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Lower Marginal Tax Rates Don’t Correlate With Increased Economic Growth

I was looking for some data on tax rates vs economic growth for a longer piece I’m working on when I came across this interesting gem by Mike Kimel, in which he runs the numbers and finds no correlation between lower top marginal tax rates and real GDP growth (at least, in the United States). He does this in the form of a classic economics style bet. It’s fascinating and well worth the read. Here’s the bottom line, though:

The way to read this graph…. consider the cell with t to t+3 on the horizontal and 50 years on the vertical. That cell has 62.1% in it. That indicates that of the 29 fifty year windows in which you can measure the growth in real GDP from a given year to three years later, 18 of them (or 62.1% of them) show a positive correlation between the top marginal tax rate. That is to say, in 62.1% of those windows, growth is faster when top marginal tax rates are higher than when tax rates are lower.

Notice… most of the squares have numbers above 50% in them. That means, in most situations we considered, more often than not, the correlations between marginal tax rates and growth rates are positive, not negative. When the negative correlations do occur, they tend to occur over the very short term. Put another way – they have negative repercussions that hit later. (And yes, that is what the table indicates.) Over longer periods of time, the percentage of time positive correlations are observed approaches 100%. This cannot in any way be reconciled with libertarian theory.

I have to admit that this is not the result that I would anticipate. But given the anemic economic growth we’ve seen since the last round of marginal rate cuts, it’s hard to be surprised.

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About Alex Knapp
Alex Knapp writes about pretty much everything under the sun, including politics, art, religion, philosophy, sports, music, culture, and science.

Comments

  1. MarkedMan says:

    Whoa. You’re encroaching on “Serious Conservative Conventional Wisdom” here. Beware. The idea that tax cuts always increase growth is to “Serious Conservatives” what original birth certificates are to Birthers. Despite this, though, I predict that you will be relatively unscathed. “Serious Conservatives” unlike birthers, don’t froth at the mouth and attack the messenger when their core beliefs are threatened. They simply ignore the data, and the messenger. Thus, my prediction – this analysis will have absolutely no effect on the world view of, nor generate any response from, the mainstays of the Republican Party, or its various captive think tanks.

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  2. An Interested Party says:

    Shame on you, Alex….how dare you commit this sacrilege against conservative true faith…i guess this really is nothing but a socialist left-wing website after all….

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  3. Dave Schuler says:

    I think we should be cautious about which way the causality goes. My guess is that higher marginal rates become more acceptable as tthe rate at which income is growing increases.

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  4. This doesn’t surprise me at all. I’ve been harping about a great deal of anecdotal evidence for this over the last 60 years, just waiting for an economist to actually study it. Higher rates force the wealthy to actually invest their money in business that create wealth, as opposed to lower rates which allow the wealthy to extract it. We’ve been on an extraction binge for almost forty years now.

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  5. David Shuler: yes, of course, that’s exactly why everyone supported the Clinton tax hikes! The economy was in such good shape that people felt marginal rates were soooo much more acceptable. Because we all know the Clinton economy was due to Regan’s tax cuts!

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  6. Alex Knapp says:

    Dave: You’ll note that the model is built with different time windows, and I think that obviates your hypothesis.

    Of course, even the model-maker notes that this is just a correlation and just one of many different factors. It even notes that cuts in the top marginal rate produce short-term economic growth (but over the long term causes economic decline.) But what it makes clear is that it simply cannot be the case that lower marginal income rates = increased economic growth. The data just isn’t there to support that hypothesis.

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  7. Carl B. Sullivan, Jr. says:

    Perhaps this article (WSJ, 12/23/10) will point you in the right direction. Insofar as I’m concerned, the answer is obvious. When times are good and you are making money hand over fist, you can stomach higher taxes. In tough times, however, increasing taxes is like kicking a man when he is down. Besides, it doesn’t take a Harvard economist to understand that people respond to incentives. This is as true for the venture capitalist as it is for the assembly line. Real people in the real world know that running your mouth about pointy-headed economic theory or tax policy doesn’t put hamburger on the table. Productive hard work and doing a better job than the competition is what brings home the bacon 99 percent of the time. (Duh!)

    By ALAN REYNOLDS
    When President Obama announced a two-year stay of execution for taxpayers on Dec. 7, he made it clear that he intends to spend those two years campaigning for higher marginal tax rates on dividends, capital gains and salaries for couples earning more than $250,000. “I don’t see how the Republicans win that argument,” said the president.

    Despite the deficit commission’s call for tax reform with fewer tax credits and lower marginal tax rates, the left wing of the Democratic Party remains passionate about making the U.S. tax system more and more progressive. They claim this is all about payback—that raising the highest tax rates is the fair thing to do because top income groups supposedly received huge windfalls from the Bush tax cuts. As the headline of a Robert Creamer column in the Huffington Post put it: “The Crowd that Had the Party Should Pick up the Tab.”

