Once an idea is misrepresented, it is easily impugned. This has been the fate of the proposal by Rep. Jack Kemp and Sen. William Roth, supported by Ronald Reagan, to amend the federal income tax laws. Almost everywhere you look you will see Kemp-Roth described as a "tax-cut" proposal, frequently expressed in revenues lost to the government. For example, after Reagan's recent speech endorsing Kemp-Roth, The Wall Street Journal described the "proposed tax cuts, amounting to $172 billion by 1985." The New York Times alluded to Reagan's "call for a 30 percent reduction in federal income taxes over three years."
The Kemp-Roth bill aims to lower marginal tax rates by 10 percent a year over three years. The essence of the new "supply side" economic theory, now widely disparaged by traditional economists, forecasters and journalists alike, is that tax rates and tax revenues are not necessarliy proportional.
Prof. Arhtur Laffer's curve graphically depicts just this point. Above a certain level, tax rates can be increased, yet revenues will decrease. And vice versa. Thus, to call a tax-rate reduction "a 30 percent reduction in federal income taxes" is precisely to blur the crux of the supply-side argument.
Kemp-Roth would cut the top tax rate on earned income from the current 49 percent to 44 percent in the first year. This tax rate takes effect at $34,100 of taxable income for single taxpayers. (These tax-rate "thresholds," as they are called, would remain unchanged.) When people talk about "marginal" tax rates, they mean (for example) that for every taxable dollar earned over $34,100, the government takes 49 cents. Since people in that income bracket would also be paying sizable state, sales and possibly real estate taxes, they would be in a marginal tax bracket well over 50 percent. Tax rates devised for the rich are now beginning to hit the entire middle class.
Kemp-Roth would likewise reduce all marginal tax rates. The top, on "unearned" income (interest and dividends), would be reduced from 70 percent to 63 percent, and the bottom from 14 percent to 12 percent.
A tax rate should be thought of as a barrier inserted between two economic participants, not as a receptacle that ineluctably "nets" the share due to government. The barrier, if high enough, will deter the participants, and the government will net nothing.
In a free society, alternative courses of action are open to the individual who faces discouragingly high tax-rate barriers. He can turn to leisure, for example, or crime (by not filing returns) or tax havens. Leftists who profess to believe that individuals will work cheerfully for the collective good of course deny that high tax rates create disincentives; nevertheless, they are often among the first to recommend buying real estate -- a tax haven.
Present tax rates stimulate consumption and deter savings, which are taxed twice: a prescription for inflation. At the same time, an enormous volume of discretionary money is being funneled into tax shelters: according to one unofficial estimate, one-third of Merrill Lynch's account activity. Tax-rate reductions would immediately pull this sheltered money out of hiding. (It is time-consuming and expensive in itself to shelter it.)
That is why supply-siders are confident that rate reductions would instantly capture new revenue, without having to wait for productivity increases and new factories. That also is why it is most important to cut top tax rates, where most descretionary income-switching occurs.
Perhaps the most important point about supply-side theory is that after incentives are changed, the future can no longer be projected as a continuation of the past. Those who express tax-rate reductions as revenue losses precisely fail to allow for this. Unfortunately, the economics profession if now loaded down with people whose job it is to forecast the future. They naturally tend to reject an idea whose implication is that their "models" and computer programs will prove misleading. Nevertheless, tax-rate changes clearly do alter the relative "price" of work and leisure, and of saving and consumption.
With the exception of the Vietnam War surcharge, marginal income tax rates in the United States have not changed since the mid-1960s. The sizable tax-rate cuts of 1964-66 were followed by large revenue increases. The same thing happened in the 1920s, at the time of the Coolidge-Mellon tax-rate cuts. The problem is for the demand-siders who continue to dominate economic policy to find one case where rate cuts were not followed by revenue increases.
The most recent illustration has been provided in Puerto Rico. Marginal tax-rate cuts of 5 percent per annum have been enacted in each of the last three years. Tax revenues have increased by 13.5 percent, according to a May 25 article in the San Juan Star.
D.C. residents might finally wish to ponder the recent sharp increase in the local gasoline tax. Such a tax, interposed between buyer and seller, is the exact equivalent of a tax rate. After the tax increase, a drop in gasoline sales was reported. Admittedly, it is not too difficult to drive to Maryland or Virginia. And that, surely, is what happened. But once again we see incentives at work. To deny that they are the mainspring of economic activity is to reinvent human nature.