by Steve Forbes
That cigarette smoking has declined is a consequence less of taxes on smoking than of greater public awareness of its health effects. New York State has the highest cigarette taxes in the nation. And New York City prohibits smoking in public places. But this has not stamped out smoking. What it has done is increase smoker determination to buy cigarettes from cheaper states and Indian reservations and on the black market, increasing opportunities for cigarette smugglers and criminals.
That’s why Father Robert Sirico, a Catholic priest and head of the Acton Institute, which studies moral and economic issues, is an outspoken critic of these levies:
One of the unintended consequences of sin taxes is the increased motivation for people to violate the law. Sin taxes exist as a halfway house to prohibition, and in the same way bootleggers used to smuggle liquor into the United States from Canada from 1919 to 1933, smokers will face greater temptation to engage in black market activities.25
He concludes, “The temptation to impose sin taxes is one that should be resisted for economic and moral reasons.”26 Indeed, some sin tax proposals are more than a little morally ambiguous—like when Texas governor Rick Perry advocated funding education by imposing taxes on exotic dancing. Not surprisingly, the plan, ridiculed in the media as “tassels for tots,” went nowhere.
Sin taxes often don’t work because states end up dependent on the very activities they’re supposed to be taxing out of existence. When the activities decline, so do tax revenues. In 2008 the city of Chicago enacted a levy on bottled water. Five months later, experts predicted that it would bring in less than half the revenue estimated in its first year.
The state of Maryland doubled the cigarette tax to two dollars a pack to pay for expanded healthcare coverage. But as the Wall Street Journal reported in 2008:
Eight months later, cigarette sales have plunged 25% and the state is in fiscal distress again. A few pols are pretending to be happy that 30 million fewer cigarette packs have been bought in the state so far this year. As House Majority Leader Kumar Barve put it, fewer people smoking is “a good thing.” Yes, except that Maryland may be losing retail sales more than smokers. Residents of Maryland’s Washington suburbs can shop in nearby Virginia, where the tax is only 30 cents a pack, and save at least $15 per carton. The Maryland pols are so afraid this is true that they’ve made it a crime for residents to carry two packs of cigarettes that weren’t purchased in the state. In other words, the state says it’s legal to smoke, so long as you use cigarettes that the government can tax and thus become a financial partner in your bad habit. But if you dare to buy smokes across state lines, you can be fined.27
There’s also the issue of “fairness.” Like other excise taxes, sin taxes are regressive, which means they take a greater percentage of the income of low earners. A National Center for Policy Analysis Report, “Taxing the Poor,” explains why:
Consider two families, one earning $10,000 a year and the other earning $100,000. If both spend $100 a year on cigarette taxes, the amount constitutes 1 percent of the lower earner’s salary, but only 0.1 percent for the higher earner.28
Also, lower-income people often spend more on the activities commonly taxed. About one-third of lower-income adults smoke versus one-fifth of middle-and high-income earners, according to the Centers for Disease Control and Prevention. The NCPA points out, “The portion of income spent on alcoholic beverages by the lowest fifth of earners is double that of middle earners and more than three times that of the highest earners, on the average.”
Father Sirico asks whether we truly want a tax system that is financially dependent on people’s bad habits, while the addiction to wasteful government spending is totally ignored. He concludes,
We must ask ourselves whether we want to charge politicians and bureaucrats with sanctioning sins in areas that are morally ambiguous. Or should this task be left to community, family, church, and tradition—social institutions that are often more trustworthy in determining the limits of non-violent behavior?29
REAL WORLD LESSON
So-called sin taxes, like other sales taxes, penalize lower-income people. They rarely produce the revenue expected and undermine freedom and individual choice.
Q WHY SHOULD CAPITAL GAINS BE TAXED DIFFERENTLY FROM INCOME?
A CAPITAL GAINS ARE TAXED DIFFERENTLY FROM INCOME BECAUSE THEY COME FROM RISK TAKING AND INVESTMENT—ACTIVITIES THAT PRODUCE GROWTH AND BENEFIT SOCIETY.
