Paying For Tax Cuts – A Century Of Bad Economic Analysis

One of the many things fighting for news coverage in the U.S. is the national budget, and how to reconcile a desire for tax cuts with the need to reduce a deficit that is getting into the danger zone. Some things are evergreen, and one of them is a gross misunderstanding of how tax cuts work and how they relate to revenue numbers. Because the relationship between those things does not work in a way that is intuitive for most people (especially those people whose job it is to either make or report news), I thought that an explanation might be helpful.

Why do I think I am qualified to offer that explanation? My undergraduate major was economics, which I studied in the late 1970’s and early 1980’s – a time when tax cuts were an everyday news item and therefore were the subject of much classroom discussion. Economics is one topic that is not at all intuitive – it requires a way of thinking about things that does not come easily to many people. But it was something that came easily to me, which may explain why I often think about things in uncommon ways. Like the way my teeth grind every time I hear people in news or politics talking about the need to “pay for” tax cuts. But enough about me, let us get back to tax cuts and the deficit.

First, we need to look at what we mean when we say “tax cut”, because there are two basic kinds. The first are cuts that will definitely reduce revenue. These are carve-outs, deductions and credits like for mortgage interest or for state and local taxes. The President’s proposals for “no tax on tips” and making Social Security benefits not subject to taxation are two more. These tax cuts have an easily calculable “cost” and therefore must be offset by additional revenue or lower spending if we expect to control the deficit.

But there is another kind of tax cut that requires an entirely different analysis – this is a cut in marginal tax rates. [* Caution – a boring but necessary explanation will take up the rest of this paragraph *] Our income tax system is a graduated system with multiple tax brackets, so the more money you make, the higher the tax bracket you are in. A “marginal tax rate” is the tax rate that, for a given person at a given income level, applies to the next dollar of income. In simplest terms, let’s look at the tax brackets for 2025. If you earn $47,150 your top tax rate is 12%. The next dollar of income will be taxed at 22%, because at $47,151 you are bumped into the next tax bracket. People who think in terms of averages will look at an imaginary tax rate of 17% between those two brackets. But this rate does not exist, and thinking about an average of tax rates is a worthless (on a good day) analysis. What matters is what rates apply to what levels of income, and what such a structure encourages people to do or discourages them from doing.

Here is the takeaway that almost nobody understands – plain mathematical analysis cannot calculate the “cost” of a cut in marginal tax rates. Because in that kind of “static” analysis, the assumption is that everything will stay the same except for the way lowered numerical rates apply to the total of all taxpayers’ incomes. The reason this does not work is because that assumption is faulty – virtually nothing else stays the same. Changes in tax rates create changes in incentives to work, to invest, to produce, or to forgo those things in favor of consumption and leisure. Even the most impressive computer model cannot come anywhere close to capturing what will happen in the real world when marginal tax rates are changed.

I was fortunate to have been studying economics in the late 1970’s and early 1980’s when Ronald Reagan’s tax cuts were being discussed. When Reagan argued that lowered tax rates would likely result in higher tax revenues, he was roundly criticized – most memorably in the 1980 Republican primaries when candidate George H. W. Bush ridiculed Reagan’s ideas as “voodoo economics.”

Laffer Curve

One of the concepts which helped to explain the concept that Reagan intuitively understood was represented by something called “the Laffer Curve”. Economist Arthur Laffer had put in graph form the idea that for a given level of tax revenue, there are two tax rates that will give it to you – a high one and a low one. At a 0% tax rate, the revenue will (of course) be zero. But what about a 100% tax rate? The result here is also a revenue of zero, or something very close to it. Because when the tax rate is 100%, there is no incentive to generate income to be taxed. There will, of course, always be illegal, underground “black market” activity, but none of that activity will generate tax revenue.

The rest of the graph has no numbers, because there are far too many variables to capture in the real world. The policy implication is that if you are in the upper part of the curve, a reduction in marginal tax rates will lead to an increase in tax revenue. If we think of the economy as a big pie, most people assume that the size of the pie is constant and argue over the size of the slices that various groups will get. But lowered marginal tax rates can increase the size of the pie, which means that everyone gets a larger slice. As John Kennedy famously said, a rising tide lifts all boats. Is this just a screwy theory? To listen to most commentators, you would think so. If I had a dollar for every time I have heard someone cite “the Reagan tax cuts” as “blowing out the deficit” I would be in a higher tax bracket than I am.

