By DAVID RANSON
Apr. 30, 2009

The congressional “rescue package” includes many provisions that are advertised as tax cuts. But that’s Washington-speak.

They are that only from the federal government’s egocentric point of view, any foregone tax revenue being a cut in its income stream. None of them are tax cuts in the original and common meaning of the term: an alleviation of the tax burden on future economic activity.

Indeed, Mr. Obama has said he will repeal or sunset many of the Bush tax-rate cuts for upper-income families and small businesses.

In the end, the new administration is looking forward to higher, not lower, marginal tax rates. It is blindly oriented away from rescuing the economy, because it acts as if the driving force behind prosperity and growth were merely cash, rather than effort, enterprise and ingenuity. But no plan can stimulate the economy unless it increases the incentive to put those human qualities to work.

The tax provisions of the new law may relieve some economic suffering. But pain relief is not how doctors cure their patients’ ailments. Economic pain relief is no prescription for facilitating production and growth in the future. And without that there is no stimulus and no net creation of private-sector jobs. The new tax law is just another form of deficit spending in disguise.

This does not mean that tax policy is wholly unable to stimulate the economy. Mr. Obama would simply have to adopt a very different approach that is tragically unpalatable to most politicians: He would have to reduce tax rates and simplify the tax system. He would have to redeem the chief promise that won him the election: to make Washington do things differently.

Budget deficits resulting from handouts are an economic painkiller, but without real stimulus they can never pay for themselves. In contrast, under clearly defined conditions, reductions in tax rates can.

The basis for this is not merely supply-side ideology. It resides in a simple empirical relationship called Hauser’s Law, after its discoverer Kurt Hauser, cofounder of a San Francisco investment firm. In 1993, Hauser pointed out that “no matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5% of GDP.”

This checks out. Despite huge changes in marginal rates, the federal tax “yield” (revenues divided by GDP) has varied little, usually within the range of 17.5% to 20%. From 1952 to the present the top individual income-tax bracket has been brought down from 92% to the present 35%, and the bottom bracket from 22% to 10%. Over the same period there has been a steady increase in the standard rate of payroll tax, from 3% to 15.3%, if you combine the employer’s and the employee’s contributions.

Hauser explained in his original article why the tax yield is so nearly invariant to tax rates: “Raising taxes encourages taxpayers to shift, hide and underreport income . . . Higher taxes reduce the incentives to work, produce, invest and save, thereby dampening overall economic activity and job creation.” His empirical “law” is startling vindication of what supply-side economists have argued since classical times.

The accompanying graph underscores the close proportionality between federal receipts and GDP, using ratio scales to depict the 40-fold increase that has occurred since 1950 in both. Changes in tax rates have scarcely dented this 45-degree straight line.

To anything so politically inconvenient as Hauser’s Law, there will always be ideological hostility. Objections have centered on looking at federal revenue from individual, corporate and payroll taxes separately. Since the ratio of corporate taxes to GDP has declined to roughly the same extent as payroll taxes increased, it has been suggested that the invariance of the overall tax yield is a mere coincidence.

But to analyze these revenue components separately neglects the fact that all of them depend closely on GDP. If you change any particular tax rate, you will change not only revenues from that tax source but also economic activity itself – and through that, the revenues from the other tax sources. Total revenue is the only legitimate test of the incentive effects of taxation.

The power of the federal government to tax is so little questioned that even conservatives regularly assume that higher tax rates will automatically generate higher revenue. The actual history of tax rates and federal revenues suggests the opposite. Marginal tax rates higher than 20% or so deplete federal receipts because they change the behavior of taxpayers in a way that reduces GDP.

The only obstacle to getting the economic prescription right is ignorance itself. Although he remains unaware of it, Mr. Obama had at his disposal a simple economic rescue plan that would achieve several objectives at a stroke.

Reducing all higher marginal tax rates to a flat rate of 20% would boost the economy enough to increase federal revenue on a sustained basis. And it would minimize the wasteful activities of tax administration and reduce the economic waste from tax avoidance.

Most important, it would more than pay for itself. It would help Washington dig itself out of the bottomless fiscal hole into which deficit spending has been pushing it for many years.

Ranson is president and director of research at H.C. Wainwright & Co.

Source: Investor’s Busines Daily