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Manhattan Paper: The Dynamics of Tax Cuts

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Manhattan Paper: The Dynamics of Tax Cuts

December 15, 1988
Urban PolicyTax & Budget

Twenty-five years ago, the top income tax rate in America was 91 percent. As recently as 1980 it was 70 percent. In 1986 it was 50 percent, in 1987 38.5 percent, and for 1988 it will be 33 percent. This dramatic reduction in marginal tax rates is a product of a new development in the economics of taxation, a development that has begun to affect the politics of taxation. It represents a new consensus among students of public finance that high rates are counterproductive, both in terms of revenue and of general economic vitality.

The 1980s will be remembered as the decade of great experimentation in personal taxes. Our experi-ence has provided answers to questions that perplexed economists in earlier years. And the policy implica¬tions are dramatic.

We now know that people respond to changes in tax rates. A notion that used to be considered revolutionary—the "Laffer Curve" idea that tax cuts can actually yield higher tax revenues—has come to be more widely accepted by professional economists. The recognition that very high tax rates equal poor fiscal policy is spreading throughout the world.

This "supply-side" idea is not original to Arthur Laffer, nor is it. even new. The classical economists knew that people respond to tax rates. In 1776, Adam

Smith pointed out in The Wealth of Nations that high tax rates (specifically, higher import duties) can actually produce less revenue than lower rates.

A look at the numbers

The decade began with the enactment of the Eco-nomic Recovery Tax Act of 1981 (ERTA). Rates were cut for all taxpayers. The deepest cut came for top-bracket taxpayers whose marginal tax rate was cut from 70 to 50 percent. These were generally people with adjusted gross incomes (AGI) in excess of $200,000. Critics denounced the top rate cut, and the contemporaneous cut in the capital gains rate, as a "windfall for the rich." Economic models employed by both the Congressional Budget Office and the Congressional Joint Committee on Taxation assumed that high-income taxpayers would not change their economic behavior in response to the lower rates, and thus predicted a substantial decline in Federal tax revenues from these high-income groups.

Supply-side advocates of the bill argued that lowering tax rates would cause taxpayers to report more income, thus offsetting the revenue effect of the rate reduction. In particular, they argued that the government would collect more revenue from high-income taxpayers through a reduction of the 70 percent rate.