Floor Statement of U.S. Senator Chuck Grassley

the Fiscal Cliff

Thursday, November 15, 2012

Mr. President,

In less than two months, American taxpayers are set to experience one of the largest tax increases in American history.  With the elections behind us, it is time for us to work together to reach an agreement that can pass both chambers of Congress and be signed by the President.

Reaching an agreement won't be easy, but it must be done to avoid going head first off the fiscal cliff.  By this time we are all aware of the Congressional Budget Office warning that failing to come together threatens to send us into another recession.

An agreement is certainly doable.  But, all we hear about is what revenues Republicans are willing to put on the table.  We need to hear what the President and my colleagues on the other side are prepared to tackle in regard to reforming entitlements that are the long-term drivers of our fiscal problems.

That being said, we will not be able to reach an agreement if the other side continues to insist on punishing entrepreneurs and small businesses in the name of raising taxes on the wealthy.  My colleagues on the other side of the aisle seem to believe that tax increases, particularly on high-income individuals, do not matter.  They argue that raising taxes on the so-called wealthy will return us to the economic growth experienced at the height of the 1990s.

This defies common sense.  If you ask a business owner if raising his taxes will hinder his ability to grow his business, he assuredly will tell you they will.  He understands that the more the government takes from him, the less he has to put back into his business.

This is in line with the general understanding around here that taxes can be used as both a carrot and a stick to affect behavior.  If you want to discourage behavior you impose a tax.  If you want to encourage behavior you provide a tax incentive.

For example, the excise tax on cigarettes has been increased to reduce the number of people smoking.  A tax has been imposed on individuals for not purchasing insurance, so more will.  Our tax code is littered with tax incentives to get people to do more of the things we like and less of the things we don't like.  Individuals and businesses have and do respond to these incentives.

Yet, if we are to believe the other side, when it comes to marginal income tax rates the influence of taxes ceases to exist.  According to them, we can raise income taxes on the wealthy as high as we want with no ill effects for jobs and the economy.

Well, I have news for my colleagues; high marginal tax rates influence many factors that contribute to economic growth.  Capital accumulation and the availability of a well trained labor force are two important factors influenced by taxes.  Just as an increase in the excise tax on cigarettes leads to fewer packs of cigarettes being purchased, increasing taxes on capital reduces capital accumulation.  Likewise, the more you tax labor the fewer hours worked you will get.  In other words, taxes matter.

Some of my colleagues on the other side have pointed to a Congressional Research Service report they claim proves raising the top marginal tax rate does not impact economic growth.  There has been ample criticism of this one analysis that I will not go into here.

But, even if one gives any credence to this one analysis, it must be viewed in light of a larger body of economic research that indicates higher taxes do hinder economic growth.  This research confirms that high marginal rates reduce the hours worked and are a disincentive to small business owners and entrepreneurs.

Among this research is a 2007 study by Christina Romer that found that a tax increase of one percent of GDP reduces economic growth by as much as three percent.  According to this study, tax increases have such a substantial effect on economic growth because of the "powerful negative effect of tax increases on investment."

The last thing we need to do now is discourage business investment.  Business investment has been stagnant.  This has directly contributed to slower economic growth than in past economic recoveries.  It has also contributed to weak job creation and wage growth.

Raising marginal tax rates on entrepreneurs and business owners, thereby reducing their after-tax rate of return is not the answer.  We need to give entrepreneurs and business owners the certainty they need to start investing again.

The Organization for Economic Co-operation and Development (OECD) has issued several reports analyzing how different forms of taxation impact economic growth.  This OECD research found that income taxes significantly impact economic growth.

According to this research, the most damaging tax was the corporate income tax followed by the individual income tax.  The study further noted that highly progressive individual income tax rates are negatively associated with economic growth.

The United States of course relies extensively on both corporate and individual income taxes.  Our corporate rate of 35 percent is the highest in OECD countries, which is bad in its own right.  But a large number of American businesses are taxed at the individual rate, not the corporate rate.  We also already have a highly progressive tax system.  In fact, according to a 2008 OECD study we have "the most progressive tax system and collect the largest share of taxes from the richest 10 percent of the population."

Currently, the top individual rate of 35 percent is the same as the top corporate rate.  Starting in 2013, if the President has his way, the top rate goes up to 39.6 percent with the second highest rate scheduled to go up to 36 percent from 33 percent.  When you consider the effects of the personal exemption phase-out and limitation on itemized deductions, the marginal effective tax rate jumps to over 41 percent.

These tax increases will hinder the growth of small businesses, and of course, slower business growth means slow job growth.

Evidence of this is documented by a 2001 study available from the National Bureau of Economic Research.  This study looked at how the marginal rate cuts in the 1986 tax reform affected the growth of small firms.  The study showed that businesses that experienced the largest marginal rate cuts saw their businesses grow the fastest.  Conversely, the study concluded that when marginal tax rates go up, the growth of small businesses goes down.

