Sunday, September 16, 2012

Tax cuts and economic growth

A new study in the U.S. is the latest to say that tax cuts do not positively relate to economic growth. David Leonhardt of the New York Times excerpts its conclusions in the Economix blog:
The top income tax rates have changed considerably since the end of World War II. Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today it is 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the 1970s; today it is 15%. The average tax rate faced by the top 0.01% of taxpayers was above 40% until the mid-1980s; today it is below 25%. Tax rates affecting taxpayers at the top of the income distribution are currently at their lowest levels since the end of the second World War.

The results of the analysis suggest that changes over the past 65 years in the top marginal tax rate and the top capital gains tax rate do not appear correlated with economic growth. The reduction in the top tax rates appears to be uncorrelated with saving, investment, and productivity growth. The top tax rates appear to have little or no relation to the size of the economic pie.

However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. As measured by IRS data, the share of income accruing to the top 0.1% of U.S. families increased from 4.2% in 1945 to 12.3% by 2007 before falling to 9.2% due to the 2007-2009 recession. At the same time, the average tax rate paid by the top 0.1% fell from over 50% in 1945 to about 25% in 2009. Tax policy could have a relation to how the economic pie is sliced—lower top tax rates may be associated with greater income disparities.
Leonhardt then continues on with the subject in his column today:
But tax cuts have other effects that receive less attention — and that can slow economic growth. Somebody who cares about hitting a specific income target, like $1 million, might work less hard after receiving a tax cut. And all else equal, tax cuts increase the deficit, as Mr. Bush’s did, which creates other economic problems.

When the top marginal rate was 70 percent or higher, as it was from 1940 to 1980, tax cuts really could make a big difference, notes Donald Marron, director of the highly regarded Tax Policy Center and another former Bush administration official. When the top rate is 35 percent, as it is today, a tax cut packs much less economic punch.

“At the level of taxes we’ve been at the last couple decades and the magnitude of the changes we’ve had, it’s hard to make the argument that tax rates have a big effect on economic growth,” Mr. Marron said. Similarly, a new report from the nonpartisan Congressional Research Service found that, over the past 65 years, changes in the top tax rate “do not appear correlated with economic growth.”
Kevin Drum's take on it:
Low tax rates appear to be associated with:

Higher investment
Lower savings
But no change in growth rates

None of these three results were statistically significant, but a fourth result was: lower top marginal tax rates mostly benefit the rich, leading to much higher income inequality. The study found similar results for capital gains tax rates. All the charts are below and the full study is here.

One caveat: Generally speaking, marginal tax rates were high from 1945-1980 and low from 1980-2010. So the CRS results might just be an artifact of the fact that growth was higher during the postwar period and lower during the post-Bretton Woods era. In other words, it might have nothing to do with tax rates. But of course, that's the point. Nobody thinks that raising taxes is actively good for the economy, except to the extent that it helps balance the federal budget. The question is whether there's any evidence that lowering taxes boosts economic growth. And there really doesn't seem to be.
Information worth keeping in mind when you hear those tax cut espousing politicians linking them to economic growth. One of the Harper government's favourite slogans is their "low tax plan for jobs and growth." Let's make them prove the relationship or at least ask hard questions about whether there is any relation at all. This latest study suggests no, there is not.