Hauser’s Law: “An Inconvenient Tax Truth”

My subscription to Dennis Prager’s premium site, Pragertopia, just paid for itself, since I might not have otherwise been exposed to Hauser’s Law:

There’s No Escaping Hauser’s Law

Tax revenues as a share of GDP have averaged just under 19%, whether tax rates are cut or raised. Better to cut rates and get 19% of a larger pie.

By W. KURT HAUSER
(11/26/10)

Even amoebas learn by trial and error, but some economists and politicians do not. The Obama administration’s budget projections claim that raising taxes on the top 2% of taxpayers, those individuals earning more than $200,000 and couples earning $250,000 or more, will increase revenues to the U.S. Treasury. The empirical evidence suggests otherwise. None of the personal income tax or capital gains tax increases enacted in the post-World War II period has raised the projected tax revenues.

Over the past six decades, tax revenues as a percentage of GDP have averaged just under 19% regardless of the top marginal personal income tax rate. The top marginal rate has been as high as 92% (1952-53) and as low as 28% (1988-90). This observation was first reported in an op-ed I wrote for this newspaper in March 1993. A wit later dubbed this “Hauser’s Law.”

Over this period there have been more than 30 major changes in the tax code including personal income tax rates, corporate tax rates, capital gains taxes, dividend taxes, investment tax credits, depreciation schedules, Social Security taxes, and the number of tax brackets among others. Yet during this period, federal government tax collections as a share of GDP have moved within a narrow band of just under 19% of GDP.

Why? Higher taxes discourage the “animal spirits” of entrepreneurship. When tax rates are raised, taxpayers are encouraged to shift, hide and underreport income. Taxpayers divert their effort from pro-growth productive investments to seeking tax shelters, tax havens and tax exempt investments. This behavior tends to dampen economic growth and job creation. Lower taxes increase the incentives to work, produce, save and invest, thereby encouraging capital formation and jobs. Taxpayers have less incentive to shelter and shift income.

On average, GDP has grown at a faster pace in the several quarters after taxes are lowered than the several quarters before the tax reductions. In the six quarters prior to the May 2003 Bush tax cuts, GDP grew at an average annual quarterly rate of 1.8%. In the six quarters following the tax cuts, GDP grew at an average annual quarterly rate of 3.8%. Yet taxes as a share of GDP have remained within a relatively narrow range as a percent of GDP in the entire post-World War II period.

This is explained once the relationship between taxes and GDP growth is understood. Under a tax increase, the denominator, GDP, will rise less than forecast, while the numerator, tax revenues, will advance less than anticipated. Therefore the quotient, the percentage of GDP collected in taxes, will remain the same. Nineteen percent of a larger GDP is preferable to 19% of a smaller GDP.

The target of the Obama tax hike is the top 2% of taxpayers, but the burden of the tax is likely to fall on the remaining 98%. The top 2% of income earners do not live in a vacuum. Our economy and society are interwoven. Employees and employers, providers and users, consumers and savers and investors are all interdependent. The wealthy have the highest propensity to save and invest. The wealthy also run the lion’s share of small businesses. Most small business owners pay taxes at the personal income tax rate. Small businesses have created two-thirds of all new jobs during the past four decades and virtually all of the net new jobs from the early 1980s through the end of 2007, the beginning of the past recession.

In other words, the Obama tax increases are targeted at those who are largely responsible for capital formation. Capital formation is the life blood for job creation. As jobs are created, more people pay income, Social Security and Medicare taxes. As the economy grows, corporate income tax receipts grow. Rising corporate profits provide an underpinning to the stock market, so capital gain and dividend tax collections increase. A pro-growth, low marginal personal tax rate stimulates capital formation and GDP, which triggers a higher level of tax receipts for the other sources of government revenue.

It is generally accepted that if one taxes something, one gets less of it and if something is subsidized one gets more of it. The Obama administration is also proposing an increase in taxes on capital itself in the form of higher capital gains and dividend taxes.

The historical record is clear on this as well. In 1987 the capital gains tax rate was raised to 28% from 20%. Capital gains realizations as a percent of GDP fell to 3% in 1987 from about 8% of GDP in 1986 and continued to fall to below 2% over the next several years. Conversely, the capital gains tax rate was cut in 1997, to 20% from 28% and, at the time, the forecasts were for lower revenues over the ensuing two years.

In fact, tax revenues were about $84 billion above forecast and above the level collected at the higher and earlier rate. Similarly, the capital gains tax rate was cut in 2003 to 15% from 20%. The lower rate produced a higher level of revenue than in 2002 and twice the forecasted revenue in 2005.

The Obama administration and members of Congress should study the record on how the economy reacts to changes in the tax code. The president’s economic team has launched a three-pronged attack on capital: They are attacking the income group that is the most responsible for capital formation and jobs in the private sector, and then attacking the investment returns on capital formation in the form of dividends and capital gains. The out-year projections on revenues from these tax increases will prove to be phantom.