Similarly, a 2005 study conducted by the Small Business Administration found that "lower marginal rates on entrepreneurial income encourage more entrepreneurial entry and lower rates of exit, and lengthen the duration of spells of activity."  This means that if my colleagues are successful in raising the top two marginal rates there will be less entrepreneurial activity. Fewer people will seek to start their own business and more current business owners will be looking to close up shop.

Further research confirms that high marginal tax rates leads to fewer hours worked.    A 2008 study that appeared in the Journal of Monetary Economics and a 2004 study conducted by the Federal Reserve Bank of Minneapolis examined how taxes impact the labor supply across time and across countries.

Both these studies found that countries with higher marginal tax rates generally worked fewer hours.  Conversely, those with low marginal rates worked more hours.  In fact, these studies, controlling for other variables, found that the marginal tax rate accounted for the "vast majority" or "preponderance" of the difference in hours worked.

Research by economist Michael Keane has highlighted that high marginal rates have the biggest impact on labor over the long-run.  This is because of the effect of marginal rates on lifetime decisions.

While a sudden increase in taxes may not lead to an immediate shift in current hours worked, it will impact future decisions.  For instance, higher marginal rates will discourage the accumulation of human capital through work experience and training.  His review of research in this area further concluded that the effect of high marginal tax rates is especially pronounced when it comes to women's participation in the workforce.

There are many more examples of economic research that points to high tax rates hindering economic growth.  For the sake of time, I am not going to go through all of them. Instead, I ask unanimous consent to place a list of more than 20 studies in the record.  This is by no means an exhaustive list, but I believe these provide a good starting point for my colleagues who are interested in learning the truth about taxes.

In sum, this research suggests that soaking the rich through an ever more progressive tax code will only reduce incentives for work and entrepreneurship thereby reducing economic growth.  It means that:

-              For a couple deciding whether or not a spouse who left the workforce should go back to work, taxes matter.

-              For an individual who is considering investing in their own human capital through education or training to increase their earning potential, taxes matter.

-              For a small business owner considering hiring employees, purchasing equipment, or expanding their business, taxes matter.

-              For an entrepreneur deciding whether or not a business venture is worth pursuing, taxes matter.

Let me turn to another argument used by my colleagues on the other side to support increasing taxes.  This argument is that tax increases on the wealthy are necessary to reduce the deficit and balance the budget.

The truth is there are not enough so-called rich people to make this happen.  Based on 2009 tax returns, if you raised the top tax rate on income over $200,000 to 100 percent, you would still come short of covering the $1.1 trillion budget deficit for fiscal year 2012.

This back of the envelope calculation assumes that people will not work less or engage in tax planning or fraud to avoid such a confiscatory tax.  I imagine my colleagues on the other side would even concede this would be the case with such a high rate.

For people out there who think they don't have to worry about the President's proposals because you are not wealthy, my message to you is this:  You should be worried, because in order to tackle the deficit and pay for all his proposed new spending, the President will have to increase taxes on individuals well under $200,000.

The President, of course, claims that he wants a balanced approach to deficit reduction.  He says we should do a combination of tax increases and spending cuts.  So far he has been rather specific about his tax increases.  However, he has not said much about entitlements that are going to be the main drivers of our national debt over the coming years and decades.

The President needs to lead in this area to get a serious discussion rolling.  He needs to begin offering serious solutions, not just attacking those that have been offered up by Congressman Ryan in his budget proposal.

Given my tenure in Congress, I have learned to be skeptical when people around here start saying we will reduce the deficit by raising taxes now and cutting spending later.  Especially when no specifics are articulated regarding what programs can be cut or what reforms they will accept for addressing entitlements.  It's been my experience in these situations, the taxes always go up, but the spending cuts never happen.

Professor Vedder of Ohio University, who has studied tax increases and spending for more than two decades, confirms this in recent research.  Professor Vedder looked at tax increases and spending spanning from the end of WW II through 2009 and discovered that  "each dollar of new tax revenue has been associated with $1.17 in new spending."

If we are ever going to get a handle on the deficit, we are going to need to learn to live within our means.  Spending as a percent of GDP has averaged about 20.5 percent since 1970.  From 1998 to 2001, when we did balance the budget, spending as a percent of GDP averaged 18.5 percent.  In fact we have never balanced the budget with spending as percent of GDP exceeding 20 percent.  Spending under President Obama has averaged 24.5 percent of GDP.  We must curtail our spending if we ever hope to balance the budget in the future.

Some around here insist that cutting spending will be as damaging, if not more so, than increasing taxes. They use the rationale of spending multipliers pushed by some economists that suggest for every dollar of spending by the government we will get more than a dollar in economic activity.

This theory is deeply flawed.  Even if we assume the government spends money wisely with no fraud, waste or abuse - and that is a big if - it means one less dollar to be spent by the private sector.