Let’s look at some history. There have been four significant cuts in income tax rates in the last century. Let’s have a peek at what those rate cuts did to revenues. The following table includes the top marginal tax rates and levels of revenue for personal income taxes for a few years before and after those four major events. Spoiler alert – even when marginal tax rates were reduced (sometimes dramatically), personal income tax revenues almost always went up instead of down.

The years selected were chosen to include a reasonable number of years before and after a significant cut in marginal tax rates. There is a typo in the tax rate for the year 1919 – the top marginal tax rate for 1919 was 73%
  1. The Coolidge Tax Cuts of the 1920’s

America was in a terrible recession after WWI, and remained mired in stagnation into the early 1920’s. In 1918 the top marginal tax rate had been 77%, and it had been reduced to 73% for 1919-1921. Coolidge’s Treasury Secretary Andrew Mellon believed that tax rate reduction would generate enough new economic activity that revenues could increase enough to pay down debt from WWI. Top rates went from 77% in 1918 to 25% in 1924. Revenue figures are hard to find this far back, with only the two figures in the table being readily available.

2. The Kennedy-Johnson Tax Cuts of 1964

Tax rates went up during the 1930’s and up even more during WWII (when, coincidentally, the system went from taxpayers writing a check once a year to money being withheld). Rates stayed high all through the 1950s, and the economy got quite sluggish starting in 1956. Things had not signifiantly improved by the early 1960’s and John Kennedy believed that a tax cut would stimulate things. Following Kennedy’s assassination, Lyndon Johnson helped shepard Kennedy’s proposed cuts through congress. This example is the least dramatic of our four examples, with rates being cut from 91% in 1963 to 70% in 1965.

3. The Reagan Tax Cuts

Ronald Reagan was elected in November of 1980, and faced a terrible economy. Jimmy Carter’s appointment to the Federal Reserve (Paul Voelker) squeezed the money supply to choke off inflation (which is nothing more than excessive money in the system). Carter should get more credit for this appointment than he has usually gotten, but Voelker’s necessary action led to a deep recession that was getting worse by the time Reagan entered office in early 1981.

There were actually two rounds of cuts during the Reagan years. The first cut in 1981 reduced a 70% top rate to 50% for 1982. Reagan was forced into a political compromised, which put these rate cuts into effect gradually, with stepped cuts occurring in October 1981, July 1982 and July 1983 (something that the source material for our chart ignores). A second round of cuts in 1986 reduced the top rate further, to 38.5% in 1987 and 28% thereafter.

4. The Trump Tax Cuts

This was a smaller tax cut which reduced a top rate (which had crept up to 39.6%) back down to 37%. The table stops at 2019 because that was the last year before COVID changed everything. (For data nerds, revenues dropped to $1,608,663 in 2020 but rebounded to $2,044,377 in 2021 on an unchanged top rate).

The Takeaway

The table tells just how much money those tax cuts “cost” (to the extent that citizens getting to keep more of their own money is a “cost”, but that is another topic.) The table shows us that personal income tax revenue actually declined following a tax cut in one single year – 1983 – during a period of revenue stagnation before the larger cuts took effect. Aside from that anomaly, the pattern is one of revenue growth following each of those four marginal tax rate cuts. (1)

I think the most reasonable conclusion that can be drawn is this: Even after significant cuts in marginal income tax rates, revenues have either remained amazingly steady or have indeed jumped dramatically. The fears which preceded each of those four historical cuts – losses in tax revenue – were fears of something that largely failed to occur. My own conclusion is that instead of obsessing over feared revenue losses from marginal tax rate cuts, we would all be better off transferring that obsession to the blowouts on the spending side of the ledger, which has been growing so much that it has swamped any additional revenue that has come in.

(1) It is unclear whether these revenue figures have been adjusted for inflation and my assumption is that they have not been. Because we are not comparing revenue figures over long expanses of time, such inflation adjustments become less important. If inflation is considered, it would likely serve to flatten the increases of the latter 1960’s and again from 1979-82 in the chart above.

