Taxation and Economic Growth

[Stephen Bezruchka]

It has been interesting to give a series of sessions in a Seattle public
school this past week on social justice and health. This piece on taxation
and growth is interesting because the studies it addresses conflict with
many commonly held beliefs.  Stephen
****
NYT October 31, 2002 Do Lower Taxes Mean Faster Economic Growth? By JEFF
MADRICK

As Election Day approaches, serious discussion about economic policies is
hamstrung by the devotion of both parties to reducing taxes. The big
reason, of course, is that President Bush emphasizes tax cuts, including
elimination of the estate tax, to the exclusion of almost everything else.
The Democrats, in turn, hesitate to propose an economic plan that does not
include long-term reductions for middle-income workers, and most refuse to
talk about rescinding the Bush tax cuts for the wealthy.

But the degree of misleading information emanating from both Washington
and the media about how taxes affect the economy is disturbing. As I
listen to the radio, watch TV news and read a variety of newspapers, it
seems that quite a few Americans, including economics writers and media
hosts, think that low-tax countries unquestionably grow faster than
high-tax economies. Right and left, they seem to attribute more rapid
growth in America to lower taxes.

What may surprise them is that there is no evidence for that. "You can
make a theoretical case that high taxes impede economic growth, but it is
just not supported by the evidence in the U.S. or across countries," said
William Easterly, a former World Bank economist soon to join the faculty
of New York University.

One of the most interesting research papers on the subject was done a few
years ago by two economists from institutions that are hardly hotbeds of
liberal protax views, the University of Chicago and the University of
Rochester. Nancy L. Stokey of Chicago and Sergio Rebelo, then at Rochester
but now at Northwestern, noted that income tax revenue in the United
States rose to 15 percent of gross domestic product in 1942, from about 2
percent in 1913, when the tax was introduced -- providing a useful natural
experiment about the economic effects of taxes.

But, they concluded, "This large rise in income tax rates produced no
noticeable effect on the average growth rate of the economy."

Comparing other nations' experiences adds considerable weight to the
argument that the level of taxes has had little long-term effect on
growth. Joel Slemrod of the University of Michigan has written with Jon
Bakija an excellent book on the subject, "Taxing Ourselves" (MIT Press).
The authors compared the G.D.P. per capita with the level of taxes in the
two dozen member nations of the Organization for Economic Cooperation and
Development.

Relatively low-tax nations like the United States and Japan did well, they
found, but so did high-tax nations in Scandinavia and elsewhere. More
important, the authors contradict earlier findings that purported to show
that high taxes reduced growth rates. There is no such relationship, they
found; many economists now agree.

"The earlier studies were not very robust," said Mr. Easterly, who with
others reviewed much of Mr. Slemrod's work.

In the short run, tax cuts, like President John F. Kennedy's in the
1960's, can be stimulative. But why has tax policy had no clear influence
over growth in the long run? It would seem that if taxes were lowered,
people would work harder. But Mr. Slemrod and others have found little
evidence that workers put in more hours when tax rates fall or fewer when
they rise.

Others assert that high marginal tax rates erode the entrepreneurial
spirit. After President Bill Clinton early in his first term engineered an
increase in the highest bracket to 39.6 percent from 31 percent,
economists like Martin Feldstein of Harvard argued that the wealthy would
now earn less because they had less incentive to work and invest.

Incomes of this group did go down in 1993, but only because so many
shifted income to 1992 to avoid the tax increase. But by 1994, the income
of the wealthy was rising rapidly, despite the higher marginal rates.

American economic history since World War II also provides a natural
experiment about taxation. The rate of economic growth slowed markedly in
the early 1970's from its rapid pace the previous 25 years. But taxes did
not rise in this period. To the contrary, the federal government has been
collecting about the same proportion of G.D.P. in taxes for 50 years.

On the other hand, the composition of taxes changed. Marginal rates fell
for the rich much more than they did for the middle and poor over this
period. In the early 1980's, tax cuts by President Ronald Reagan plus
increases in payroll taxes made the American system considerably less
progressive than it was in the 1950's and 1960's.

If lower taxes for the rich do indeed raise incentives to
entrepreneurialism, the United States should have grown faster, not more
slowly.

Arguing along those same discredited lines, some economic analysts assert
that the capital gains tax cut of 1997 produced the economic boom of the
late 1990's. But not one serious study, Mr. Slemrod said, suggests that it
did.

These questions remain open to new research. At least one new study
suggests that lower marginal rates may encourage people to work harder,
but the preponderance of evidence still argues against it. Other
economists have done studies to show that segments of the economy may be
stimulated by tax cuts, like small business, but other economists counter
that this does not mean the economy over all will benefit. You more or
less take from Peter to pay Paul.

Then why do many high-tax countries do so well? "Looking at taxes only is
only one-half of the story," Mr. Slemrod said. "If government raised taxes
but then spent the money poorly, the economy would grow more slowly."

Could it be that some governments spend tax revenue more effectively than
others and may even promote growth in the process? Now there's a good
question for Americans to ponder as they go to the polls next week.