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Marginal Tax Rates and Economic Performance

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Message Seymour Patterson

If you subscribe to Grover Norquist's worldview, tax increases anytime, anywhere, and under any circumstances are verbatim. In fact, taken to its logical extreme, this worldview infers that the only meritorious fiscal policy action the US government needs to consider is tax cuts. Granted that in a period of declining output and high unemployment, tax cuts are hypothesized to stimulate economic growth. How? When the government cuts your taxes, your disposable income rises, and higher disposable income leads you (me and generally anyone participating in the tax cut) to greater consumer spending on goods and services. To meet the higher consumer demand, businesses such as J.P. Penney, Sears, Macy's; Ruby Tuesday, Olive Garden; Apple Inc., HP, Ford, GM, and  . . . well, you get the drift, hire more workers (and/or expand, i.e. invest in new plant and equipment). This is not a novel take on the countercyclical effects of tax cuts--Lord Maynard Keynes made such an argument as far back as 1936 in his book the General Theory of Employment, Interest and Money. Since then , tax cuts as instruments of growth in an economic downturn have been a staple of fiscal policy. One could also point to certain periods in the last century when tax cuts appeared to have had positive effects on economic performance in two ways: (1) government revenues rose; and (2) economic output, i.e., GDP expanded. The oft-cited evidence of such tax-cut outcomes is President Kennedy's tax cuts (The Revenue Act of 1964), and President Reagan's (Economic Recovery Tax Act of 1981). Kennedy's tax cut was of an order of magnitude of $11.50 billion while Reagan's was a whopping $38.30 billion. Economic growth in the 1960s averaged between 4 and 5 percent compared with a slightly more than two percent economic growth rate in the 1950s. The Clinton era tax policies included tax increases in 1993 and tax cuts in 1997. Clinton left office with a budget surplus and record economic growth. But it is still being debated whether the good economic performance was due to the tax cuts or the tax increases.

Grover Norquist might be notorious for the Taxpayer Protection Pledge that 95 percent of Republican Congressmen took. This is a pledge to oppose marginal income tax rate (MTRs) increases on individuals and businesses, among other things. And the rationale for lower marginal tax rates is that higher marginal tax rates have a negative impact on work effort, saving, and investment. Higher MTRs also encourage people to avoid and evade paying taxes, and thereby undermine government revenues. In the Reagan era, Arthur Laffer illustrated that marginal tax rates could be cut because they were too high and the government could collect more tax revenues from lower rates. In fact, the Laffer Curve posits two tax rates that yield the same level of income, so reducing tax rates will increase revenues, on the assumption that taxes were already too high. This might have been Reagan's impetus to bring marginal tax rates down from 70.1 percent (MTRs were stratospheric in the fifties at ninety percent) to 28.4 percent.

How many people do you know who decide to start a business ask, what is the marginal tax rate? Rather, they might be motivated to go into business for themselves because it is profitable. The overarching motor drive behind the decision might be how much you can make (in terms of profits), rather than how much you get to keep after taxes.

There is something perverse about taxation, for while it is used to fund public goods (roads, defense), it is by its nature confiscatory of the fruits of a person's sweat and toil. However, if you are self-employed you can pay yourself a wage (as much as you like or nothing), and you will be required to contribute to Social Security and Medicare--self-employment taxes. But if there is profit (the difference between revenue and cost of operations), you would also need to make an income tax payment to Uncle Sam. Now, the self-employment taxes add up to 15.3 percent. And the personal income tax rates range from 0 and 35 percent.  If the top marginal tax rate were raised to say 39.6 percent for incomes above $250,000, would an additional tax bite of 4.4 percent likely change behavior? Probably not! This simple analysis implies marginal tax rates do not matter. And if they don't matter, they needn't be zero.

There is no shortage of theories purporting to show that marginal tax rates reductions spur economic growth. In the spirit of Occam's razor, I use a simple set of marginal tax rates and real GDP growth rates from 1930 to 2011 to examine the relationship between these two sets of data. There exist lots of analytical quantitative techniques that can be used to manipulate data from which to glean important information. To proceed, however, and without addressing the issue of causality between marginal tax rates and economic growth rates, I attempt to focus on a slightly different question. That is, do these two sets of variables move together? That is, is the link between them significant? For if they move together, then other undetected forces might also be at play here. The data might be showing that high MTRs don't negate growth at all, and might even encourage it.

Data for the U.S. are readily available. For an analysis the1928-2011 data on GDP growth rates and MTRs were culled from the Web.  Data for MTRs are from Tax Policy Center Urban Institute and Brookings Institution, Tax Facts Historical Top Tax Rate, January 31, 2011. Data on GDP can be obtained online at Econ Data -- Stone Garden Economics. Table 1 shows the MTRs and U.S. GDP growth correlations.

Table 1 Correlation between MTRs and GDP growth     

Period   Correlation*  

1930-1939   0.561  

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)
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