Why Should Taxes Be 18 Percent of GDP?

By :: April 27th, 2011

“The Path to Prosperity,” Congressman Paul Ryan’s (R-WI) solution to federal budget deficits, called for keeping “overall revenue as a share of the economy at historical averages between 18 and 19 percent.” The House budget resolution chose the higher value and set the revenue target at 19 percent of GDP through 2050.

What’s so special about those numbers? Nothing.

It is true, as Ryan’s plan noted, that that level of revenues matches the historical average for recent years. Over the past half century, the share of GDP claimed by federal taxes has ebbed and flowed, ranging from a high of 20.6 percent in 2000 to a low of 14.9 percent each of the last two years. The 50-year average was just a hair under 18 percent (see graph). But nothing says this should be the correct level of taxation going forward.

Four major factors drive the ups and downs of federal revenues:

  • The economy. Revenues, particularly from income taxes, climb in economic upswings and fall in recessions. The sharp revenue drops around 1970, in the early 1980s, and twice in the past decade all derived at least in part from economic downturns. Conversely, the economic boom in the latter half of the 1990s sent revenues soaring to the highest fraction of GDP ever. In addition, until Congress indexed much of the tax code for inflation starting in 1985, rising prices pushed taxpayers into higher tax brackets and caused revenues to climb.
  • Progressive tax rates and the income distribution. The federal individual income tax is progressive, levying higher tax rates on higher income brackets. When the income distribution changes, so do revenues. The increasingly unequal distribution of income in recent decades has caused a greater share of income to face the higher rates in the top tax bracket, boosting revenues as a share of GDP (and allowing across-the-board rate cuts without reducing the long-run average tax rate). A shift toward greater income equality would reverse that trend.
  • Economic growth. Economic growth also interacts with progressive tax rates to increase federal revenues. As the economy grows, real incomes rise, moving taxpayers into higher tax brackets with higher rates. That “real bracket creep” raises revenues faster than incomes grow.
  • Congressional action. When taxes grow significantly, Congress has acted to reduce them—as it did in both 1981 and 2001. Congress has also cut taxes to stimulate the economy in downturns, as it did in each of the last three years. And Congress has occasionally even raised taxes to cover its spending. The 1968 surtax contributed to paying for the Vietnam War, the 1982 tax act offset part of the even larger 1981 tax cut, and tax increases in 1990 and 1993 helped to turn budget deficits into surpluses by the end of that decade.

Those four factors, along with other smaller ones, have caused tax revenues to rise and fall over the past five decades, although never much above or below 18 percent. For some observers, that suggests that that level is a ceiling we shouldn’t breach, at least not for long and never intentionally.

Yet there’s nothing intrinsically right or wrong with any given level of taxation. As Americans get older, spending on Social Security and healthcare will necessarily rise. Doing what we do now will simply cost more. At the same time, the new technologies that will help doctors provide better care will boost costs still further. And, as we grow wealthier, we may choose to spend more for things we want—helping those in need, improving our roads and schools, or paying to build more and better infrastructure.

Or we may decide we don’t want to do those things. Or we may choose to do them but stop doing other things that we decide aren’t worth the cost—farm subsidies, excessive health spending, and some highly-publicized earmarks come to mind. Or that we’d be a lot more willing to pay for them through a reformed tax system that is simpler, fairer, and more efficient.

Those are political decisions that lawmakers make all the time. But there’s nothing magical about 18 or 19 percent.

12Comments

  1. Morning Must Reads: Moving | Swampland  ::  8:26 am on April 27th, 2011:

    […] Why should revenues be 18% of GDP? No particular reason. […]

  2. In The Know: April 27, 2011 | OK Policy Blog  ::  9:58 am on April 27th, 2011:

    […] and Sen. Tom Coburn over taxes and the deficit. In today’s Policy Note, the Tax Policy Center explains why there is no rationale for capping tax revenue at 18 percent of […]

  3. Secondary Sources: Bernanke, Unemployment, Tax Revenue – Real Time Economics – WSJ  ::  10:04 am on April 27th, 2011:

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  4. Sid F  ::  1:22 pm on April 27th, 2011:

    The level of taxes (and hence government spending if one supposes a balanced budget) is a political rather than an economic issue. Taxes as a percent of GDP is the answer to the question, “How much of national income should be devoted to the public (Federal) sector?” The economics of the argument are simply a means to support whatever one’s political position happens to be.

