see Business cycle theories
Classical theory tends to support policies that are relatively laissez-faire. Most classical theorists are skeptical about the efficiency of big government and fear that government outlays may "crowd out" more valuable forms of private investment and consumption. Requiring a balanced budget may curb politicians' impulses to spend.
Another wing of the "new classical" school, supply-side economics, spearheaded a tax-cutting mentality in the early 1980s and has been as much a political agenda as a mode of analysis. High tax rates are alleged to (a) inspire widespread tax evasion and tax avoidance, (b) intensify lobbying for tax loopholes, and (c) smother productivity.
Does Taxation Have a Natural Limit?
An advisor to an Egyptian pharaoh is credited with first observing that high tax rates may hinder incentives to work and investment, reducing actual tax revenues. Joseph Schumpeter, while serving as Finance Minister in Austria during the 1920s, proposed an "economic law" that taxpayer resistance precluded any government from collecting taxes of more than 27 percent or so of people's income. He may have been close to right.
The Laffer Curve
Arthur Laffer, a celebrated supply-sider, explained this concept to a journalist at a Washington, D.C. restaurant, and sketched on a napkin what has become known as the Laffer curve.
The Laffer curve: Very low tax rates might be raised to yield higher tax revenue, but raising tax rates excessively eventually drives tax revenues down when taxpayers decide either (a) that the extra effort necessary to generate extra taxable income is not worth it, or (b) that cheating the tax system is okay.
If Uncle Sam's bite is too fierce, many taxpayers will prefer leisure over additional work and will consume immediately from income instead of saving and investing. And tax evasion may divert more activities into the underground economy. A modified Laffer curve is shown in Figure 6.
FIGURE 6 The Laffer Curve
If tax rates did not affect the tax base, tax revenues would be exactly proportional to tax rates and could be drawn as a straight line, such as T0. Erosion of the tax base occurs when people legally avoid taxed behavior (e.g., they supply fewer resources) or illegally evade taxes, so tax revenues eventually peak and then decline.
Supply-siders argue that high tax rates are disincentives to produce, so that income shrinks as tax rates climb. This means that the same tax revenues might be generated by both a high tax rate and a low one.
Marginal tax rates are the percentage taxes on small amounts of extra income.
In Figure 6, marginal tax rates that average either 15 percent or 75 percent yield tax revenues of $500 billion, while marginal tax rates that average X percent yields $1 trillion to the tax collector. Any increase in marginal tax rates over X percent actually shrinks tax collections.
How will people react if high marginal tax rates reduce the gains from working, saving, and investing? Potential workers may adjust to high tax rates with more nonmarket activities, such as do-it-yourself projects. Potential savers and investors will realize less interest income if marginal tax rates are high, so they will consume more currently, forgoing future consumption.
Evidence of this sort of behavior was provided when wealthy people in Britain splurged on furs, Rolls-Royces, and other luxuries in the 1970s when marginal income tax rates peaked at 99 percent. Investing was not worthwhile because of rapid inflation and the staggering tax rates on investment income. The British economy stagnated in the 1960s and 1970s, while areas of London where high society gathered abounded with conspicuous consumption of luxury goods.
Some analysts argue that the U.S. operates close to the peak of the Laffer curve and favor reducing tax rates to ease disincentives against work and investment. They fear that tax hikes to slice recent deficits may restrict economic growth and slash tax revenues. Ronald Reagan, a major convert to supply-side economics, persuaded Congress to cut marginal tax rates by an average of 25 percent between 1981 and 1983. Results? Between 1980 and 1994, the economy grew by 134 percent, while federal tax revenues grew 145 percent. But budget deficits grew because politicians failed to control federal outlays, which expanded 152 percent.
Notice that Keynesians may accept the general form of the Laffer curve while perceiving different behavior as its basic cause. New classical economists blame declines in tax revenues as tax rates rise on reduced incentives to comply with tax laws and to supply goods and services. Keynesians perceive high tax rates and fiscal drag as smothering Aggregate Spending. Admitting that high tax rates also inhibit supply incentives, Keynesians still perceive macroeconomic problems as originating primarily from the demand side, while new classical economists see high tax-rate disincentives as more powerful on the supply side. Predictably, concerns about both efficiency and equity become more pronounced when the issue of tax structures is raised.
Tax Revenue and Progressive Marginal Tax Rates.
Social reformers have long advocated progressive taxes to flatten the distribution of income. (Recall that a progressive tax is one for which higher marginal tax rates fall on higher incomes.) Many economists in the classical camp, however, argue that sharply progressive tax rates (a) cannot accomplish this goal, and (b) diminish and distort productive activity.
After passage of the Sixteenth Amendment in 1913, relatively low tax rates were initially levied on only the top 2 percent or so of income recipients. Income tax rates climbed over the next 30 years, and were applied more broadly. By the end of World War II, top marginal tax rates on personal income had peaked at 91 percent, and corporate incomes faced marginal rates exceeding 70 percent—at least on paper. But few Americans were in the top brackets, and almost none paid rates anywhere close to the legal maximum. A deluge of loopholes—tax exemptions, deductions, credits, rapid depletion and depreciation allowances—made the top rates a farce, so complicating the tax code that even experts often felt as lost as lab rats in an endless maze.
