Obama and Romney vie to cut taxes on Americans assuming tax cuts lead to economic growth. Tax cuts raise after tax income and buying power. But, the case for tax cuts is unclear--some plus in the short run, in the Kennedy and Reagan years; but not in the Clinton years--higher tax rates correlate with better economic growth. From 1913 to 2011 across the board tax cuts were less effective than targeted cuts of the same size.

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The battle lines have been drawn between Republicans and Democrats on taxes. Democrats champion tax cuts for people whose income is less than $250,000, which include about 98 percent of taxpayers. Democrats (particularly, Senator Reid) hound Mitt Romney to put out more years of his tax returns for public viewing--really dissecting. Steadfastly, he's declined to comply, alleging he'd get hounded even more if he did. On the other hand, Republicans are adamant for tax cuts for everyone, i.e. including the very wealthy, the top 1 percent of taxpayers. But hush . . . both groups are Keynesians (even Republicans who are loath to admit that publicly) for advocating tax cuts to promote economic growth. At an intuitive level, no one would argue with the idea that tax cuts put money in consumers' hands, some of which they spend, thereby helping the economy grow. If the tax cuts favor the middle class and the poor, they are redistributive from the rich (top 1 percent). No rocket science here. And it appeals to Americans' notions of equality and fairness. In terms of equality, rich and poor Americans should be treated equally (before the law), but before the IRS (International Revenue Service), it is unequal treatment to tax one cohort, the middle class, more--while Romney pays 13 - 15 percent, and some businesses (called persons) pay nothing, but you (average Joe Blow) pay about 28 - 33 percent.  Here from the Chicago Sun-Times (March 27, 2011) is a partial list of "persons' that paid not taxes:

"1) Exxon Mobil made $19 billion in profits in 2009. Exxon not only paid no federal income taxes, it actually received a $156 million rebate from the IRS, according to its SEC filings.

2) Bank of America received a $1.9 billion tax refund from the IRS last year, although it made $4.4 billion in profits and received a bailout from the Federal Reserve and the Treasury Department of nearly $1 trillion.

3) Over the past five years, while General Electric made $26 billion in profits in the United States, it received a $4.1 billion refund from the IRS.

4) Chevron received a $19 million refund from the IRS last year after it made $10 billion in profits in 2009.

5) Boeing, which received a $30 billion contract from the Pentagon to build 179 airborne tankers, got a $124 million refund from the IRS last year." (Source: click here)

Fairness implies that taxing the rich more is unfair because it punishes them for being who they are . . . rich! There're problems at many levels here--cohorts are different for scads of reasons--accident of birth, innate abilities, appearance, etc. But few are the rich, I suspect, greeted by the sun at dawn who fret about breakfast.

Things are not often as they seem. The world is complex and that forces us to drill below the surface of our intuitions for answers. First, people behave differently in response to their environment. In a complex world, oftentimes people seek complex methods to find simple answers to questions shaped by intuition. For instance, I want to know how people (taxpayers) respond to stimuli--that is, tax cuts. Do people work harder if they are rich, or poor? I contend the answer is yes, economic status matters. But I was not satisfied with just asserting that answer. I wanted proof--not mind-bending mathematically sophisticated proof, but simple testable data supported answers. Well, to support my approach choice, I invoked Occam's razor, which says "the simplest explanation that fits the facts" is the best. So, while it is true that many factors determine economic performance--employment, investment, confidence, economic stability, even perhaps geography, in the current political environment we are being led to believe that the solution to the economic malaise is tax cuts. The political conversation of the two presidential candidates is centered around the economic merits of changing marginal tax rates.  So, ignoring other factors of growth, I looked solely at economic performance in relation to marginal tax rates.

To address this conversation with evidence, I sought out data online for real gross domestic product (GDP) in 2005 dollars from 1913 to 2011. I also got data on top and bottom marginal rates for the same period. Three graphs were developed from this data--one for the Kennedy Administration, another for the Reagan Administration, and a third for the Clinton Administration. Later in the analysis 100 years of data are used to examine the effects of changes in the marginal tax rates on economic growth in the long run. However, the actual statistical results were not shown but can be requested from the author.