    Arguments for these retaliatory tax penalties invariably begin with estimates by economists Thomas Piketty of the Paris School of Economics and Emmanuel Saez of U.C. Berkeley that the wealthiest 1% of U.S. households now take home more than 20% of all household income.

    View Full Image

    Images.com/Corbis
    .This estimate suffers two obvious and fatal flaws. The first is that the “more than 20%” figure does not refer to “take home” income at all. It refers to income before taxes (including capital gains) as a share of income before transfers. Such figures tell us nothing about whether the top percentile pays too much or too little in income taxes.

    In The Journal of Economic Perspectives (Winter 2007), Messrs. Piketty and Saez estimated that “the upper 1% of the income distribution earned 19.6% of total income before tax [in 2004], and paid 41% of the individual federal income tax.” No other major country is so dependent on so few taxpayers.

    A 2008 study of 24 leading economies by the Organization of Economic Cooperation and Development (OECD) concludes that, “Taxation is most progressively distributed in the United States, probably reflecting the greater role played there by refundable tax credits, such as the Earned Income Tax Credit and the Child Tax Credit. . . . Taxes tend to be least progressive in the Nordic countries (notably, Sweden), France and Switzerland.”

    The OECD study—titled “Growing Unequal?”—also found that the ratio of taxes paid to income received by the top 10% was by far the highest in the U.S., at 1.35, compared to 1.1 for France, 1.07 for Germany, 1.01 for Japan and 1.0 for Sweden (i.e., the top decile’s share of Swedish taxes is the same as their share of income).

    A second fatal flaw is that the large share of income reported by the upper 1% is largely a consequence of lower tax rates. In a 2010 paper on top incomes co-authored with Anthony Atkinson of Nuffield College, Messrs. Piketty and Saez note that “higher top marginal tax rates can reduce top reported earnings.” They say “all studies” agree that higher “top marginal tax rates do seem to negatively affect top income shares.”

    What appears to be an increase in top incomes reported on individual tax returns is often just a predictable taxpayer reaction to lower tax rates. That should be readily apparent from the nearby table, which uses data from Messrs. Piketty and Saez to break down the real incomes of the top 1% by source (excluding interest income and rent).

    The first column (“salaries”) shows average labor income among the top 1% reported on W2 forms—from salaries, bonuses and exercised stock options. A Dec. 13 New York Times article, citing Messrs. Piketty and Saez, claims, “A big reason for the huge gains at the top is the outsize pay of executives, bankers and traders.” On the contrary, the table shows that average real pay among the top 1% was no higher at the 2007 peak than it had been in 1999.

    In a January 2008 New York Times article, Austan Goolsbee (now chairman of the President’s Council of Economic Advisers) claimed that “average real salaries (subtracting inflation) for the top 1% of earners . . . have been growing rapidly regardless of what happened to tax rates.” On the contrary, the top 1% did report higher salaries after the mid-2003 reduction in top tax rates, but not by enough to offset losses of the previous three years. By examining the sources of income Mr. Goolsbee chose to ignore—dividends, capital gains and business income—a powerful taxpayer response to changing tax rates becomes quite clear.

    .The second column, for example, shows real capital gains reported in taxable accounts. President Obama proposes raising the capital gains tax to 20% on top incomes after the two-year reprieve is over. Yet the chart shows that the top 1% reported fewer capital gains in the tech-stock euphoria of 1999-2000 (when the tax rate was 20%) than during the middling market of 2006-2007. It is doubtful so many gains would have been reported in 2006-2007 if the tax rate had been 20%. Lower tax rates on capital gains increase the frequency of asset sales and thus result in more taxable capital gains on tax returns.

    The third column shows a near tripling of average dividend income from 2002 to 2007. That can only be explained as a behavioral response to the sharp reduction in top tax rates on dividends, to 15% from 38.6%. Raising the dividend tax to 20% could easily yield no additional revenue if it resulted in high-income investors holding fewer dividend- paying stocks and more corporations using stock buybacks rather than dividends to reward stockholders.

    The last column of the table shows average business income reported on the top 1% of individual tax returns by subchapter S corporations, partnerships, proprietorships and many limited liability companies. After the individual tax rate was brought down to the level of the corporate tax rate in 2003, business income reported on individual tax returns became quite large. For the Obama team to argue that higher taxes on individual incomes would have little impact on business denies these facts.

    If individual tax rates were once again pushed above corporate rates, some firms, farms and professionals would switch to reporting income on corporate tax forms to shelter retained earnings. As with dividends and capital gains, this is another reason that estimated revenues from higher tax rates are unbelievable.

