Sunday, January 30, 2011

Tax Rates and GDP Growth

Let's see whether we can prove that higher taxes are bad for the economy by charting the top marginal tax rate versus the % growth in GDP for each year. If higher taxes stifle the economy, we should see an increase in growth each time we lower tax rates. And likewise, if the theory holds, we'll see a drop in growth each time we increase the tax rate. Does that pan out?

Left scale for top US marginal income tax rates. Right scale for GDP growth in chained 2005 dollars. A 10 year moving average for each figure is also included. GDP data from the BEA. Tax rate data from TruthAndPolitics.org
There's a lot of fluctuation, including some times when the line for GDP growth is off the chart; but the 10 year moving average trend gives a good idea of the general direction. Growth ramped up after the tax rate increased sharply following the Great Depression. Then after sling-shotting back down, growth gradually stabilized with a rather steady 10 year moving average lightly bouncing around 3% growth from the late 1950s through 2007. Interestingly, that 3% stabilization formed during the years when the top marginal tax rate was 91% or higher. From 1951 through 1963 the top tax rate varied between 91 and 92%. During those years, the average rate of inflation adjusted GDP growth (using chained dollars) rested at 3.51%, a rather robust growth rate. By contrast, the GDP growth under the average 37.4% top tax rate from 1986 through 2008 was only 2.83%, 0.68% lower.

Overall, the past 80 years show us a thorough lack of clear correlation between the top marginal tax rate and GDP growth. The data's closest hint of a relationship derives from the slightly more robust average GDP growth back when the top rates were higher, but that closest hint isn't close enough to be sure of an ideal rate. The notion that lowering the top tax rates improves the economy just doesn't hold water. Indeed, these 8 most recent decades show us that increasing the top tax would not necessarily have any impact on the economy, let alone slow it at all.

Update 02/03/2011:  see Chained to Real: Tax Rates, Inflation-adjusted GDP Measures, and the Difference for a version of the above chart using another inflation-adjusted measure of real GDP growth (with roughly the same result).

Original chart
Update 02/07/2011:  Replaced original chart with improved version featuring better parity of scales, better visibility of trendlines, and replacement of the poly trend with a linear. The change in scale does suggest an interesting symmetry in the past two or three decades. We'll look at that in more detail later. 

10 comments:

  1. Control more variables!

    I'm sorry, but I can't swallow this. There should be a correlation: For better or worse, taxes are government intervention that have an impact on the economy. However, this particular tax, as you have shown, does not have a very significant impact on output. That does not mean there is no correlation. If the point is that this tax should be discussed less because it is not terribly significant, I think you have data to support that argument. But a lack of correlation?

    As I started with, control more variables, or find some different data.

    If I vary the amount of fertilizer in my garden over 30 years, and then compare that to the rate plant growth in the city I live in, of course the data will not show a correlation. That does not mean adding fertilizer has "a thorough lack of clear correlation" with plant growth.

    Sorry to bitch,

    Thanks for the post.

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    1. "There should be a correlation"
      I want it to be so and have invested my pride and identity in believing it to be so, therefore it must be so!

      "If I vary the amount of fertilizer in my garden over 30 years, and then compare that to the rate plant growth in the city I live in, of course the data will not show a correlation. That does not mean adding fertilizer has "a thorough lack of clear correlation" with plant growth."
      Actually, that's EXACTLY what it means. If there is no pattern of change in plant growth over 30 YEARS, then there is NO correlation.
      And if there is no consistent measurable correlation of U.S. tax rates (especially capital gains), then there is NO correlation.

      Everybody would like to keep more of their money, so it's natural to want to believe their must be a correlation. But it's not logical to assume that people will refuse to invest if they can only earn great returns rather than obscenely great returns. Americans (especially this group will not take their money and move to Russia, Iran or Venezuela. Rational people will not spite themselves to spite the government.

      There may be many valid arguments for cutting taxes. But a guarantee of economic growth is not one of them.

      This is not to say that there are no situations where people will cut investing in the U.S. Obviously, if they have the knowledge and resources to do so (usually still somewhat constrained by personal loyalties and beliefs) , investors will invest where they can make greater returns. For decades, this worked in our favor. But for a variety of reasons, the U.S. is on the decline, and other stars are rising.

