Actually, Tax Cuts Don’t Seem to Have Much Impact on Economic Growth

It has been something of an article of faith among conservatives that the solution to America’s problems is in smaller government and lower tax rates. The argument on taxes goes something like: ‘We need to unleash the wealth creators, who stimulated by the prospect of more income (due to lower tax rates), will create wealth for all of us.’ And, that any tax increase — for even the wealthiest taxpayers — would have catastrophic consequences.

Actually the post World War II American economy provides a nice empirical test of this hypothesis — the maximum marginal income tax rate gradually declined from about 90% to about 35%. Shouldn’t this decline have lead to an explosion of economic growth as our wealth creators were unleashed? Sorry, Sarah Palin… it didn’t.

During the ultra high tax 1950s (top marginal income tax rate of 90%), the United States had some of its best real economic growth (over 4%/year). And, for the decade where we had our lowest marginal income tax rates — we had our worst real economic growth (about 1.5%/year). (See Table 1 below.)

So what happened? Well, first of all (Spoiler Alert! The following will upset ideologues!), the real world is complicated. Taxes are one part of the American economy, but by no means the only driver of our decision making process. People are motivated by lots of things — not just money. In all the recent discussions about Steve Jobs, I can’t recall a single quote, anecdote or story that suggested income tax rates had any influence on Steve Jobs’ behavior. Does anyone really believe that if US income tax rates had been slightly higher Bill Gates would have founded Microsoft in Singapore (or some other low tax center)? As another example — Warren Buffet, who has been an active investor from the 1950s to today, certainly could have moved offshore when tax rates were higher. He didn’t.

Also, keep in mind that economic growth is not driven just by entrepreneurs and their hard work (okay, I’ve now simultaneously infuriated both the left and the right). In the 1950s, the global economy was emerging from World War II and the United States was the only industrial economy relatively unscathed. With better policies (arguably, the then current 90% tax rate was too high), we might have had even higher economic growth rates in the 1950s. But, our strong economic growth throughout the 1950s was helped by a strong tail wind (from outside the US).

In the early 21st century, we suffered relatively anemic economic growth (despite much lower tax rates), but we also faced a far more competitive world and a disastrous real estate bubble. It is not clear that lower income tax rates would have had much impact. But higher income tax rates and other policy adjustments might have avoided the real estate bubble from which we are now recovering.

Finally and most importantly, it is not just how the money is raised, but how it is spent. Tax revenues that improve infrastructure, and pay for basic research and education are investments in our future, and will foster economic growth. Tax cuts that primarily favor high end consumers might stimulate the purchase of luxury goods (McMansion anyone?), but may not contribute much to overall economic growth.

My point, and I do have one — is that ideology is a poor substitute for pragmatic approaches to complicated problems. In fact the evidence that tax rates influence economic growth in any way is equivocal at best. A myriad of other factors are involved. Simply reducing tax rates, and primarily for the wealthy, may hinder — rather than enhance our economic recovery.

Table 1: Comparison of mean marginal tax rates and mean real GDP growth rate
2011-10-25-Screenshot20111025at4.50.07PM.png
Sources: The real GDP growth rates are from www.wolframalpha.com; the income tax rates are from the National Taxpayers Union.

This post is cross-posted from the Huffington Post with permission.

10 Responses to "Actually, Tax Cuts Don’t Seem to Have Much Impact on Economic Growth"

  1. Drew   September 3, 2012 at 11:23 pm

    Looks like there were 462 comments when this was first posted on last year. What's disappointing is that the overwhelming majority reveled in confirmation bias, "Take that awful Republicans!". A few others pointed out that facile correlations fall far short of useful scholarship. To that end I'd add the fact that regardless of the top income tax bracket, the top quintile (of income earners) payed an EFFECTIVE, real tax rate of 26% +/- 2% since the Carter admin, when the 'list price' was 70%.
    Tax rates may not have impeded Steve Jobs' desire to innovate, but Apple most certainly makes decisions based on taxes. As does anyone in business who hopes to survive.

  2. cettel   September 4, 2012 at 7:02 am

    What do you refer to by "Mean Marginal Tax Rate" since that is different for different taxpayers depending upon the amount of their income?

    Frankly, closing with a Table like that makes a mush of your article and even makes me distrust the rest of it because of that sloppiness: I ask myself: What else could the article's writer have slopped over or gotten outright wrong?