    The Grover Norquist faction of the Conservative group supports taxes and spending at about 14-15% of GDP, and returns Federal spending to it early historical role of Defense, Justice, Treasury and Foreign Affairs (thankfully even they are willing to give up the Post Office). This goal is met by the Ryan Plan in 2050, (in theory, but not of course in fact) since presumably meeting it sooner is not even politically feasible for Ryan.

    The U. S. is sharply divided on the role of the Federal government, and hence the strong disagreement on spending and taxes that we currently have. Until this disagreement is settled, the debate on taxes, tax structure and the level of taxes is largely useless because it does not address the underlying issue of just what do citizens want from the Federal government. Currently, we know that they want high spending and low taxes, which produces a deficit that cannot be sustained. One way or the other the issue will be resolved, and when it does, tax structure and tax policy can gain take center stage.

  5. AMTbuff  ::  2:41 pm on April 27th, 2011:

    Excellent comment, Sid. I would add that extremists on both sides do not trust the public to decide this crucial question. They want to maneuver the public into a corner from which the only escape is their preferred outcome.

    Not only will such tactics fail, but they are ensuring a sudden and massive collapse when China and other lenders revoke our credit card. The forced outcome will be sky-high tax rates and a loss of most government benefits for all but the poorest recipients. Plus a second Great Depression in which those who are not already unemployed go on strike to protest their greatly reduced disposable income. A trifecta of unintended consequences for the extremists.

  6. Sid F  ::  3:50 pm on April 27th, 2011:

    I am fearful that AMTbuff is correct in that the resolution of the issue of taxes and spending will only come with a major financial and economic crisis brought on by rising debt, a failure of the credit markets to absorb the amount of U. S. debt securities, inflation from the FRS monetizing of the debt and the collapse of social programs.

    Even low income individuals will not be exempt, see the NY Times story on the “privatizing” of Medicaid in Florida to for-profit organizations.

    http://www.nytimes.com/2011/04/28/health/policy/28medicaid.html?hp

    Extreme positions result in extreme outcomes.

  7. Michael Bindner  ::  4:39 pm on April 27th, 2011:

    The consensus on taxation must eventually approach the consensus on spending, which seems to include hefty defense spending and fully funding Medicare and Senior Medicaid at current levels of entitlement, including the Medicare Prescription Drug program.

    Once that is clear, income taxpayers have a choice – to keep putting off paying for it or allowing taxes to rise. To some extent, our temporarily advantageous trade balance allows massive deficit spending. Until the Chinese are unwilling to sell us stuff and OPEC is unwilling to sell us oil, they will keep buying our debt.

    This will work until their masses of workers and non-working poor begin demanding products and services at our level of comfort. At that point, the global south’s labor will be exploited. It will only be after there is no cheap labor left on the planet that the potential for automation will be explored.

    Not if, but when. Of course, if development were done the right way – through cooperative ownership structures rather than exploitive capitalist ones – automation and worldwide development could come more quickly.

    Either way, once their is no one left to exploit, the grand children of today’s wealthy will be presented with a bill for accumulated debt. The sooner this becomes clear, the sooner that taxes will be increased to pay it off – although by this point the polity may be enlarged to include the rich of other nations and their central banks, making payments lower and allowing more to be monetized.

    At some point, if cooperative employment and purchasing situations expand (and because they are less exploitive, in time they are sure to), a labor hour standard will be used for exchange among cooperatives and most cash wealth will be so much useless green paper – utterly useless for buying usable land or human capital.

  8. Michael Bindner  ::  4:45 pm on April 27th, 2011:

    In the end, cooperative arrangements will also absorb both health care funding and retirement funding, as well as social programs and the housing sector. There won’t be much in the way of government, but there won’t be much in the way of useful wealth either, at least where wealth means having the means to impose your will on others. At some point in the far, or maybe even the not so distant future, the wealthy will find that their wealth means nothing. They will be like the rich visitors to Utopia who wear gold and will be made fun of as “great babies” although it won’t be funny to them, since they will have to join cooperatives and work like everyone else (or not work, if everything is automated).

  9. Around The Dial – 4/28/11  ::  3:02 pm on April 28th, 2011:

    […] TaxVox looks at the logic (or lack thereof) of spending caps. […]

  10. HCG Diet  ::  1:44 am on May 2nd, 2011:

    We may choose to do them but stop doing other things that we decide aren’t worth the cost. Can someone tell more about GDP Tax?

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