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December 30, 2011

Do the Math

President Obama has exhorted his Republican critics to “Do the Math” on more than one occasion. His point is that the Republican critics should see the need for increased tax rates in order to balance the budget. The purpose of this post is to do the math.

Over the past 60 years there have been a goodly number of tax policy regimes. However, over this entire period, total tax revenue has been between 15% and 20% of Gross Domestic Product . . . with only very brief exceptions. That is, the Laffer curve might be thought of as more of a plateau than a hill. There is no math that would suggest that by fiddling with the tax code we can reasonably expect revenues to rise in any sustainable fashion.

Thus, if you want to balance the budget you must get expenditures in this same range. Increasing tax rates simply will not do what the President wants to do.

Right now, expenditures are running at about 25% of GDP. We need cut expenditures down by about 28% if we want a balanced budget to be sustainable with expenditures at 18% of GDP. Static analysis from the Congressional Budget Office (CBO) is fantasy, not math; such analysis does not take the reactions of the economy into account. If you tax work at higher rates, you will get less work. If you tax investments at higher rates, you will get the nature of investments to change . . . investors will find instruments that are taxed at lower rates.

So what should guide the redesign of the tax code? We should focus on a tax code that does not favor certain lawful activities over others. Most importantly, we should focus on those features that provide incentives for hard work and creative energies.

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