Again, there is a sense of universal bragging that cutting taxes ipso facto leads to economic growth.  Yet, a plausible counterintuitive argument can be made that high top tax rates don't necessarily mean poor economic growth--don't believe me, just look at the Figure 3 for the Clinton Administration below. Note in the graphics below, TMTR is the top marginal tax rate line, BMTR is the bottom marginal tax rate line, and GDPGR is the real GDP growth rate line.

Figure 1 above represents the Kennedy years (1961-1969)--though he died in 1963. The very top line is the behavior of the top marginal tax rate from 1960 to 1969. The mid line is the bottom marginal tax rate, and the last line at the bottom of the graph is the annual growth rates of real GDP.  Figure 1 show, too, that in the early years of the 1960s the top marginal tax rate was in the stratosphere. The Revenue Act of 1964 reduced the top marginal rate from 91 percent to 70 percent, which resulted in growth rates of 5.3 percent (1965), 4.5 percent (1966), and 5.5 percent (1967). Note, rates were increased in 1968 and 1969 but economic performance just mirrored 1962 and 1963 when the top marginal rates were 91 percent. The upshot seems to be that reducing the top marginal rates spurred economic growth, but raising them a little had mixed results. Of course, this questions the merits of the tax cuts absolutism as an economic strategy in a small way. Republicans obstinately refuse to give, even a little on this position. In their lexicon compromise--the given and take in negotiation for the public good--is surrendering principles. This is commendable only if it can be argued with absolute certainty that tax cuts have the effects they assert--i.e. improve economic performance.

Figure 2 below depicts the Reagan Administration and the steep cut in the top marginal tax rate from 70 percent to 50 percent, although the bottom marginal top rates (the second line) went from 15 percent to 10 percent (not much of a change by comparison). The effect of the Reagan tax cuts on real GDP growth (bottom line) was spectacularly positive. It rebooted the recovery in 1982 in a way that saw a whopping 7.18 increase in real GDP in 1984. However, further cuts in the top marginal tax rates between 1986 and 1988 did not increase economic growth. Nor did the increase in the bottom marginal tax rates from 11 percent in 1987 to 15 percent in 1988 change the real GDP growth rates. Here we begin to realize that tax cuts do not draw a straight line to economic recovery, and might even harm it. The story of the Reagan tax cuts seems murky. Trace the behavior of the changes in the top marginal top rates and the bottom marginal tax rates on real GDP performance (1982), and what you see is that in some years lower rates produced worse economic performance, and constant tax rates correlate with better GDP growth (1984). Once again a dogmatic adherence to tax cuts by either side of the political aisle as a means to economic growth is not supported by Figure 2.

Figure 2 Reagan Administration

Figure 2 confirms the argument that there is little relationship between marginal tax rates at the top and economic performance. To reiterate, the Reagan tax cuts were enacted in 1981 and by 1982 the economy took a nosedive.  It recovered in 1983 and 1984 and output fell again and did not rise much by 1989; raising the bottom marginal tax rate made no difference for the growth rate of the economy in this instance.

Figure 3 shows the Clinton Administration tax rates behavior.  President Clinton raised taxes from 31 percent in 1992 to 39.6 percent in 1993. Astonishingly, economic growth followed. Of course, what President Clinton did flies in the face of the tax-cuts-economic-growth connection argument? And intuitively, defies logic--the logic of the throughput process from tax cuts to economic growth. It turns this on its head and makes the opposite argument. Why? Because raising taxes on the top taxpayers does at least three things: (1) it increases government revenue for a given level of national income, thus, leading to a decline in the national deficit, (2) it taps into the low marginal propensity of the rich to consume (give Bill Gates another buck will not cause him to spending it); (3) it encourages tax avoidance, leaving taxpayers to increase saving--investment. This latter assertion means that when tax rates are high you can avoid paying the tax by not making profits part of personal income. The profits are retained in the firm and used as investment to grow the business. Finally, President Obama's willingness to raise taxes in top one percent of income earners is Clintonian because it assumes as in Figure 3 economic growth would follow.