In 2003, the Bush administration cut capital gains taxes from 20 percent to 15 percent. The cuts are supposed to expire in 2010. Tax hikers—who included Barack Obama when he ran for president—have proposed letting the cuts expire or even raising the tax as high as 28 percent. While a hike would score political points in some quarters, it would be disastrous for an economy struggling to emerge from the worst recession in nearly three decades.
Cutting taxes on capital gains is frequently derided as a giveaway to the rich. In fact it’s anything but. Millions of Americans depend on stock market gains for wealth-building savings and retirement. Thirty years ago, only about 13 percent of Americans owned stock. At least 50 percent of American households do today.
Capital gains taxes, of course, are not paid only on stock sales. They apply to income from the sale of other investments, such as a business or work of art. Some capital gains are exempt from the tax. For example, a couple doesn’t have to pay the tax on the first $500,000 of gains from the sale of their primary residence if they buy another home within two years.
The tax is paid on the “gain”—the difference between proceeds from the sale and the asset’s original price. One problem with the capital gains tax is that the “gain” is not necessarily real profit. The tax has what policy analyst Stephen Moore and others refer to as an “inflation penalty.” Moore explains, “The seller pays tax not only on the real gain in purchasing power” realized by an asset sale, “but also on [an] illusory gain attributable to inflation.”30
In the 1970s, the cruel reality was that people paid punitively high rates of almost 50 percent on inflated gains that were essentially illusory. In effect, the tax was confiscating principal, wealth that had already been taxed. No wonder the seventies were a decade of stagnation and paltry investment. 31
Capital gains have traditionally been taxed at lower rates than income. That’s partly because, unlike salaried income, the gains are achieved after an individual or corporation has placed capital at risk. Experts like Stephen Moore believe that the reward for risking capital isn’t big enough and that the capital gains tax in fact contains a “bias” against risk taking. Why? Because if your risk taking doesn’t work out, you get to deduct only part of a loss—up to three thousand dollars a year.
Experts agree that capital gains tax cuts produce an especially large bang for the buck. They’re a great way to boost the economy. That’s because high capital gains rates cause what is called a “locked-in” effect. Investors hold off on selling assets to avoid the tax. But if capital gains taxes are cut, those same people sell—and invest. “Locked-in” wealth is released. Growth soars, along with a surge in tax receipts.
The Bush administration’s 2003 capital gains tax cut was a key reason that the economy finally recovered from the 2000–2001 recession. Donald Luskin, chief investment officer of Trend Macrolytics, LLC, analyzed the Congressional Budget Office’s annual “Budget and Economic Outlook” report in 2006. He concluded that the cuts actually ended up generating more money for government, not less, as had been feared. “Instead of costing the government $27 billion in revenues, the tax cuts actually earned the government $26 billion extra.”32
Nor did the rich get a free ride from those cuts. According to Stephen Moore’s study for the National Center for Policy Analysis,
[T]he rich did not get a huge tax cut from the capital gains cut; in fact, the percentage of income taxes paid by the rich increased from 34 percent to 39 percent from 2002 to 2005 (the most recent year for which data are available). The capital gains tax cut did
not only benefit wealthy Americans; more than half of all tax filers with capital gains had incomes of less than $50,000 in 2005 and more than two-thirds had incomes of less than $100,000.33
Many have wondered why capital gains are taxed at all. Capital and income are two very different things. Income is the fruit that comes from ongoing enterprises. Capital fuels the enterprises and investments that drive growth and generate income for many. Reducing the amount of capital through taxation reduces this societal benefit. Freemarket skeptics fail to understand this Real World economic truth—the “gain” produced for government by taxing capital is far outweighed by the cost to the economy and to people.
REAL WORLD LESSON
Capital gains taxes penalize the critical risk taking essential to business investment and growth. Cutting or eliminating capital gains taxes would benefit not only the rich, but people of all incomes.
Q WHY NOT JUST GIVE MONEY DIRECTLY TO THE POOR INSTEAD OF GIVING TAX CUTS TO THE RICH?
