Wednesday, November 9, 2011

Why the CBO Won't Use GOP Growth Estimates, Red State Socialism

Do Lower Taxes Mean Higher Tax Revenues?
The idea that you can cut tax rates and gain higher revenue by increasing economic growth is not a new idea.  President John F. Kennedy argued for the reduction of top marginal rates in order to spur economic growth (albeit when top marginal rates were over 90%.)  Ronald Reagan famously fought for lower rates, to the consternation of his eventual Vice President and Successor to the Presidency, George Herbert Walker Bush, who, in perhaps the most famous political quotation of the past 30 years, called Reagan's plan "Voodoo Economics".  Economist Arthur Laffer sketched a curve on a napkin for Reagan once that showed tax revenues declining after a point when you increase rates.

I've written extensively before on this topic.  But it is becoming a burning issue today.  Congressional Republicans are attempting a very nuanced method of proposing a path to financial sustainability.  We all know that they have been in favor of significant spending cuts (other than defense spending.)  They have also opposed any tax increases.  Their latest line of argument is that they are supported increased revenue by supporting decreased taxes.  They have been bemoaning the fact that the non-partisan Congressional Budget Office (CBO) refuses to consider increased revenues as a result of increased economic growth from tax cuts.

At the extremes, the GOP hypothesis is easy to understand.  The so called Laffer curve, which shows tax revenues going up quickly when the first few taxes are instituted, then flattening out and eventually declining makes sense in that we would all agree that a 1% tax will generate more revenue than a 0% tax, since 0% will always yield no money and 1% will always yield at least some money.  Similarly, a 100% tax, I think we would all agree would crush an economy.  So the question isn't if the Laffer curve theoretically works, it is if it is meaningful in the range of taxes that we are talking about in this country.

From 1934 through today federal taxes have ranged between 4.8% of GDP (in 1934) and 20.9% of GDP (in 1944).  For most of post-World War 2, they have stayed in a relatively narrow range between 14.4% (in 1950) and 20.6% (in 2000).   Taxes right now are right at the lowest level they have been since World War 2, at 14.9% of GDP in both 2009 and 2010.

Utilizing the tax data (from the CBO) and GDP growth data (from the BEA) I went searching for a correlation.  The scatter plot of the two data series is below:

It is very hard for me to see any sort of correlation in these data, but there is a mild one.  A simple regression line shows that higher taxes do, in general lead to economic growth.  For every 1% increase in taxes as a percentage of GDP (approximately a 7% tax increase at today's rates), there is a reduction in GDP growth by about 0.6%.  This relationship explains only about 12% of the total difference between GDP growth in the years shown.

The Pre-World War 2 and World War 2 data may distort the information for a couple of reasons.  Prior to World War 2, government spending was at such a low level (keep in mind, there was no Medicare or Medicaid) and economic growth was so distorted from the great depression that the data may not be meaningful.  Similarly, World War 2 itself was a period of unprecedented and unequaled government spending which would likely distort the statistics.

If I limit the data to 1945 and beyond, the scatter plot looks as follows:
As you can see from this chart, there is no correlation in the Post-World War 2 data.  A regression line explains exactly 0% of the variation.  In other words, there is no meaningful evidence in the range that we are currently operating in that level of taxes within that range (from 14% to 21% of GDP) has any impact on economic growth whatsoever.

I'm fully prepared for a deluge of comments from the right on this chart.  I'd ask this - send me numbers not arguments.  If I'm not looking at the data correctly, I'd love to discuss it.  What I'm not interested in is partisan talking points.  The evidence, of yet, doesn't bear them out.

No wonder the CBO won't score the GOP's budget proposals with big extra growth assumptions backed in: there is no evidence it will happen.

Why the Republican States Are Socialist Republics
Okay, I'll admit it, the headline is deliberately extreme to grab your attention.  Plus, I thought conservatives would already be seeing red (no pun intended) after reading my above post on taxation that I'd just go ahead and get all the anger out of the way at once.  The issue I'm bringing to light is about how federal money gets collected and how it gets spent.

You see, the dirty little secret is that most conservative states are heavily subsidized by the federal government at the expense of most liberal states.  It isn't a deliberate conspiracy and there are many reasons.  Firstly, conservative states tend to, in general, be a lot poorer than liberal states.  Mississippi, Alabama, Arkansas, Louisiana, etc. all have very high rates of poverty and low incomes while states like California, Connecticut, New York and New Jersey tend to sport lots of high income individuals and while all have pockets of heavy poverty, it is nothing like the level seen in the deep south.  Secondly, conservative states tend to be smaller (think of all the red flyover states) and due to the structure of the Senate (two senators per state) therefore get a disproportionate share of the federal dole.  Finally, our system of agriculture subsidies tends to favor red states, since big ag tends to live in red states and receives big dollars from the government for growing crops (or not growing crops.)

For purposes of this exercise, I'm going to categorize states as "red", "blue" or "purple".  A "red" state will be a state that voted for the Republican Presidential candidate in the last 3, a "blue" state one that has voted for the Democrat in the past 3 cycles and a "purple" state one that has split its Presidential vote.

By that measure, the following 18 states are categorized as blue:
Washington, Oregon, California, Hawaii, Minnesota, Wisconsin, Michigan, Illinois, Pennsylvania, Maryland, Delaware, New Jersey, New York, Connecticut, Rhode Island, Massachusetts, Vermont and Maine

The following 22 states are categorized as red:
Alaska, Arizona, Utah, Idaho, Montana, Wyoming, North Dakota, South Dakota, Nebraska, Kansas, Oklahoma, Texas, Missouri, Arkansas, Louisiana, Mississippi, Tennessee, Alabama, Kentucky, Georgia, West Virginia and South Carolina.

The following 10 states are categorized as purple:
Nevada, Colorado, New Mexico, Iowa, Indiana, Ohio, Virginia, North Carolina, Florida, New Hampshire

There are probably some quibbles you could make with this list.  It seems weird to not have Pennsylvania on the list of purple states.  It's also odd that Indiana qualifies but Missouri (a traditional swing state does not.)  But minor questions aside, I think most would agree that in general this methodology generates a good breakdown of the country. 

The figures below use research from The Tax Foundation, which is publicly available here.

On average, for every $1 in federal taxes paid, the states receive the following benefits by category:
Red States: $1.40
Purple States: $1.10
Blue States: $0.94

The figures don't appear to average to $1 since the blue states that pay heavy taxes relative to their benefits are much larger than the small states that receive a disproportionate share of the benefits.

The most subsidized states?
New Mexico (a purple state) because of the cost of Indian reservations and systemic poverty in rural areas plus a large number of military bases and Mississippi (a red state) because of extreme poverty - they receive $2.03 and $2.02 respectively for each dollar in taxes paid.

The most subsidizing states?
New Jersey (a blue state) due to high levels of wealth and relatively few urban areas and Nevada (a purple state) due to heavy taxation on gaming revenues - they receive $0.61 and $0.65 respectively.

So if we are going to have a conversation about smaller government, let's start with a discussion about state equality.  If every state only received the level of government benefits that New Jersey and Nevada do, we could balance the budget today.

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