Tax Theory 101: Tax Revenue is Relative to Economic Growth

An economy in recession will provide a drop in revenues to the government, whereas an economy in expansion will provide an increase in revenues to the government. When an economy shrinks, so does the tax base. Businesses start to close down, leaving fewer businesses to collect revenues from. More people are unemployed and left without an income, this leads to more people collecting unemployment benefits from the government. This leads to a smaller tax base and increased outlays for the government, which is a double-negative. With a shrinking economy also comes a lack of investing, savings, and spending. More businesses, people, and capital begin to move out of the country and the incentive to avoid any means of taxation goes up. All of which shrinks the tax base, because of the shrinking economy. When an economy is expanding, the tax base also expands. Businesses start to open, more people have jobs and incomes, the incentive to avoid taxation is less, more people invest, save, and spend their money, and more people, businesses, and capital enters the country. This all leads to a larger tax base which increases revenues. Tax revenue is relative to economic growth.

Example: In 2001 the 9/11 recession hit, made worse by the Clinton Business Cycle Recession (Dot-Com Bubble Bust). The Bush Tax cuts were passed before the 9/11 recession, therefore rendering them ineffective (Principle 2 of Tax Theory). As the economy shrunk, so did revenues. In 2003 when the second wave of the Bush tax cuts took effect, the economy began to recover. Revenues went up as the economy began to expand.

CBO Historical Tables: http://www.cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf

Bureau of Labor Statistics Historical Unemployment Statistics: http://www.bls.gov/cps/prev_yrs.htm

For a complete list of the Seven Principles of Good Tax Policy/Theory, click here.