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The Private-Sector Cost of $1 in Government
Tax Revenue
Tax Notes
July 26, 2006
By Ernest S. Christian and Gary A. Robbins
Have you ever wondered how much it costs the
private-sector economy to provide the government with an additional
$1 in tax revenue? The rather shocking answer can readily
be derived by the type of work now starting to be done by
Treasury's fledgling Dynamic Analysis Division.
The cost to the private sector of providing the government
an additional $1 in tax revenue is about $2.50 and in some
circumstances much more. Even academics on the left now acknowledge
that taxes adversely affect economic performance and, therefore,
when taxes go up, it is not just the private sector's after-tax
income that goes down; its pretax income suffers as well.
Thus, when the question is how much does it cost the private
sector to provide the government with another $1 in tax revenue,
the answer is $1 plus the amount by which people's incomes
in the future are smaller than they otherwise would be, but
for the negative effects the tax increase has on economic
growth.
The amount of future pretax income that the private sector
loses when government raises taxes varies, depending partly
on whether the extra tax is on labor income or capital. Both
respond to tax changes, declining when taxes go up and rebounding
when taxes are reduced -- but capital is particularly sensitive
to taxes.
Table 1 is based on our model and illustrates a range of
results when the government attempts to raise an additional
$1.
The mainstream story is told by line (c) of Table 1, where
the government undertakes to raise $1 in additional tax revenue
by an across-the-board rate increase calculated on a static
basis to produce that result. It indeed does collect an additional
$1 -- in a mindless bookkeeping sense -- but the economy responds
negatively to higher taxes, and, as a result, pretax incomes
(and tax collections) are less than they otherwise would be
-- and the government ends up on net having collected only
$0.68, as shown in column (1). The government <147>lost<148>
$0.32 because taxpayers lost $1.07 of pretax income that otherwise
would have been produced and that would have been taxed at
an assumed average marginal rate of 30 percent ($1.07 x 0.30
= $0.32).
Up to this point in the story, the total cost to the private
sector is $1.75 ($0.68 + 1.07), but the government has on
net collected only $0.68 in tax. The government can continue
to raise tax rates and ultimately net an additional $0.32
as shown in column (5) -- but that will cost the private sector
another $0.50 in lost income, thereby bringing the total cost
up to $2.57 per $1 of tax revenue.
The story in line (c) of Table 1 about an across-the-board
tax increase on both labor and capital is consistent with
recent work by Martin Feldstein at Harvard as well as a recent
paper by Gregory Mankiw, also at Harvard. Mankiw has also
recently done groundbreaking analysis about the economic response
to a change in taxes solely on capital. His results are consistent
with the story illustrated in line (d), where the total cost
is $4.33 for $1 of additional tax revenue from capital. Mankiw
also estimated the economic response from a tax change solely
on labor income. Line (a) illustrates the result in the case
of a $1 tax increase. The total cost is $1.68.
Line (b) of Table 1 is consistent with the Congressional
Budget Office's estimate of the short-term economic response
to an across-the-board tax change, and line (c) is consistent
with the CBO's estimate of the long-term response.
By anybody's reasonable estimate, the bottom-line results
are clear. The cost of an additional $1 in taxes and spending
is much more than $1 -- most probably $2 to $3 -- and the
real burden of taxes on the American people (counting lost
income) is much greater than the government admits.
If taxes were both reduced and reformed (so that the drag
on economic performance per $1 of tax would be less), the
economy would be larger, government would be smaller, and
everyone would be better off.
Notes
1) Martin Feldstein, The Effect of Taxes on Efficiency
and Growth (Cambridge, Mass.: National Bureau of Economic
Reserch, 2006).
2) N. Gregory Mankiw and Matthew Weinzierl, Dynamic Scoring:
A Back-of-the-Envelope Guide (Cambridge, Mass.: NBER,
2006).
Ernest S. Christian and Gary A. Robbins are, respectively,
the executive director and chief economist of the Center for
Strategic Tax Reform, a Washington-based organization that
has for more than a decade been doing research on tax reform
options. Both now are also visiting fellows at the Heritage
Foundation in a project focused on the relationship between
tax reform, economic growth, and personal liberty.
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