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Let’s clear up a couple misconceptions on tax cuts

Updated: May 3, 2013 12:14PM

Originally published: April 15, 2004

It’s income tax day -- the day of reckoning. Fortunes are spent trying to understand the tax code and file documents that accurately reflect taxes owed while attempting to legally minimize the amount that must be paid.

In 2002, taxpayers spent an estimated 5.8 billion hours complying with the federal income tax code, according to the Tax Foundation. The total estimated cost of compliance was over $194 billion. That’s equivalent to a 20.4-cent surcharge for every $1 in taxes collected!

The agony of filing a tax return is a subject for psychiatrists and punsters, as well as politicians. Albert Einstein famously said: “The hardest thing in the world to understand is the income tax.” And he died in 1955, before it got really complicated.

But it’s not only the challenges of complying with the tax code that are misunderstood by so many. The real confusion arises over the impact of income taxes on generating tax revenues.

Challenging tax assumptions

At first glance, it seems logical to assume that if you raise tax rates, you’ll increase revenues. And that if you cut tax rates, revenues will fall. But history clearly shows those assumptions are faulty. And if you put politics aside to look at the numbers, you can see that tax cuts actually increased revenues throughout the 20th century.

John F. Kennedy proposed major tax cuts in 1963, and in February 1964, after his assassination, the top tax rate was cut to 70 percent from 91 percent. Tax revenues nearly doubled in the next four years. After Ronald Reagan cut taxes in the mid-1980s (and those tax cuts were phased in over a period of years), revenues grew to $1.2 trillion from $900 billion.

In fact, Kennedy recognized the phenomenon that the government can get more revenues by cutting taxes in this famous statement: “An economy hampered by restrictive tax rates will never produce enough revenues to balance our budget, just as it will never produce enough jobs or enough profits. ... In short, it is a paradoxical truth that tax rates are too high today, and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the tax rates now.”

If tax cuts have worked to increase revenues, why, then, has our country run such huge deficits? The answer lies on the spending side. There has never in the last 50 years been a year of lower federal tax revenues than the previous year. And there has never been a year of lower spending. The gap grows when spending outpaces revenues. That’s a fact understood by every family facing a budget.

Another misperception is that tax cuts benefit the rich. Since the “rich” pay more in taxes, they do receive more benefits from a tax cut. But that’s not to say the rich don’t pay their fair share -- and an even greater share when rates drop. After the Kennedy tax cuts, the proportion of taxes collected from those in the top brackets surged. The same results came from the Reagan tax cuts. In 1981, the top 10 percent of taxpayers paid 48 percent of the taxes collected. But after the Reagan tax cuts were fully phased in, the same top 10 percent of taxpayers paid a 57 percent share of taxes collected.

The reasons are logical. In the top brackets, people have a choice of working more or working less. If every extra dollar they earn is taxed at a high rate, they simply decide it’s not worth it to work the extra hours -- or make the extra investments to expand their businesses.

The United States is the best place on earth to live (pardon the chauvinism), so very few people leave to avoid taxes. But when rates get too high, people do resort to other measures, things like tax shelters and an underground cash economy, all of which distort the efficiency of our economic system. It’s far better to have a reasonable and lower tax rate, which history has shown will bring in greater tax revenues.

Spending restraint

Then all we need is some restraint on spending to balance our budget.

Today, on April 15, Income Tax Day, our tax code has become so complex that even the IRS can’t give consistent answers to tax questions. This year, Americans worked until April 11 -- Tax Freedom Day -- to pay all their federal, state and local taxes. There must be a better system.

The federal income tax was in its infancy when Will Rogers, who died in 1935, said: “The income tax has made more liars out of the American people than golf has!” Now, that’s a Savage Truth.

Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast. Distributed by Creators Syndicate.

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