The data in the chart above is from the following sources:

https://www.heritage.org/taxes/report/the-historical-lessons-lower-tax-rates

https://taxpolicycenter.org/statistics/amount-federal-revenues-source

23 thoughts on “Paying For Tax Cuts – A Century Of Bad Economic Analysis”

    • You have lots of company! I probably bored more than a few readers with this, but I had been so irritated every time this issue has been discussed in the news lately (and on both sides of the political aisle) that I felt like tackling it. I have been trying hard to avoid the kinds of political topics that get people upset, but this is one that I believe cuts across the spectrum.

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  2. Thanks for the trip back to the early 80’s when I got degrees in both Finance and Economics. I agree with you – the main focus today should be on the expense side. We cannot keep spending more than is coming in, that’s simple economics that anyone can understand (excepting it seems our elected officials).

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    • Ah, I love finding a kindred spirit! Alas, it seems that any attempt to cut spending, no matter how small, always starts a bunch of partisan bickering.

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  3. No tax cut has ever done anything for whatever income bracket I was in. I’m lucky if it turned out to be pennies. I would refer to myself as a middle of the road liberal, but in the past, even I’ve shuddered at things people expect the government to pay for as “not viable”, as well as “none of the governments business”. Expense reduction, whether you’re in private business, or local, state, or federal government; should be the first place to look for efficiencies, and many times your only option! There are so many things the government should be paying for, and isn’t, and so many things they are paying for, that they shouldn’t.

    He’s a story about when I was self employed for a number of years in the advertising photography business. At my most productive, I realized that between my federal tax rate, my state tax rate (at the time, in a highly taxed state), and my self-employment tax (all of the FICA both you and your employer paid if you were working someplace), I came to the understanding that I was paying virtually 50% of my gross. Lets not even count the non-deductible health insurance, or the fact at the time, there weren’t any viable retirement plans, pre tax, that had been rolled out by the mutual fund companies (altho passed in the late 70’s, it really didn’t start rolling out until the late 80’s). It was impossible NOT to start thinking that everything I bought, that was not tax deductible, I also owed the government the same amount of money! I new pair of jeans, and a jacket, $75.00? That means I owed the government $75.00 as well! It is a stifling realization and makes you freeze up on what you need to be accomplishing. The entire tax system is not meant to be conducive to the small independent worker, especially quarterly tax payments on a fluctuating income. You need a crystal ball to calculate what you’ll need later in the year, vs. what you don’t want to get fined on for not paying!

    There are a number of things I learned. It was common biz school knowledge that you should never start a business or freelance yourself, for a job that you could have working for someone else. This was made very apparent. Also much of my competition was surviving on their spouses employers health insurance, and retirement programs, which I was funding for myself. This made me financially uncompetitive. I couldn’t work an hour more a week to make more money, but it wouldn’t take one more fully employed person working for me to make more, it would take about three before it would filter down to me! If you were a single self-employed person, it would take easily an hourly rate of three times what the average salary was for a person working in your position in a company, for you to even live close to what an in-house employee would be living like. The outcome of all this, is that I’ve noticed that even in the “fly-over”, companies are now trying to use “gig economy” hiring to keep from hiring long term employees; but unfortunately, these “fly-over” economic markets to not have the volume of employers to make all of that work. Add on the self employment quarterly tax filing, and it becomes even more confusing. Even in my state, they’re trying to make short term employers take out taxes and pay their share of FICA as freelancers get paid. We’ll see what happens.

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    • I’m with you 100% on the plight of the self employed person in a small service business – a law firm, in my case. And in my era (late 90s-2000s) the health insurance situation had gotten worse.

      There are many things I would do differently if I were put in charge, but lowering and flattening the tax rates would be near the top, and probably with a system that doesn’t start taxing income until over $150k. I suspect that a flat 15% over that and we would be surprised at the revenue jump. Of course that won’t help if Congress then spends 150% of the increase.

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      • Ditto on lowering and flattening the tax, with a healthy amount that won’t be taxed at all. I have more than a few friends who are flat tax proponents, as well as a healthy amount that feel that a flat tax would be regressive against the poor. I always tell them that 15% of $35K, is far less money than 15% of $150K, so as far as I’m concerned, in simple math, it seems more fair for everyone. For someone making that $35K, that $5250. is far less that his wealthier pal, where its $22,500.