Mr. Hauser is chairman emeritus of the Hoover Institution at Stanford University and chairman of Wentworth, Hauser & Violich, a San Francisco investment management firm. He is the author of “Taxation and Economic Performance” (Hoover Press, 1996).

Hauser’s Law

October 12, 2008

by W. Kurt Hauser and David Ranson

Soak the rich? You can’t. A vital observation, first noted by former Hoover board chairman W. Kurt Hauser, banished this bit of wishful thinking.

W. Kurt Hauser is a San Francisco investment economist who published fresh and eye-opening data about the federal tax system fifteen years ago. His findings imply that there are draconian constraints on the ability of higher taxes to generate fresh revenues. I think his discovery deserves to be called Hauser’s law, because it is as central to the economics of taxation as Boyle’s law is to the physics of gases. Yet economists and policy makers are barely aware of it.

Like science, economics advances as verifiable patterns are recognized and codified. But economics is in a far earlier stage of evolution than physics. Unfortunately, it is often poisoned by political wishful thinking, just as medieval science was poisoned by religious doctrine. Taxation is an important example.

The interactions among the myriad participants in a tax system are as impossible to unravel as are those of the molecules in a gas, and the effects of tax policies are speculative and highly contentious. Will raising tax rates on the rich increase revenues, as Barack Obama hopes, or hold back the economy, as John McCain fears? Or both?

Hauser uncovered the means to answer these questions definitively. In a Wall Street Journal article in 1993, he stated that “no matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5 percent of GDP.” What a pity that his discovery has not been more widely disseminated.

The chart on this page, updating the evidence to 2007, confirms Hauser’s law. The federal tax yield (revenues divided by GDP) has remained close to 19.5 percent, even as the top tax bracket was brought down from 91 percent to the present 35 percent. This should cut the Gordian knot of tax policy debate.

The data show that the tax yield has been independent of marginal tax rates during this period but that tax revenue is directly proportional to GDP. So if we want to increase tax revenue, we need to increase GDP.

What happens if we instead raise tax rates? Economists of all persuasions accept that a tax-rate increase would reduce GDP, in which case Hauser’s law says it would also lower tax revenue. That is a highly inconvenient truth for redistributive tax policy, and it flies in the face of deeply felt beliefs about social justice. It would surely be unpopular today with those presidential candidates who plan to raise tax rates on the rich—if they knew about it.

Although Hauser’s law sounds like a restatement of the Laffer curve (and Hauser did cite Arthur Laffer in his original article), it has independent validity. Because Laffer’s curve is a theoretical insight, theoreticians find it easy to quibble with. Test cases, in which the economy responds to a tax change, lend themselves to many alternative explanations. Conventional economists, despite immense publicity, have yet to swallow the Laffer curve. When it is mentioned at all by critics, it is often as an object of scorn.

Economics is often poisoned by political wishful thinking. Taxation is an important example.

Because Hauser’s horizontal straight line is a simple fact, it is ultimately far more compelling. It also presents a major opportunity. It seems likely that the tax system could maintain a 19.5 percent yield with a top bracket even lower than 35 percent.

What makes Hauser’s law work? For supply-siders, there is no mystery. As Hauser said: “Raising taxes encourages taxpayers to shift, hide, and underreport income. . . . Higher taxes reduce the incentives to work, produce, invest and save, thereby dampening overall economic activity and job creation.”

Putting it a different way, capital migrates away from regimes in which it is treated harshly and toward regimes in which it is free to be invested profitably and safely. In this regard, the capital controlled by our richest citizens is especially tax intolerant.

The economics of taxation will be moribund until economists accept and explain Hauser’s law. They will have to face up to it, reconcile it with other facts, and incorporate it within the body of accepted knowledge. And if this requires overturning reigning doctrine, then so be it.

Presidential candidates, instead of disputing how much more tax to impose on whom, would be better advised to come up with plans for increasing GDP and ridding the tax system of its wearying complexity. That would be a formula for success.

====

See also: “The Futility of Tax Hikes in Pictures:

See also: “Hauser’s Law: This Reality Isn’t Negotiable.”

And for anyone who has issues with Hauser’s Law, you might want to check out Political Calculations’ number-crunching before you start spouting off on the topic.

12/6/10 update:

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2 Responses to Hauser’s Law: “An Inconvenient Tax Truth”

  1. Pingback: The Rich and Taxes - Page 2 - Southern Maryland Community Forums

  2. GDolan says:

    Hi,

    These videos from Dan Mitchell are a quick introduction to the Laffer Curve, I thought they may be a good contribution to the discussion:

    Part 1 – http://www.youtube.com/watch?v=fIqyCpCPrvU
    Part 2 – http://www.youtube.com/watch?v=YsB_rnzBA08&feature=channel
    Part 3 – http://www.youtube.com/watch?v=Mw7LtVwDCbs&feature=channel

    Thanks!

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