Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

Per one’s request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don’t lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%. Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that the first question I wanted to answer was “how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?” After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980’s. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush) the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.


As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won’t like what this data shows, but again, numbers don’t lie.

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9 Thoughts on “Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

  1. Chad,
    Looking at the data is a good idea, but it’s quite possible that the particular data point you used isn’t the relevant one.

    The government could have extracted more money via taxes even if the very top marginal tax rate declined, if, for example, the tax rate in the next-highest bracket went up, or if the cutoffs between the brackets changed.

    You might be right, but you’d need to look at more data to prove it.

    One statistic to look at might be total income tax receipts as a % of GDP each year. If that figure also went down that it would be clear that we did not reduce the national debt by raising income taxes.

  2. er, “THEN it would be clear that we did not reduce the national debt by raising income taxes.”

  3. Agreed, Jim. The top tax bracket doesn’t tell the whole story total receipts does. If I work multiple jobs to pay off student loans It doesnt matter what my highest paying job is. All that matters is that they get paid off as fast as possible because of the hit you take from interest. I just dont think the best paying job to student loan ratio is useful. The only thing that counts is total income(the total tax recipts which is derived from the sum of the income generated by production in the country, the gdp) to the amound of debt, ie. the debt to GDP ratio.

  4. Couple of speeeeeeling errors in there…sry.

  5. The question “why the tax cap bracket” kept coming to my mind while reading too.

    It is interesting to know how much of the taxs revenues are generated by the highest bracket versus all others.

    It is logical to assume lawmakers will protect the few rich at the expense of the rest.

  6. Chad Brand on August 20, 2009 at 10:54 AM said:

    The top rate is most important because the wealthiest Americans represent the largest percentage of federal income taxes paid. The numbers are as follows: top 1% pay 40% of the total, top 5% pay 61% of the total, and top 10% pay 71% of the total.

  7. If anything it says to me that the top 10% could use a tax hike compared to historic levels. It looks as if at about 1986-87ish there is an inflection point. Assume that the the 10% pay 71% (i have no reason to doubt that) then clearly the top 10% haven’t been paying a steady lets call it tax bracket vs. debt-to-GDP ratio. I have no problem wiht the top tax bracket paying less assuming the debt-to-GDP ratio is proportionally down.

  8. ..similarity if the top 10% “tax bracket tax rate vs. debt-to-GDP ratio” is down then it should be increased correspondingly.

    Edit: In the above comment I would like to change “tax bracket vs. debt-to-GDP ratio” to what i use in this post, “tax bracket tax rate vs. debt-to-GDP ratio.”

  9. I think the top bracket is also relevant for the current circumstances because of Obama’s tendency to tax upper income before mid to lower income. If he does raise taxes on anyone, it would be the top bracket. He’s not going to raise across the board, especially not if he wants to get re-elected.

    Very interesting read Chad, thanks.

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