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Why tax cuts work

Both President Kennedy (left) DemocrPresident Reagan Republican understood thyou generate more tax revenue when you cut taxes not raise them.

Both President Kennedy (left), a Democrat, and President Reagan, a Republican, understood that you generate more tax revenue when you cut taxes, not raise them.

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Updated: May 3, 2013 12:15PM

Economists, philosophers, and politicians have understood this simple bit of common sense throughout the ages -- and so should you. It's a practical lesson that defies political parties, demagoguery, and dictatorship. It is intuitive, understandable -- and provable. Yet it is forgotten in the heat of the moment, and must be relearned by every generation -- a very costly lesson: Raising tax rates above a certain level actually reduces tax revenues.

President John F. Kennedy said it clearly on Nov. 20, 1962:

''It is a paradoxical truth that tax rates are too high and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the rates now. . . . Cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.''

Under Kennedy, the top personal tax rate was cut from 91 percent to 70 percent. He didn't live to see the so-called "Kennedy boom" that followed. But in the four years following the Kennedy tax cuts, federal tax revenues grew at 8.6 percent, four times the rate of the four years preceding the tax cuts.

The idea of collecting more tax revenues from lower tax rates has its roots in antiquity. In the 14th century, the Muslim philosopher Ibn Khaldun wrote in The Muqaddimah:

"It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

And the great economist, John Maynard Keynes, wrote in 1972 about the British economy:

"Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget."

By the time the Laffer Curve was popularized by economist Arthur Laffer during the Reagan administration, the commonsense idea that the way to increase tax revenues is to cut tax rates had been demonstrated, but was still decried.

Then, the 1981 Reagan tax cuts (Kemp-Roth) cut marginal tax rates 25 percent across the board, over a three-year period. The top tax rate immediately dropped from 70 percent to 50 percent. Allowing for the delayed impact of the tax cuts, in the four years before 1983, federal tax revenues had fallen at an annual rate of 2.6 percent.

After the tax cuts were fully phased in, federal revenues grew at 2.7 percent per year. And tax revenues derived from the wealthy increased, despite the huge cut in the top tax rate.

History shows that tax cuts produce increased tax revenue and economic growth. History also shows that politicians from both parties produce spending -- and deficits.

The temptation of taxes

There's a double temptation to raising taxes, in spite of the lessons of history. The first is that simple belief -- though proven wrong by experience -- that raising tax rates will bring in more tax revenue. The second temptation is the belief that raising tax rates on the wealthy will bring more "equality" or "fairness" to the system.

Again, history shows that doesn't work in practice, though it might sound attractive in theory. People who are smart (or lucky) enough to earn more, tend to be smart enough (or get financial advice) that enables them to change their earning patterns, actually paying less in taxes.

The Beatles famously wrote about the "Taxman" -- who said "19 for you, and one for me" -- referring to the confiscatory top 95 percent tax rate in Britain at the time. And they left. In 1971 the Rolling Stones left England for France to escape high taxes. When Swedish taxes soared, tennis star Bjorn Borg and Ikea founder Ingvar Kamprad fled the country, taking their money with them.

Don't think that leaving will be an option in America. In the "Heroes Act" passed a year ago, Congress resolved that anyone voluntarily giving up his or her citizenship will be taxed on all of his assets as if he or she had sold them -- paying capital gains on assets that have increased in value, even though they have not been sold.

Americans want to make our system better, not leave it. Providing health care to all is truly a goal worthy of our society. But it can be paid for only through economic growth. Higher taxes have historically destroyed economic growth -- and tax revenues. That's the lesson of history. And that's The Savage Truth.

Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.

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