Relative prosperity in the United States for the past 50 years or so has bumped increasing numbers of voters into higher real income brackets. The most successful rebellions against high tax rates have come from voters who describe themselves as middle class. From the 1950s into the 1980s, sporadic tax cuts and tax reforms have erratically "flattened" marginal income tax rates. Between 1986 and 1991, nearly all tax loopholes were closed and the number of marginal tax brackets on personal income fell from 15 (ranging from 11% to 50%) to four—15%, 28%, 31%, and 33%. Unfortunately, these reforms did little to simplify our tax laws.
The 1993 Budget Reduction Act raised marginal tax rates on high-income individuals. The number of tax brackets expanded to five: 15%, 28%, 31%, 36%, and 39.6%. Critics question whether more tax revenue is collected from "the rich" through high marginal tax rates or lower ones. Opponents of increased progressivity cite evidence that flattening tax rates increased the share of total taxes borne by upper-income taxpayers in the 1980s and early 1990s, as shown in Panel A of Figure 7. Between 1981 and 1988, the share of income taxes paid by the top 2 percent of income recipients rose by 50 percent—from roughly 18 percent to almost 27 percent.
Figure 7 Tax Revenues and the Progressivity of Tax Rates
Panel A traces the shares of total tax revenues borne by taxpayers near the top of the U.S. income distribution. Their shares of total tax payments have risen when taxes rates have been flattened. Tax revenues as percentages of GDP appear almost impervious to the degree of progressivity, as shown in Panel B. Declines in taxes as percentages of GDP across recent decades have tended to reflect economic downturns, while increases in this tax/GDP ratio generally reflect periods of recovery from recession. Any relationship between government's tax take and the degree of progressivity is hard to discern from these data. These results suggest that policies to "soak the rich" may be most effective when high income individuals are not discouraged by high tax rates from working hard and investing wisely.
ED: 2 column Figure
More evidence that increased progressivity may be counterproductive is provided in Panel B, which traces federal tax revenues and federal revenues from individual income taxes as percentages of GDP. The relationships are comparatively constant. Tax structures have been flatter in some periods, and steeper in others. Nevertheless, roughly 29 percent of GDP has been collected in total taxes, with roughly 10 percent being collected in income taxes on individuals, regardless of how progressive tax rates were at any point in time. Critics of progressivity echo "Schumpeter's Law," which suggests that people ultimately find ways to beat any tax system intended to collect more than about 27 percent of their income. Choosing not to make much income is one such technique.
What appears to be true for the United Staes, however, may not hold world wide. As Figure 8 illustrates, tax revenue as a percent of GDP varies from nearly 50 percent in Sweden to the 20-30 percent range in Australia, Japan, and the United States. The effective tax rates in the former Soviet Union (hidden in the form of low wages and high prices set by the government) were higher than any shown in Figure 8. The collapse of the USSR and mounting pressures for tax cuts in the countries where taxes are heaviest may be evidence that it may take a long time for tax burdens to fall to an equilibrium consistent with Schumpeter's law—if it is truly universal.
Figure 8 Tax Burdens on the International Scene
Tax burdens (as measured by taxes as a percent of GDP) have been rising in most industrialized countries for decades. Americans complain about being heavily taxed, but, as you can see, they get off much easier, on average, than people in many other countries.
Source: The Economist, Sept. 4th, 1993, p.103
ED: 2 column figure.
Government Purchases and Transfers: Neo- Classical View
Keynesians view government purchases as direct sources of Aggregate Spending, and transfer payments as quickly translated by recipients into new consumer spending. Advocates of the new classical economics sense that this focus on demand is shortsighted: Modern government provides school lunch programs, public parks and highways, medical care for the poor and the aged, subsidized housing and transportation, and a host of other goods. Consequently, there is less incentive to sacrifice our time by working and less net gain from investing if the government guarantees us a reasonably comfortable life by providing many necessities.
The apparent two-pronged provision of disincentives seems to concern new classical economists the most. First, incentives to work and invest are reduced for those who work and invest, and who then pay taxes that government channels to others. Second, // extensive government purchases and generous transfer payments trap low-income individuals in a rut—a "psychology of dependence" takes hold, discouraging work effort and deterring attempts to improve their economic status. The welfare reforms implemented in the late 1990’s by the Clinton administration were designed to control this "cycle of poverty" by helping low-income individuals get back on their feet. The emphasis is on limits to the duration of government support, job training, a base-line health care system, and such services as day-care for the children of poor parents who work.
In conclusion, new classical economics would redirect fiscal policy makers to (a) set non-intrusive economic policies that permit markets to make long-run adjustments, and (b) limit tax rates and government outlays because of disincentives that dampen Aggregate Supply. Keynesians, in contrast, have traditionally focused on cures for short-run problems and stressed activist fiscal policy as a tool to adjust Aggregate Demand. Specific differences between these schools of thought are summarized in Figure 9.