    The Piketty and Saez estimates are irrelevant to questions about income distribution because they exclude taxes and transfers. What those figures do show, however, is that if tax rates on high incomes, capital gains and dividends were increased in 2013, the top 1%’s reported share of before-tax income would indeed go way down. That would be partly because of reduced effort, investment and entrepreneurship. Yet simpler ways of reducing reported income can leave the after-tax income about the same (switching from dividend-paying stocks to tax-exempt bonds, or holding stocks for years).

    Once higher tax rates cause the top 1% to report less income, then top taxpayers would likely pay a much smaller share of taxes, just as they do in, say, France or Sweden. That would be an ironic consequence of listening to economists and journalists who form strong opinions about tax policy on the basis of an essentially irrelevant statistic about what the top 1%’s share might be if there were not taxes or transfers.

    Mr. Reynolds is a senior fellow at the Cato Institute and the author of “Income and Wealth” (Greenwood Press 2006).

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  8. anjin-san says:

    > Mr. Reynolds is a senior fellow at the Cato Institut

    Sounds totally unbiased to me :)

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  9. michael reynolds says:

    Besides, it doesn’t take a Harvard economist to understand that people respond to incentives. This is as true for the venture capitalist as it is for the assembly line.

    Actually, it would take an economist because only economists are sufficiently naive to posit the existence of “rational man.”

    In the real world people do not in fact respond like robots to input. In the real world people behave unpredictably. They buy houses they can’t afford. They buy cars that can go 160 mph knowing they’ll never get over 80 on the freeway. They buy clothing that’s two sizes too small. They have unprotected sex. They shoot heroin. They shoot each other for five dollars or a pack of cigarettes.

    If people were even remotely like the programmable robots libertarians and economists imagine them to be then getting very rich would be very easy.

    And yet, in the real world, people don’t get rich by precisely predicting the reactions of homo sapiens to incentives. They get rich by lying, by cheating, by gambling, by making wild intuitive leaps, by creating things even when they don’t have any reason to assume that they’ll be bought. Sometimes they get rich by pandering, sometimes they go broke pandering. Sometimes they get rich by following some obsessive passion of their own.

    Economists know dick about humans. Libertarian economists even less. This is why its a shame to see so many college kids eschew liberal arts: because they end up believing transparently stupid bullshit like, “people respond to inventives.”

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  10. michael reynolds says:

    Um, incentives not inventives.

    Not sure what inventives are, but it feels like it should be a word.

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  11. Brian Knapp says:

    Michael, inventive (n): assertion made to be taken as evidence but which is actually completely unverifiable.

    Not as good as “refudiate”, but still not bad.

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  12. john personna says:

    I didn’t actually find this guy’s chart that convincing, but I am even less convinced by the chart-less denials in this thread.

    Basically this guy thinks he has a correlation (which we should count on being answered by the economists he has called out), and a lot of people here say “no it’s not, because I believe otherwise.”

    Never bring an opinion to a data fight.

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  13. Doug says:

    In a free market economy you can play with calculus models to determine all kinds of results and potential results from micro and macro but in a semi controlled economy we truly must recognize what the Econ Professor tells his students in Econ 101 that Economics is the Dismal Science and always will be. When things get going good then you have OPEC kicking in and when things go bad you have the government stepping in to mess everything up. Obama is a game changer as he scares everybody so old rational conclusions must be put in the closet and a new fresh start approach must be made similar to zero based budgeting. With Summers leaving maybe we will get someone with some real empirical experience. At this point though people are not looking at it as a marginal rate but rather as a tax bracket but credit must be given as the market has come back quite a bit.

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  14. MarkedMan says:

    Carl,
    After an admittedly quick scan it seems as if your article is BS. Sorry, but he switches from income to salary about a third of the way in. The top 1% of earners in this country have many more sources of income than salary. Famously, Bill Gates made a peak salary of something like $375,000/year from Microsoft, while his income was obviously quite a bit higher. I admit I didn’t finish the article, as once i saw the slight of hand I decided he was a paid lobbyist posing as an academic rather than someone who was objective about the outcome.

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  15. Dave Schuler says:

    Of course, even the model-maker notes that this is just a correlation and just one of many different factors.

    I was trying to head off the claim that higher taxes cause economic growth.

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  16. john personna says:

    “I was trying to head off the claim that higher taxes cause economic growth.”

    The “balanced budget stimulus” is suddenly in vogue. Link, link, link, or at least when Shiller talks, people listen.

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  17. […] on yesterday’s post about Mike Kimel’s data crunching of top marginal rates vs. economic growth, today Kimel has […]

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