  3. Schofield   September 4, 2012 at 3:07 pm

    The last thirty odd year's control of Congress by the Neo-Conservative rich has seen a steady accumulation of tax loopholes and all the greediest and smartest corporation robber barons now make extensive use of tax havens as articles on Mitt Romney have made clear. So relating tax levels on the rich to GDP growth seems a red herring. Why isn't the article making reference to outsourcing and increasing debt burden placed on the real economy as the main factors lying behind the drop in growth rate.

    • DiranM   September 5, 2012 at 1:58 am

      This kind of ideology is exactly the same thinking of the PASOK party who dominated Greek politics for the last 30 years – buying votes with government entitlements, etc and rolling up a high level of debt on a declining productive base. Even back in October 2009, PASOK argued for expanded entitlements with Greece just months before an IMF bailout. Like the Dems and Obama, they were going to fund this by chasing all those evil, bastardly rich folk who are for them the scum of the earth into order to give to those whom them deem as 'good folk'.

      This is at the heart of all arguments of the Left. Good and bad folk. Offering free stuff that they make others pay for by illusion. Unfortunately when the bill arrives, even the little folk get whammied as in Greece with 23% VAT on food stuffs and head taxes on the electic bill but Leftist politicans still in big limousines, etc.

      Obviously academics love this kind of thinking, but if most of these people – like their politician brethren – had the skills and abilities to earn money and create value as opposed to proposing to spend lavishly other people's money, they would have a different profession…..

  4. DiranM   September 5, 2012 at 1:55 am

    Romney is very obviously much more a practical problem solver than Obama – except for party-oriented academics like the above writer. Obama is more the ideologue by his very nature. Further Obama has no skills or education in economics, whilst Romney does – as well as proven executive skills, so it is a lot more likely as the stronger, more qualified candidate that Romney is going to be a change for the better.

  5. Nelson   September 5, 2012 at 3:42 pm

    Here are a few facts about corporate investments that economists should integrate into their equations.
    If a corp invests in a project to increase VOLUME, in the end it will create more jobs.
    If a corp invests in a project to decrease COST, in the end it will kill more jobs.
    If successful both projects will create more PROFIT, in the end it will create more tax revenue.
    If the TAX RATE is increased it will create more tax revenue without decreasing profits (not before tax profits, but it would reduce after tax profits of course !)
    In such case FINANCING of the project will be shifted, using LESS retained earnings and MORE borrowed money (where paid interests are tax deductible, negating the increased tax rate). This increase in borrowing demand will INCREASE interest rates and revive money markets.
    The smaller use of retained earnings in financing will make them available for INCREASED dividends. Retained earnings have already been taxed in the corporate hands but not in the investor's hands so this payment of dividends will release the MARGINAL TAX REVENUE hidden in that sitting money.
    And finally, this will increase GDP while shifting the BURDEN of borrowing from governments to corporations, increase tax revenue, investors revenue, financial sector revenue, corporate IBITDA, and eventually VOLUME.

  6. Billy T   September 6, 2012 at 2:20 pm

    Tax reductions for middle class, who tend to spend all of their income, does stimulate the US economy as their increased buying makes more jobs in the US; However, tax breaks for the super rich, who invest most of their incomes, mainly destroys US jobs. Here is why:

    They build more modern factories in Asia where the risk adjusted rate of return on their investment is at least double that in the USA. Then the US´s older factories close or out-source as they can no longer compete against more modern factories which also have much lower labor costs.

    SUMMARY: Tax breaks for those with annual incomes greater than $250,000 create jobs in Asia and destroy jobs in the US. GWB´s tax reductions for the very rich are main reason why US factories have closed or cut jobs by out-sourcing.

  7. Bill   September 10, 2012 at 12:36 pm

    Absolute nonsense . Unemployment plunged and tax receipts soared every year after the 2003 Bush tax cuts went into effect . And the % of taxes paid by the top 10% went higher every year thereafter as well making Bush the sneakiest progressive tax collector in modern history

    • Ryan Costa   November 12, 2012 at 7:53 am

      like the reagan tax cuts, the bush tax cuts were insignificant.
      it was just lowering interest rates on the fed, and looking the other way when old regulations were ignored. bubble—bursting bubble.

  8. Ryan Costa   November 12, 2012 at 7:51 am

    Professor Ravi Batra covered all this over ten years ago.
    naturally, he was marginalized and the work was not promoted.