Figure 3 Clinton Administration

The three figures tell conflicting stories about the effects of changes in marginal tax rates on economic growth in the United States. Both the Kennedy and the Reagan tax cuts had positive effects on growth, although long term the effects seemed to peter out. On the other hand, raising the top marginal tax rates as Bill Clinton did also increased economic growth. Higher rates in the Kennedy years and the Clinton years were consistent with economic growth. Why? To repeat, one reason for this is: if you are facing a marginal tax rate of 90 percent, you have two choices: pay it or not declare it as income by leaving it in the company to support investment for growth. Now, if the top marginal tax rate is cut, what do you do as a rational human being--you take it and spend it on luxury. No one envies success. We admire it. When we see a Maserati or a Bentley zip by, we emote wow! Who hates the Queen for Buckingham Palace because she is rich? The point is when you lower the tax rates at the top, there follows an increase extravagance there--car elevators in your come to mind. It is not the specialty and the custom made items that help the economy to grow; rather it is the mass production for mass consumption that does.

The graphical analysis above represents three snippets that hide the in-between (excluded years) behavioral responses of the data for a longer period 98 years from 1913 to 2011. To make up for this limitation, I set about to frame a question of the analysis around the relationship between economic performance and marginal tax rates. The prelude to the answer is reductions in the top marginal rates don't assist economic growth, while reductions in the bottom tax rates do--in the long term. Short term, the rich adjust significantly more rapidly to shocks than the poor.

I could have used any number of techniques to see if these data series moved together. But one has to be careful. Because two things (series) that same to move together might at closer examine be entirely unconnected. Visualize two people walking along a sidewalk randomly in the same direction. The fact that they are traveling in the same direction tells you nothing about their ultimate destination. But there's the counter example of a man walking his dog on a leash--they are both engaged in a random walk process--the dog sniffs and wets--but is connected to the man by the leash, and if we know where the man is going we might infer that the dog is going there, too. We know, for example, that the actions of President Obama and Mr. Romney are "cointegrated" because if Mr. Obama says he's wants to cut taxes for the middle class, Governor Romney will say he wants cuts for everyone; if Mr. Obama says the Affordable Care Act is good, Mr. Romney will say its bad; if President Obama uses the word redistribution, Mr. Romney says it is class warfare. The two men are linked by sloganeering and personal attack to garner votes. It is like a musical counterpoint. And we know they are on a journey in the same direction although only one will get there. In any event, we like to think that the actions of the man and his dog are cointegrated, but the two people walking along the sidewalk are not. What this means is that you don't want your data to be explosive; that is, drifting away from a central value--such as mean or variance. Unfortunately, the real GDP data for the United States from 1913 to 2011 exhibited this explosive tendency--not stable. The top marginal rate data was stable and the bottom marginal rate was not. Fortunately, there are relatively easy statistical methodological fixes to this problem of finding the relationship between these series--one stable and two unstable.

I will not reproduce the equation fitted to the data. However, the results show that cutting top marginal tax rates by 1 percent would reduce economic growth by 0.055; on the other hand, cutting the bottom marginal tax rate by 1 percent would raise real GDP by -0.161 percent. Think of these numbers as how sensitive the taxpayers are to changes in marginal tax rates. The implication of this is significant, because if Romney cut the top marginal rate by 20 percent real GDP in the U.S. would decline by 1.1 percent; but cutting the bottom marginal tax rates by 20 percent will raise economic growth by 3.22 percent. On the other hand, suppose Obama raise the top and cut bottom rate by 20 percent each. The net effect on economic growth would be greater--i.e. the sum of 4.32 (=1.1+3.22) greater for Obama than 2.12 percent for Romney. These results, of course, are more robust than the graphical analysis and speak more clearly to policies choices. If the goal is to win political office, the appeal to voters is to tell them you will cut their taxes. However, if the goal is economic growth, the policy choice is much clearer - cut rates on the lower end and even raise them on the upper end of the tax schedule.

Authors Bio:
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 Botswana in 1991 and the most recent in Ethiopia in 2009. He was on the Truman State University faculty until 2008.