose credibility. The interesting part of this project is that with or without the adjustments, the bottom line decision about the value of tax cuts is the same.
Tax Cuts and Budget Deficits, Not the Answer
Republicans promise to cut taxes to “get this country working again”. The concept makes sense. Generally speaking, people make more prudent spending decisions than a cumbersome government. Putting more money in the hands of citizens should provide an economic stimulus. Determining if this theory actually works is a prudent step. The following analysis, based on the last 31 years of data, finds tax cuts closely associated with lower employment and slower economic growth.
Note: In all cases, Annual Tax Increases have positive values and Annual Tax Cuts have negative values. Figure 1 illustrates annual tax increases and cuts along with employment rates since 1981. Notice how the Employment Rate rises with Tax Increases and falls with Tax Cuts. Figure 2 illustrates the relationship between taxes and economic growth, measured by changes in Gross Domestic Product (GDP). Tax increase and Tax cut calculations are in the Introduction and the Appendix.
Figures 1 and 2 provide visual illustrations of the annual impacts of Tax Increases/Decreases on Employment Rates and GDP growth. Figures 3 and 4 and the associated regression and correlation data provide a more analytical view.
r = 0.6377; Two-tailed probability using Pearson correlation co-efficient, p<0.01; y = 0.425x + 0.946; R2 = 0.4067.
Interpreting the above data, tax increases and higher employment rates are closely associated. Conversely, tax cuts are closely associated with lower employment rates. Every 1% increase in taxes (as a percent of Gross Domestic Product) is associated with a 2.1% increase in the Employment Rate. Approximately 41% of the variation in Employment Rates are associated with changes in adjusted tax increases/decreases. The Confidence range is greater than 99%.
It is important to point out that high correlation coefficients tell us two independent items are closely associated. This does not necessarily mean there is a cause and effect relationship between them.
r = 0.4934; Two-tailed probability using Pearson correlation co-efficient, p<0.01; y = 3E-05x + 0.0636, R2 =0.23016
Economic growth also suffers from tax cuts. Again, this comes with a greater than 99% level Confidence range. If there is a cause and effect between tax cuts and unemployment and economic growth, the above data tells us there is less than a 1% chance they will improve our economy. If no cause and effect is assumed, spending trillions of dollars on tax cuts is a wasted effort. Again, the logical decision is not to cut taxes.
Given this information and President Barack Obama’s reliance on tax cuts to bring us out of our current recession, our slow economic recovery shouldn’t surprise us. Logically, Obama’s miscalculation should have cost him his job. Unfortunately, our choice was a political party committed to even larger tax cuts
Somehow, cutting taxes for high income earners seems to resonate with Republican core voters, especially non-college graduate white men making less than $100,000. This group has an almost religious belief that rich people must get continual tax cuts or they will quit generating jobs. The data in this analysis indicates this is not the case.
Since 1981, our federal government increased our debt by $10.1 trillion. Net tax cuts during this period totaled $6.8 trillion. Never has so much been spent for so little.
Summing up…
President Obama has made many mistakes during his presidency. Relying on tax cuts is probably his biggest blunder. Even more puzzling is his allowing Republicans to define him as a big spender and taxer who won’t compromise with them. The reality is that his year on
year percent spending increases are lower than any Republican president going back to Eisenhower, he is history’s biggest tax cutter and he not only compromised with Republicans, he based his economic recovery program on Republican dogma.
Hopefully, this analysis and the Spending Increase paper also on this site contribute to a measured discussion about the harm that government stimulus programs do to our economy. We have 31 years of data telling us that true conservatism, epitomized by President Bill Clinton’s small spending increases, balanced budgets and opening barriers to international trade, is the way to higher employment and a broad-based economic growth.
Appendix – Some background in defining tax cuts and increases
Frugal Ron acknowledges the following is not an easy read and is provided for those wanting to know how the Tax Increases/Cuts used in this analysis were calculated. Readers have more confidence in the analysis if the data and calculations are transparent. Don’t hesitate to suggest better ways to do this analysis.
There are two major challenges in analyzing tax cut effects on the U.S. economy:
- Defining a tax cut and quantifying its annual magnitude.
- Identifying and neutralizing contributing factors.
Like many things, the devil is in the details. Rather than trying to calculate the effects of various changes to the marginal tax rate (rate paid by the highest income tax payers), this analysis takes a broader approach. Our federal government’s “Ending Balance”, is the difference between all receipts (mainly taxes) and expenditures. This balance has been negative so often it is typically called our government deficit. Whenever the Ending Balance is negative, that negative balance is a subsidy to taxpayers. That subsidy is defined as a Tax Cut in this analysis. When the adjusted Ending Balance is positive, that is a Tax Increase.
This analysis focuses on the effects of tax cuts on our economy. Government spending increases are analyzed in the separate Spending Increases analysis on this site. Because of this, it is important to eliminate spending increases from this analysis. The simplest way is to add each year’s annual spending increase onto the Ending Balance. For example, the Ending Balance in 2011 was -$1.394 trillion. The spending increase was $22.2 billion. After this first adjustment, the adjusted Ending Balance is $1.372 trillion. This value is the “Tax Increase/Cut” value used in Figures 2 and 4 analyzing Tax Increase/Cuts effects on Gross Domestic Product.
