Exploring Tax Cut Myths


One of the more contentious- and misrepresented – issues in American politics is the role of taxation on the economy. As with most political issues today, empirical evidence has been tossed overboard in favor of tribal responses. We owe it to ourselves to look at the hard evidence.

Tax cutting as a political religion began in the 1980s under President Reagan, when the Economic Recovery Tax Act of 1981 (Kemp-Roth) was enacted. The chief feature of Kemp-Roth, and the one that most affects the average American taxpayer, was the drop in the top individual tax rate, phased in over three years, from 70% to 50%. In addition, there were modest exclusions for two-earner married couples, and a boost in the threshold for taxing interest income. But the marginal tax rates are the items that most people fixate on. Many people, in their minds, immediately calculate Kemp-Roth as a 20% reduction in personal taxes, which would be a noticeable difference. However, this part of the tax equation is not as big as it looks. Since most people in this bracket itemize, they are able to deduct mortgage interest, local property taxes and state and local income taxes. The reduction in the tax percentage has the effect of crimping the value of those deductions, so the “cut” is never quite what it seems. In effect, the deductions themselves have undergone a tax hike.

As with most religions, the true believers tend to overlook some of the inconvenient history. Kemp-Roth wound up being hastily modified by the Tax Reform Act of 1982, as it was quickly realized it was a bit overgenerous, and the deficit was getting unwieldy. However, instead of modifying tax brackets, it chose more obscure methods of revenue enhancements. This was clever marketing. Some critics, in retrospect, called TEFRA 1982 the biggest peacetime tax hike in U.S. history. Often left unnoticed is the "Deficit Reduction Act of 1984," (DEFRA!) which eliminated more of the perks of Kemp-Roth. But while all of this fiddling was going on, the strong medicine that Paul Volcker administered to get inflation under control was getting its dosage reduced: The Fed Funds Rate began it's decline. From a peak of 22.00% on January 1, 1981, the process of rate reduction began. So housing, auto sales, business lending activity, etc. began to recover as these rates declined, and the economy began its climb out of recession.

In perhaps the greatest conflation of causation and correlation in economic history, it now became an article of faith that tax cuts grow the economy, and because of that, they even pay for themselves.

Which would be wonderful if it were true. Especially when "cuts" aren't really "cuts," and they're quietly repealed as soon as they're enacted, leaving the myth intact. But the main focus was still sleight-of-hand: keep marginal rates low, which is an easy sell politically, and try to make it up in other areas that were less visible.

One way to "prove" the efficacy of tax cuts is to claim they pay for themselves. Example: Capital gains taxes were cut from 28% to 20% under Kemp-Roth. Revenues from capital gains taxes jumped 50% afterwards. Which is a convenient "proof" since the Dow Jones Industrial Average went from a low of 788 in August of 1982 (when the law took effect) to about 1200 by August of the following year. That's also about 50%, for anyone whose counting. Likewise, when it was hiked back up to 28% in 1987 after the deficit had been tripled, revenues from capital gains declined. Of course, there WAS that major crash in 1987 which might have affected that figure, and taxpayers are allowed to carry forward losses in subsequent tax years. So much for correlation.

Fast forward to the year 2001, where the economy hit a soft patch, thankfully nowhere near the brutality or length of the 1981-3 period. It was deemed time for a new round of tax cuts to "jump start the economy," but here, the lessons of 1981 were unlearned. While reductions in capital gains taxes and interest income were deemed something of an overreach in the 1980s, rates for income, both earned and unearned, were cut dramatically. This time, there would be no quick adjustments. Without the massive interest rate mountain Volcker was able to climb down from, the economy was still lackluster. In fact, wages stagnated, and millions of Americans turned to leverage to salve their sagging lifestyles. You know the outcome.

In any case, it should be apparent that tax cuts hadn't outlawed recessions, the business cycle, or the effects of exogenous shocks to the economy. Nor did it offset wage stagnation, or substitute for the ever tightening choke hold health insurance costs were placing on the American family.

We now turn to today, after the biggest “tax cut” in American history has been executed. Did you miss it? Because of the belief that every reduction in expense to a working American must surely represent an in-kind boost to the economy, the true believers of supply side theory have come to liken each one to a "tax cut.” Some of them purport to be economists, even if no one in the profession recognizes them as such. But to them, even a drop in price of a bushel of corn is hailed as an economic stimulus.

Since December of 2008, due to the fiscal crisis, the Federal Reserve undertook several steps to suppress interest rates, including lowering the Federal Funds rate to Zero, and in order to further suppress the long end of the rate curve, they proceeded to buy Treasury paper and Mortgage Backed Securities. At the time of the home buying and cash-out refinance frenzy of the 2006-2008 period, the 30 year mortgage rate stood at an average of around 6.25%. Those rates have since dropped by 300 basis points. In that time, over $6 trillion in mortgages have been refinanced by the American homeowner. People with jobs. People with equity. People with spending power.

Let us presume each borrower lopped off a mere 2.25% of interest on their 30 year fixed mortgage. It's hard to know an exact figure, since many refinanced into 15 year fixed mortgages, which would keep mortgage payments level while amortizing faster, some may have refinanced more than once, and the timing is different for all of this refinance activity taking place. Last month alone, for example, yet another $60 billion was refinanced as the 10 year Treasury dropped to near historic lows. So the savings might be more, or might be less, but by this back-of-the-envelope calculation, the American homeowner has been saving over $8 billion – every month. For years. And that number is growing.

Moreover, this is an instant savings that consumers can see and feel. Some people are (finally) getting wise to the fact that offering a “tax credit” that manifests itself every April 15th may not be much a behavioral game changer, and hence, will not materially affect consumption, a child's welfare, or help the economy. It's ephemeral. Lopping hundreds of dollars off your monthly debt service is, by comparison, instant gratification. A monthly annuity.

As with other tax “cuts,” the value of the interest deduction is lessened- there's less to pay, and so a smaller sum to report on Schedule A. But instead of the Treasury taking a net loss, this is all gravy for deficit reduction. To this, we can add yet another "tax cut:" Cheap and abundant energy. So what we've been told is the Great Panacea for all that ails us in economic performance hasn't put the economy on steroids. There is no piece of tax policy that could be executed that could possibly duplicate the savings boost to the American taxpayer than what we've just seen.

So, what's the takeaway here?

  • Fiddling with marginal tax brackets isn't all that critical for the economy, but it can certainly have seriously debilitating effects on Federal finances.

  • Dozens of other critical levers work their way on the economy and consumer decisions, that easily overshadow the effects of tax policy.

  • The psychology of tax cuts doesn't really work. People don't spend what they can't see, and their propensity to consume is unaffected.

  • Tax cuts never pay for themselves, and whatever boosts in revenue are seen, they are not a result of the cut itself, but due to other factors extant in the economy. At best, even if causation could be proven, based on the subsequent results to the Federal budget, the Treasury is paying $1.00 to boost revenue by 75 cents. So every time we try this, deficits and debt are sure to rise.

Here endeth the lesson.

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FloMartin Securities, Inc.

Donald R. Davret, Investment Advisor Representative

www.sec.gov

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