If this was solid economic theory our economy should be booming given all the money we have been spending around here.  The truth is spending is not the solution to our problems, it is our problem.  It is what got us into this mess in the first place.

For my colleagues who are still wedded to the idea that tax increases are preferable to spending cuts, I recommend reading a recent study by Harvard Economist Alberto Alesina.  Given the fiscal shape of many countries, Professor Alesina studied the impact of spending and tax policies put in place to address fiscal imbalances.

His research concluded that "fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax based ones.  In particular, spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Instead, tax-based adjustments have been followed by prolonged and deep recessions."

This research paper comes on the heels of a paper he released in 2009.  This paper similarly found that policies favoring spending cuts over tax increases are more likely to reduce the deficit.

In the words of Professor Alesina, fiscal adjustments "based upon spending cuts and no tax increases are more likely to reduce deficits and debt over Gross Domestic Product ratios than those based upon tax increases."

These studies confirm what through shear common sense Winston Churchill knew more than a half century ago, "for a nation to try and tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle."

In the coming weeks, I hope to work with my colleagues and the President to reach a bipartisan agreement to help put our country back on sound fiscal footing.  However, as I said in the beginning, it can't be just one side of the aisle that is expected to come to the table.  My colleagues on the other side must be willing to put real reforms to address entitlements and our out of control spending on the table.

I yield the floor.

1.            Alberto Alesina, Carlo Favero, and Francesco Giavazzi. "The Output Effect of Fiscal Consolidations." National Bureau of Economic Research

2.            Michael Keane and Richard Rogerson. 2012. "Micro and Macro Labor Supply Elasticities: A Reassessment of Conventional Wisdom." Journal of Economic Literature.

3.            Michael Keane. 2011. "Labor Supply and Taxes: A Survey," Journal of Economic Literature.

4.            Christina D. Romer and David H. Romer. 2010. "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks," American Economic Review.

5.            Robert Barro and Charles Redlick. 2010. "Macroeconomic Effects from Government Purchases and Taxes," Mercatus Working Paper.

6.            Andreas Bergh and Martin Karlsson. 2010. "Government Size and Growth: Accounting for Economic Freedom and Globalization," Public Choice.

7.            Andrew Mountford and Harold Uhlig. 2009. "What are the Effects of Fiscal Policy Shocks?" Journal of Applied Econometrics.

8.            Alberto Alesina and Silvia Ardagna. 2009. "Large Changes in Fiscal Policy: Taxes vs. Spending" NBER Working Paper.

9.            Jens Arnold. 2008. "Do Tax Structures Affect Aggregate Economic Growth? Empirical Evidence From A Panel of OECD Countries." Organisation for Economic Co-operation and Development Working Paper

10.          Lee Ohanian, Andrea Raffo, and Richard Rogerson. 2008. "Long-term Charges in Labor Supply and Taxes: Evidence from OECD Countries, 1956-2004," Journal of Monetary Economics.

11.          Diego Romero- Ávila and Rolf Strauch. 2008. "Public Finances and Long-Term Growth in Europe: Evidence from a Panel Data Analysis," European Journal of Political Economy.

12.          Donald Bruce and Tami Gurley. 2005. "Taxes and Entrepreneurial Activity: An Empirical Investigation Using Longitudinal Tax Return Data." Small Business Administration Office of Advocacy

13.          Edward Prescott. 2004. "Why Do Americans Work So Much More Than Europeans?" Federal Reserve Bank of Minneapolis Quarterly Review.

14.          Steven J. Davis and Magnus Henrekson. 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," National Bureau of Economic Research.

15.          William M. Gentry and R. Glenn Hubbard. 2004. "Success Taxes, Entrepreneurial Entry, and Innovation, National Bureau of Economic Research.

16.          Emanuela Cardia, Norma Kozhaya, and Francisco J. Ruge-Murcia. 2003. "Distortionary Taxation and Labor Supply," Journal of Money, Credit, and Banking.

17.          Olivier Blanchard and Roberto Perotti. 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," Quarterly Journal of Economics.

18.          Fabio Padovano and Emma Galli. 2002. "Comparing the Growth Effects of Marginal vs. Average Tax Rates and Progressivity" European Journal of Political Economy.

19.          Fabio Padovano and Emma Galli. 2001. "Tax Rates and Economic Growth in the OECD Countries (1950-1990)," Economic Inquiry.

20.          Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey S. Rosen. 1998. "Entrepreneurs, Income Taxes, and Investment" National Bureau of Economic Research.

21.          Eric Engen and Jonathan Skinner. 1996. "Taxation and Economic Growth" National Tax Journal.

22.          Nada Elissa. 1995. "Taxation and Labor Supply of Married Women: The Tax Reform Act of 1986" as a Natural Experiment," National Bureau of Economic Research.