Less taxes are collected when the U.S. has a low employment rate. This affects the “Ending Balance” and consequently the calculated Tax Increase/Cut used in this analysis.
The following adjustments attempt to neutralize Employment rate’s influence on the Ending Balance. The goal is to make the correlations reflect the influence Tax Increase/Cuts have on the Employment rate while nullifying the opposite relationship. To identify the government’s income and expense accounts that are significantly affected by Employment rates, correlations were run on a number of different parameters.
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Linear regressions were done for each of the significant accounts (p-value <0.05).
Regression results are below:
| Account | Regression Equation | ||||
| Federal Unemployment Tax Receipts | y = 25.715x – 17.972; R2 = 0.17309 | ||||
| Federal Unemployment Insurance Payments | y = -1018.1x + 989.66; R2 = 0.2843 | ||||
| Current Tax Receipts | y = 9012.4x – 7514.1; R2 = 0.15058 | ||||
Each year’s balance is adjusted using regression results to reflect receipts and payments if the Employment Rate equalled 93.6%, the average of the period studied (1981-2011). Example Adjusted Tax Receipts for 2005 = ((((9012.4 * 93.6%) – 7514.1) * 0.15058) -(((9012.4 * 2005’s Actual Employment Rate) – 7514.1) * 0.15058)) + Actual Tax Receipts for 2005.
| Adjustment Results of Equalizing Employment Rates | |||||||
| All values in $billions – Adjusted to 93.6% Employment Rate | |||||||
| Year | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 |
| Employment Rate | 94.9% | 95.4% | 95.4% | 94.2% | 90.7% | 90.4% | 91.1% |
| Actual Current Tax Receipts | 1383.7 | 1558.3 | 1637.6 | 1447.7 | 1163.6 | 1309.8 | 1502.7 |
| Adj. Current Tax Receipts | 1366.7 | 1534.5 | 1613.8 | 1440.2 | 1203.6 | 1353.8 | 1537.2 |
| Actual Federal Unemployment Tax Receipts | 7.2 | 7.2 | 7.3 | 7.1 | 6.6 | 6.8 | 8.0 |
| Adj. Federal Unemployment Tax Receipts | 7.1 | 7.1 | 7.2 | 7.1 | 6.7 | 6.9 | 8.1 |
| Actual Federal Unemployment Insurance Payments | 31.8 | 30.4 | 32.7 | 50.9 | 131.2 | 138.9 | 108 |
| Adj, Federal Unemployment Insurance Payments | 35.4 | 35.5 | 37.8 | 52.5 | 122.7 | 129.5 | 100.6 |
| Final Adjustments Converting Ending Balance to Tax Increase/Cut | |||||||
| All values in $billions – Adjusted to 93.6% Employment Rate | |||||||
| Year | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 |
| Employment Rate | 94.9% | 95.4% | 95.4% | 94.2% | 90.7% | 90.4% | 91.1% |
| Ending Balance* | -352.4 | -247.2 | -315 | -756.2 | -1457.4 | -1490.5 | -1394.1 |
| Adjusted Ending Balance ** | -373.1 | -276.2 | -344.0 | -765.4 | -1408.8 | -1436.9 | -1352.1 |
| Spending Change*** | 202.00 | 132.20 | 196.60 | 290.50 | 417.80 | 196.50 | 22.20 |
| Tax Increase/Decrease**** | (171.1) | (144.0) | (147.4) | (474.9) | (991.0) | (1,240.4) | (1,329.9) |
| * Bureau of Economic Analysis, Table 3.2, Line 46 | |||||||
| ** Ending Balance + Change Current Tax Receipts + Change Federal Unemployment Tax Receipts – Change Fed. Unempl. Insurance Payments | |||||||
| *** Bureau of Economic Analysis, Table 3.2, Line 40 minus previous year total | |||||||
| **** Adjusted Ending Balance + Spending Change | |||||||
To nullify the effects of inflation, the Tax Increase/Cut value is divided by that year’s Nominal Gross Domestic Product and expressed as Tax Increase/Cut (% of Gross Domestic Product) in Figures 1 and 3.
Gross Domestic Product (GDP) Calculations
The analysis of tax changes on GDP uses a different Tax Increase/Cut value with fewer adjustments than the measure in the employment rate analysis. This is necessary because in the employment rate analysis, the X-value was the Annual Tax Rate Cut as a percent of GDP. We could not use a value that is a percent of GDP in analyzing GDP changes.
The correlation of Nominal Gross Domestic Product and Total Federal Government Receipts is 0.96912. The correlation of Nominal Gross Domestic Product and Total Federal Government Expenditures is 0.97508. Total Receipts minus Total Expenditures equals the Ending Balance that the Tax Increase/Cut is calculated from. No adjustments to either measure was attempted due to the extremely high and almost equal correlations. Therefore, the Tax Increase/Cut value used for each year in this analysis is simply the Ending Balance plus that year’s Spending Increase.