A BECAUSE ACROSS-THE-BOARD CUTS HELP MORE PEOPLE AND ARE THE BEST REDUCERS OF POVERTY.
A question that has been raised by tax-cut opponents is “How are the poor going to be helped by tax cuts when many of them pay little or no taxes?” Barack Obama’s campaign tax proposal favoring tax credits to lower-income people—instead of an across-the-board cut in tax rates—was based on this thinking. People who already paid no taxes would receive their tax “credit” in the form of a check from the government.
Giving money to people sounds generous. For politicians it can get votes. But in the Real World it is at best a one-shot solution that doesn’t go very far. In fact, Real World experience shows that meaningful cuts in tax rates are the best way to generate more money for the poor.
We’ve explained in detail why this is so earlier in this chapter: cuts in tax rates boost the economy. Not only do such reductions let entrepreneurs and individuals keep more of what they earn, but even more important, lower tax rates increase incentives to take risks, to work more productively, to succeed. More people are hired. More wealth is produced. The result is a bigger, stronger tax base that produces more tax revenues that can be used to help those in need.
Analyst Brian Riedl of the Heritage Foundation points out that tax cuts between 1979 and 2003 resulted in not less but dramatically more government spending on the poor:
Antipoverty spending has leaped from 9.1 percent of all federal spending in 1990 to a record 16.3 percent in 2004. The data clearly show that…the people with the highest incomes are paying more of the tax burden while the poor are receiving more [government social] spending. Yet the misperception that the federal government is doing the opposite persists. 34
John Tamny of RealClearMarkets reminds us that expanding the tax base is the best way to increase funding for the poor because of a Real World principle few people know: no matter how much you raise taxes, they tend to remain at a fixed percentage of the tax base—around 18 percent of GDP.
That’s the lesson of the Laffer curve—raise taxes and all that happens is the tax base shrinks. You get 18 percent of a smaller base—in other words, lower collections.
Tamny writes, “What this means is that if we grow the overall economic pie, we expand the taxable base. Sure enough, the reductions in top marginal rates that began in 1981 helped U.S. GDP to grow sixfold over the last twenty-five years and as a result, federal revenues have hit record levels nearly every year since.”35
REAL WORLD LESSON
Tax cuts are the best antipoverty measure because they create the economic growth that lifts people out of poverty through employment while generating tax dollars for government.
Q BUT DON’T TAX CUTS DEPRIVE UNCLE SAM OF THE MONEY NEEDED TO RUN THE COUNTRY?
A TAX CUTS OR TAX INCREASES, THERE ARE NEVER ENOUGH REVENUES, BECAUSE GOVERNMENT JUST KEEPS GROWING.
We’ve all heard the “logic”: tax increases are the only way to “reduce the deficit” and balance the budget of a government strapped for funds and groaning under the weight of debt made worse by “tax cuts for the rich.”
House of Representatives Speaker Nancy Pelosi, just one of countless politicians and pundits who subscribe to this misconception, declared the Bush tax cuts to be “the biggest contributor to the budget deficit,” said to be $1.3 trillion for fiscal year 2009.36
The populist narrative advanced by Pelosi and others is that the “massive deficits” of the Reagan years and the second Bush administration were the result of tax cuts. Meanwhile, they hearken back nostalgically to the income-tax increases of Bill Clinton, which they insist produced “the Clinton surplus” and an era of prosperity.
The Real World truth is that deficits are not created by tax cuts. And they can’t be fixed by either tax cuts or tax increases—if the size of government keeps growing.
Federal, state, and local government spending grow year in and year out, no matter which party is in power. At the start of the twentieth century, total government spending on all levels was not even 7 percent of the nation’s economic output. By 2010 it is expected to exceed 41 percent.
