Taxes Don’t Always Drive the Economy–Sometimes the Economy Drives Taxes

Don’t tell my Tax Policy Center colleagues I said this, but it isn’t always about taxes.

If you listened to the presidential campaign this week, you’d think the very fate of the nation rests on what happens to the 2001/2003 tax cuts. It would be hard to believe otherwise as Mitt Romney’s warns us daily about President Obama’s job-killing tax hikes while the president calls for the rich to pay their fair share.

But the Congressional Budget Office told a very different story the other day:  There is a lot more going on in the economy besides taxes. Sometimes, tax changes are the result of that broader economic activity, not the cause of it.

Heresy, I know.

CBO looked at what happened to taxes and incomes in 2008 and 2009 and found the average effective tax rate fell from 19.9 percent in 2007 to 17.4 percent in 2009. The Obama people, of course, immediately announced this was evidence that the president was a tax-cutter, not a tax-raiser.

Republican pols, for whom taxes reside in the center of the universe, were remarkably silent.

But for the most part, this drop in average tax rates was not about policy changes at all. The explanation was much simpler: People made less money in the Great Recession so they paid lower taxes.

It is true that Obama cut taxes in 2009, winning congressional approval of his Making Work Pay credit and other more modest tax cuts aimed mostly at low-income working households. And those tax cuts played an important role in softening the blow of the crumbling economy, especially for low- and middle-income households.

But the bigger story was that many people’s taxes fell because they lost their jobs or worked for lower wages. For those at the top, the collapsing stock market wiped out trillions of dollars in capital gains.

The CBO tells the story in dramatic terms. In 2007, an average household  made $67,600 (in 2009 dollars). But by 2009, its average income fell to just $64,300—a 5 percent decline. The sharpest plunge came for those in the top 1 percent whose average pre-tax income fell by 36 percent and whose after-tax income plunged by 37 percent.

Households in the middle of the income distribution saw their pre-tax income fall by about 5 percent and after-tax income fall by about 2 percent. Among the lowest earning 20 percent, average pre-tax income fell by about 2 percent, while their after-tax income actually increased by 3 percent. Both groups were aided by Making Work Pay and other tax cuts targeted to those with low-incomes.

So Obama’s tax cuts did ease the burden a bit for working-class families. But the crucial message is not that lower taxes drove the economy. It is that the economy drove lower taxes.

Despite what you hear, it sometimes works that way.