Where Did All the Tax Revenue Go?

Don't read this post unless you like numbers.

In fiscal year 2000 the federal budget was actually in surplus. Revenues were higher than expenditures and the national debt was reduced a small amount. Economists hadn't predicted that strange occurrence; it was certainly a consequence of soaring tax revenues from profits on bubble IPOs and a robust economy. On the expenditure side, the trajectory of welfare payments had been reduced by reform supported by Bill Clinton and Republicans; and we weren't fighting any wars. By fy2001, revenues were declining and expenses were still climbing. Post 9/11 in fy2002, we were back to running an annual deficit and we haven't recovered yet – the fy2009 deficit was an astonishing $1.413 trillion dollars, 10% of our gross domestic product (GDP). My former colleague in state government Tom Pelham describes this well in a Vermont Tiger post.

What went wrong? On the expenditure side, the answer is simple: government spending went from $1.789 (18% of GDP) in 2000 to $2.983 trillion (21% of GDP) in fy2008 to $3.517 trillion (25% of GDP) in 2009. Spending ratcheted up during the Bush years; then soared with stimulus spending as well as increased demand for government services like unemployment insurance and welfare in the first full year of recession and the Obama presidency. Federal spending has not been this high as percentage of GDP since WWII. The closest was 23% of GDP in fy1982. We can't sustain this level of spending and still be the same kind of county we've been. Some people think we should be a different kind of country, more like the welfare states of Europe where the percentage of government expenditure is even higher; I'll leave that argument for another day.

But what happened to revenue? Did the Bush tax cuts do us in? Have the rich somehow managed to escape their fair share? In fy2000 the feds took in $2.025 trillion (20% of GDP); in fy2008, after the tax cuts, revenue was UP to $2.524 trillion (but only 18% of GDP); in 2009 revenue was DOWN to $2.105 trillion (15% of GDP). The last time federal revenue was this low as a percentage of GDP was in 1943! It would NOT change the nature of the country to have federal revenues work their way back up to the 17% or 18% of GDP which they have historically been in modern times. Put another way, we WILL be changing the nature of the country – perhaps for the better, perhaps not – if we keep federal revenues at such a low percentage of the GDP. We will certainly roll back the role of government to what it was before WWII in peacetime with no standing army and much smaller social commitments. I'll leave that argument for another day, as well.

Assuming we want to get government revenues backup to their modern norm, how do we do that? First we have to understand why revenue declined.

After the Bush tax cuts, federal revenues did decline for a couple of years; partly because of the tax cuts and partly because of the lingering effects of the dotcom crash and 9/11. By fy2005 federal revenues were back at record highs in nominal dollars and continued to climb strongly for a few more years. The revenue loss from fy2007 to fy2009 came from recession and wiped out all these gains and more. Because taxable income declined by almost a trillion dollars, personal income tax receipts declined from $1.163 trillion to $0.915 trillion while the corporate income tax was off an even greater percentage, shrinking from $0.370 trillion to $0.138 trillion. Together that's over $400 billion/year of lost revenue which had nothing to do with the Bush tax cuts; in fact, if tax rates had been higher, the declines in revenue would have been even greater. Almost all of the decline in personal tax revenue is from those with adjusted gross income above $200,000 both because they paid 52% of the income tax and had 40% of modified taxable income in 2007 and because their modified taxable income was down 34% over those two years.

So the well-to-do – who have more income to lose – lose a greater percentage of that income during a recession than everyone else. That's no consolation, of course, to someone who has lost his or her job and all of the income that went with it; but it does explain why an income tax system which gets the majority of its revenue from the wealthy has lots of downside during a recession. According to the IRS, in fy2008 the top 1% of taxpayers paid 23% of all income tax and the top 0.1% paid over 12%. When the big bucks don't roll in for the rich, they don't roll in for the federal government as a whole. It's not an exaggeration to say that our tax system was playing the stock market and the housing market. When those markets tanked, revenue went with them. That's easy to understand.

Harder to understand is why, even though GDP was higher in FY2009 than FY2007, both corporate and personal taxable income were still much lower in the latter year. Part of the answer, indubitably, is that people didn't have many assets to sell off at big gains as the country came slowly out of a recession. There were almost no IPOs with big payoffs nor as many lucrative buyouts – that 0.1% who pay 12% of our taxes aren't all the same people very year; they're just the ones that scored big. Corporate profits are up but the tax law permits tax loss carry forwards. So it takes a few good years in a row before corporate income taxes can recover to pre-recession levels.

Possible good news in all this is, if we don't dip back into recession, tax receipts should start a strong recovery on their own without any need to increase rates. The Congressional Budget Office estimates fy2012 GDP at just over $15 trillion. If federal revenues were to recover to the 18% of GDP that they were in fy2007 (still less than the 20% it was in 2000), we would take in $2.7 trillion – just about enough money to balance the budget if we could get spending in dollars down to where it was in fy2007 (not allowing for inflation).

This particular scenario is a pipedream; spending won't come down that fast; the recovery is slow. But the lesson is still correct. We can reverse our revenue shortfall if we can get our economy chugging again.

President Obama has proposed rolling back the Bush tax cuts for people earning more than $250,000 per year. However the Bush cuts lowered taxes for everyone who pays them – especially those in the lower brackets. Repealing the cuts just for these "millionaires" would raise something over $0.1 trillion/year even assuming they didn't just find new tax shelters and keep their income down; so all of our taxes have to go up if increased tax rates are the answer. In order to increase revenue from 14% to 20% of GDP just through increased taxes, we would have to raise taxes on the average by close to 50%. And we'd still have to bring government spending down a huge amount to live within these new revenues.

We need a booming economy! More government spending won't get us there and government has nothing left to spend anyway. So how do we get there?

1. Tap America's abundant energy resources now, especially abundant natural gas. The payoff will be a rebirth of manufacturing - and lots of middleclass jobs – based on low energy costs compared to our competitors.
2. Reform permitting drastically so that corporations like Google and Amazon can spend the huge amounts of earnings they have in their coffers to boost their worldwide presence from their American base and so that the 20 year backlog of public and private infrastructure projects awaiting approval and fighting off nuisance lawsuits can be done in the next five years.
3. Reform the tax code to eliminate loopholes and reduce the nominal rates dramatically. Actually this will increase the share of taxes paid by the rich (because they use loopholes more). It will also make America a competitive place to invest corporate cash (see #1 and #2 above).
4. Don't bail out anymore banks.
5. Reduce federal spending to less than 20% of GDP.
6. Through all of the above, increase the relative wealth of the middle class so that our government revenues are not so much at risk in years when top earners are not earning top dollar.

The sources for all these numbers are directly or indirectly the IRS, the Census Bureau, and the Congressional Budget Office. The Tax Foundation, usgovernmentspending.com, and usgovernmentrevenue.com do a particularly good job at aggregating.

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