        You are correct about the health care situation. I forgot to mention above, that the biggest impact on my paycheck in all the places I’ve lived, is the amount of “benefit percentage” associated with whatever company I’m working for. I’ve certainly gotten much larger take home checks from companies that have had paid my entire health care monthly, and had 1 to 1, 401 (k) matches, than companies that only covered 20% of my monthly health care fees, and only awarded 12 cents on the dollar against my retirement contribution, and that was in corporate stock, and only awarded once a year! In the upper midwest, it is now relatively common, and has been for about 15 years now, for your employer to pay only a percentage of your health care monthly bill ONLY for you, and your family, or those who need it in your family, are billed to you monthly AT FULL COST, no employer percentage paid. If there is any “red flag” that the U.S. health care system has now gone way over the edge of being broken, it is certainly that!

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  4. You ever work a jigsaw puzzle and see a bunch of pieces lying around, knowing they fit together somehow, but you haven’t yet figured out how? Well, you just put them together. Thank you!

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    • It feels good to get through to someone! And from my perspective, it is so frustrating to see the nearly finished puzzle and watch news and political people looking at it all with blank expressions. As an aside, it is all over the news today that people are arguing about whether we can afford a 4.5 trillion tax cut or only a 1.5 trillion tax cut. These figures are as worthless as a gas can in a forest fire. A tax cut of $X means nothing, except to accounting types who think that you can calculate the complex effects of a cut in rates by doing simple math. Grumble.

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  5. Thanks for making a difficult (for me) subject relatively plain and simple. I agree and think that it’s just common sense that you can’t keep spending more and more. You have to “tighten the belt.” I would go for a flat tax rate, it’s similar to tithing if you think about it and as the great Ray Stevens sang a few years ago, “I believe if ten percent is good enough for Jesus, Well it oughta be enough for Uncle Sam…”

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  6. I’ve been hearing about how the National Debt is going to ruin us all since about 1982 when I was in high school. At that time, the debt was $1 trillion, which seemed astronomical. (What is it now?) And yet, here we are, four decades later, and the system hasn’t collapsed.

    Every year, on the back of the IRS Form 1040 Instructions, there is a pair of pie charts showing where the Federal Government gets its revenues from and what it spends them on. Year after year, the charts remain fairly consistent.

    In reality, “money” doesn’t really exist since dollars are no longer backed by precious metals. The government (i.e. the Federal Reserve) literally creates money out of nothing. The government is capable of creating as much money as it wants, and does so more than you think. There are off-budget items, secret “black box” projects–all kinds of things going on that nobody knows about.

    Another thing: Those earning more than $190,000/year pay more than 60 percent of all federal taxes and 72 percent of income taxes. Those earning less than $70,000/year contribute a very small percentage to overall revenues. So I think those people should be exempt from paying income taxes at all. But that would mean that such people couldn’t take advantage of “Obamacare” which is a tax credit on Federal Income Tax, often resulting in a large tax refund. So “The System” uses taxes and the tax code to do certain things that have nothing to do with generating income for the government.

    Somehow, “the system works”–things get done, needs are provided for, and everything’s fine. Logic says the system should have collapsed years ago, but somehow that doesn’t happen.

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    • Using the tax code as a system for raising revenue vs. using it as a means of promoting or dissuading certain activities is a whole different question.

      On your first point, borrowing is a way of increasing the supply of dollars, and as long as people all around the world consider the U.S. Government to be a safe investment (as has been the case for most of our history) it all works. But if we can’t sell bonds because nobody will buy them or if we have trouble covering interest costs, the only choices will be default or massive inflation. Both will be ugly. That we have managed so far is like jumping from a plane with no parachute – it works just fine until things suddenly go bad at the end.

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  7. The actuals side-by-side with the tax cuts is the proof in the pudding, but I never would’ve guessed it without your deep-dive explanation. Defies logic until you really understand the consequential behaviors. I remember taking a single economics course in college and really struggling with the concepts. It was a good exercise in determining where my intellectual strengths most definitely didn’t lie.

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    • I watched lots of people struggle with the concepts in the many econ classes I took. For whatever reason, I took to them like a duck to water. I had 2 professors who thought I was making a mistake by choosing law school over grad school in economics. I have often wondered what my life would have looked like if I had followed their advice.

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  8. Thank you for this informative post JP. I have never had any classes in economics and sometimes wonder who decided on the classes which would make for a liberal arts degree, both in the community college I attended, then the two years at university resulting in my B.A. Between never reading the classics and never including “Econ” as a subject, I do wonder. It is a difficult concept to grasp, so thank you for enlightening us.

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