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.