Tax cuts may expand the size of the economy. But a larger economy will never generate sufficient revenues if the growth of our sprawling bureaucracy continues uncontrolled and unabated. The big villains, of course, are entitlements, especially Social Security, Medicare, and Medicaid. All three need systemic reforms or they will end up impoverishing everyone, because they will require horrific increases in taxes to meet their growing liabilities. There are positive, exciting ways to change these programs so that, amazingly, they can provide increased benefits without undermining our future. We discuss these in chapters 7 and 8.
Opposition politicians seek to score points by blaming tax cuts during the Reagan and Bush presidencies for increasing federal budget deficits. But tax cuts—as we have shown above—increased the size of the economy and federal tax revenues. The problem was that Washington spent the extra money and then much, much more.
Despite Ronald Reagan’s best intentions to limit the size of government, he was ultimately unable to rein in Congress on domestic spending. Reagan did sharply boost defense outlays—and that investment paid off. We won the Cold War. Reagan’s effort to maintain fiscal discipline was stellar when compared to that of his successors, especially George W. Bush, under whose administration domestic spending growth exceeded that of Democrat Bill Clinton.
According to the Heritage Foundation, “from 2001 through 2008, federal spending surged 60 percent—6.9 percent per year, on average.” In 2008 alone, it increased by some $249 billion or more than 9 percent.37
Heritage analyst Brian Riedl says Bush would have been able to balance the 2008 budget “had [total] spending increases been limited to 35 percent—4.4 percent annually.”38
And what about the legendary “Clinton surplus” and prosperity that Paul Krugman—not to mention former Clintonites such as Robert Rubin, Robert Reich, and Larry Summers—tout as being the result of Clinton-era tax increases? People forget that while he raised income taxes (which slowed economic growth for two years), Bill Clinton subsequently cut the capital gains tax from 28 percent to 20 percent. And as we’ve discussed, he ended up cutting other taxes as well, and kept the Internet a virtually taxfree zone.
If Bill Clinton had not cut capital gains taxes, his economic record would have been far different. In a report prepared for the Heritage Foundation, Dan Mitchell wrote that Clinton administration documents showed that
in early 1995, nearly 18 months after enactment of the 1993 tax increase, the Clinton Administration’s Office of Management and Budget projected budget deficits of more than $200 billion for the next 10 years. Clearly, events after that date—including the 1997 capital gains tax cut and a temporary reduction in the growth of federal spending—caused the economy to expand and the budget deficit to vanish.39
Mitchell concluded, “The Clinton tax increase delayed the economy’s resurgence and had nothing to do with the budget surplus.”
Tax hikers at this point invariably insist that the size of government is a given, that its services are needed, and that there’s nothing that can be cut. That’s simply not true. Because government lacks the discipline of having to compete in the marketplace, there is no incentive for cost-effective management, as there is in the private sector. Politicians simply keep tapping the public for money. Bureaucratic fiefdoms keep getting bigger. Costs keep going up.
Can the size of government be cut while still preserving essential services for people who need them? You bet they can. Writes Heritage’s Brian Riedl: “A real war on government waste could easily save over $100 billion annually without harming the legitimate operations and benefits of government programs.”
Riedl offers ten examples of egregious government spending that, if corrected, could slow today’s hemorrhage of red ink. We won’t list all of them here. But they include:
“Medicare Overspending.” As Riedl reminds us, “Medicare wastes more money than any other federal program, yet its strong public support leaves lawmakers hesitant to address program efficiencies, which cost taxpayers and Medicare recipients billions of dollars annually.” The program pays as much as eight times what other federal agencies pay for the same supplies. Payment errors, frequently the results of fraud as well as plain mistakes, cost more than $12 billion annually. “Putting it all together, Medicare reform could save taxpayers and program beneficiaries $20 billion to $30 billion annually without reducing benefits.”
“State Abuse of Medicaid Funding Formulas.” Says Riedl, “Significant waste, fraud, and abuse pervade Medicaid, which provides health services to 44 million low-income Americans. While states run their own Medicaid programs, the federal government reimburses an average of 57 percent of each state’s costs.” States overreport their Medicaid expenditures to receive larger reimbursements. Riedl says the problems have begun to be addressed, but more could be done that could produce billions in savings.