Unexpectedly Intriguing!
April 10, 2008

What will be the effect of a tax hike? What will be the effect of a tax cut? Regardless of which way the Congress might go, how much can the government expect to rake into its coffers through personal income taxes?

We can now answer these questions!

When we last took up the topic of taxes, we wondered if U.S. President John F. Kennedy's claim that lower tax rates would lead to higher federal tax revenues was true. In our back of the envelope analysis, we compared the tax revenue generating performance of the steeply progressive tax rates of 1954 (with top rates and income brackets similar to those during President Kennedy's tenure) to the much flatter progressive tax rates of 2006, and found evidence that yes, lower tax rates have led to higher collections from personal income taxes over time.

But these are snapshots in time that suggest that lower tax rates lead to higher personal income tax collections. We wondered what we would find if we connected the dots for the entire post-World War 2 era.

So that's what we did. The chart below shows the percentage share of U.S. GDP represented by personal income taxes collected by the U.S. government from 1946 through 2006:

Personal Income Tax Percentage of GDP, 1946-2006

Analyzing the data presented on this chart, we make the following observations:

  1. The average percentage of GDP represented by U.S. federal personal income tax revenues from 1946 through 2006 is 8.0%. The percentage share of personal income tax revenues with respect to GDP is normally distributed, with a standard deviation of 0.8%. This defines the typical range for the personal income tax share of GDP of 7.2% to 8.8%.

  2. Recessions (shown by the vertical red bands) often coincide with decreased revenue for the federal government from personal income taxes. This is exactly what we should expect to see, as the total level of income earned falls with employment levels during recessions.

  3. There are unique circumstances that coincide with percentage shares greater than 8.8%:

    • In 1968, the Democratic U.S. Congress and President Lyndon Johnson passed a 10% income surtax that took effect in mid-year. Coupled with a spike in inflation, for which personal income taxes were not adjusted to compensate, this tax hike led to outsize income tax collections in that year.

    • The sustained high inflation of 1978 (7.62%), 1979 (11.22%), 1980 (13.58%) and 1981 (10.35%) led to higher tax collections through bracket creep, as income tax brackets in the U.S. were not adjusted for inflation until 1985 as part of President Ronald Reagan's first term Economic Recovery Tax Act.

    • Beginning in April 1997, the Dot Com Stock Market Bubble created an excessive number of new millionaires as investors swarmed to participate in Internet and "tech" company initial public offerings or private capital ventures, which in turn, inflated personal income tax collections. Unfortunately, like the vaporware produced by many of the companies that sprang up to exploit the investor buying frenzy, the illusion of prosperity could not be sustained and tax collections crashed with the incomes of the Internet titans in the bursting of the bubble, leading to the recession that followed.

  4. Unique circumstances also apply to the one period in which the percentage share of personal income taxes dipped below the lower level of 7.2%.

    • The recession of 1948 is generally considered to be an "inventory recession." Here, inventories soared as consumers had initially satisfied their pent-up demand for consumer products following the end of World War 2, as companies of the era lacked sufficient feedback to be able to better meter their production levels. The rate of unemployment doubled from 1948's level to 7.9% in October 1949, which in turn, sharply decreased personal income tax collections.

    • This surplus of inventory came at a time when many large companies completed their full transition from wartime employment levels to "peacetime" levels, which aggravated the employment situation.

  5. Years in which tax rate cuts took effect (1964, 1970, 1971, 1982, 1987, 1988, 1991 and 2003) all saw government collections of personal income taxes dip initially, then begin to rise afterward, with the total of personal income tax collections always falling in the range between 7.2% and 8.8% of GDP.

This last phenomenon suggests that the distribution of taxable income shifts in accordance with changes in the tax rate structure of the income tax code to maintain a stable equilibrium with respect to overall GDP, albeit with a small lagging effect. This level of equilibrium is given by a level of personal income tax collections representing 8.0% of GDP, plus or minus 0.8%, which holds in the absence of unique economic and fiscal policy factors.

Basically, this means that as tax rates change, people shift their level of economic production to account for the change in the tax rate structure, and do so in a way that maintains this overall level of equilibrium.

In the case of a steeply progressive tax rate structure, people act to reduce their economic output (and income) or channel it in ways so as to avoid the increased level of taxation through personal income taxes. In the case of a flatter tax rate structure, people act to increase their economic output and income, dispense with tax avoidance strategies, and personal income tax collections rise in the years following when the tax rate reduction is first implemented to levels consistent with the natural level of equilibrium.

Where the economy is concerned, higher, more progressive tax rates would result in both lower levels of GDP and personal income tax collections, while lower, flatter tax rates would result in higher levels of GDP and personal income tax collections.

This latter point is driven home by our next chart, in which we've calculated the inflation-adjusted level of personal tax collections from 1946 through 2006:

Federal Personal Income Tax Revenues, 1946 to 2006, Constant 2006 US Dollars

We confirm that beginning in 1964, with the first of a series of income tax rate reductions, personal income tax collections have risen at a much faster pace than they did under the highly progressive income tax rate structure that existed from 1946 through 1963, even after adjusting for inflation.

We'll revisit this latter chart in the future, but for now, we'll observe that regardless of what it might hope to achieve from changing the schedule of tax rates, the government isn't going to get much more than 8.0% +/- 0.8% of the pie called GDP for the effort. The real question is whether it will be 7.2%-8.8% of a growing pie that incents people to be more productive or 7.2%-8.8% of a stagnant or shrinking pie that incents people to become really good at dodging personal income taxes, or just taking it easier.

Where and How We Got the Numbers

The data from 1946 through 2003 was taken from this report produced by the left-leaning Center on Budget and Policy Priorities.

Meanwhile, the we found the percentages for 2004 and 2005 using spreadsheets containing the IRS' statistics of income data for those years. We obtained the figure for 2006 tax revenue collected through personal income taxes from this Congressional Budget Office report. We divided each of these personal income tax revenue figures by the nominal (non-inflation-adjusted) GDP we obtained from the Measuring Worth economic history resource and then converted to the percentage shown in the charts and used in our later calculations.

We found by repeating this exercise for the known percentage shares of 7.4% for 2003 given by the CBPP report and the percentage share of 8.0% for 2006 given in the CBO report that our figures for 2004 through 2006 may understate the actual percentages of personal income tax revenue by 0.1% to 0.3%. We believe these small discrepancies may be fully accounted for by the differences in the source GDP data used to calculate the percentages.

To find the inflation-adjusted personal income tax figures, we first converted the non-inflation adjusted nominal GDP for each year to constant 2006 U.S. dollars, then multiplied those figures by the percentage of GDP, again for each year.

What can we say? It's not rocket science!

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