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  2. It is easy to assume there must be a correlation, but that assumption relies on the tax rate being outside of a sweet spot range. The Laffer curve doesn't have to be a precise curve. The middle of the curve can be vast and nearly flat, with a large range of percentages that will be approximately equivalent and significantly close to ideal in terms of economic impact. Meanwhile, taxes have all sorts of impacts on the economy outside of the motivations considered by the Laffer curve. For instance, tax revenue spent on improving transportation can make the cost of doing business lower and thus spur further economic activity. As such, a tax rate that might otherwise be ideal could be inferior to a higher tax rate with the money better spent (e.g. on roads, bridges, and rail rather than on incarcerating non-violent offenders for victimless crimes). [Even if you find it important to jail people for victimless crimes, that doesn't change the fact that it is going to do less for the economy to spend on such jailing than to spend on transportation infrastructure.] As such, one might only find a direct correlation that actually becomes measurable beyond other factors when raising/lowering taxes to an extreme tax rate very near either end of the curve.

    Beyond that, the ideal rate can be changing as the economy shifts both inside the national economic structure and in relation to other nations. As such, you might happen to lower the rate to a point that is ideal when you lower it but is significantly below the ideal a decade or two later. Even if you find the "perfect rate" for your moment, that doesn't mean you have a perfect rate for all time. There is no such thing.

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  3. Total misuse of inconclusive data. There's just not enough time and too many other variables to identify a correlation.

    What has the greatest impact on economic growth is relative tax competitiveness. Case in point, you're comparing a decade when USSR killed people for keeping just a little bit of their farm products to save themselves from famine with a decade when Russia had a 13% flat tax! There was a time when Uncle Sam could tax the hell out of you and still be the light of the world - but not any more.

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  4. Alex, my main point was: one can not draw a direct correlation between lowering top marginal rates and increased growth. I'm not suggesting that there is any clear correlation in this post. Quite the opposite, I'm saying that those who claim a correlation of these two factors alone are wrong.

    Perhaps you can make an argument about tax competitiveness favoring lower taxes under some circumstances. But one can't accurately claim that simply lowering taxes on the wealthy will increase growth. The one does not necessarily follow from the other ... and depending on other factors could even interfere with the other.

    As far as tax competitiveness, however, many large corporations are paying an effective tax rate of 0% or nearly so. I'm not sure how one could argue that those large corporations are excessively taxed at effectively 0%. Tax rates on average families are also at historic lows and have fallen dramatically for the most wealthy (see http://econproph.com/2011/04/17/tax-rates-are-historically-low/). And corporate taxes are historically tiny compared to income taxes (see http://blogs.reuters.com/felix-salmon/2010/12/06/chart-of-the-day-u-s-taxes/).

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  5. Worthy of another mention:

    http://econproph.com/2011/04/17/tax-rates-are-historically-low/

    and

    http://blogs.reuters.com/felix-salmon/2010/12/06/chart-of-the-day-u-s-taxes/

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  6. Pretty nice post and nice informative chart,As a IRS Lawyer in Alabam i really impress from post...Thanks

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  7. Fascinating how the same folks that talk about "Job Creators" continue their misinformation by trying to reject evidence which contradicts their 1% philosophy

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  8. Your figures are in error. The taxes for both Clinton and Bush were calculated using the maximum rate for that selected income. For instance the Clinton 1999 tax rate on 30K was 28%, which is what they used to get the 8400 figure. However taxes are not calculated that way. The first 25K of income would have been 2013 tax brackets at the lower 15% bracket first, thus yielding a much lower figure than what you show.I am not arguing that Bush doesn't have lower taxes. He certainly does. Of course he obtained his lower tax brackets by using deficit spending and increasing the national debt. Add back in the interest payments we'll be making and I bet Bush actually cost taxpayers far more than Clinton ever did.

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    1. The chart is about tax cuts for the most wealthy, a main focus of Trickle Down. It's not an error to look at the maximum rate when we're talking about the impact of cutting taxes for those for whom the maximum rate applies to the majority of their income.

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