Economics, Taxes and Spending

7 reasons why higher tax rates hurt economic growth (A response to Diamond and Saez)

In the Wall Street Journal today, liberal economists Peter Diamond and Emmanuel Saez (better known for his income inequality work with Thomas Piketty) argue for sharply higher income tax rates. Once factoring in payroll and state and local taxes, they conclude “that raising the top tax rate is very likely to result in revenue increases at least until we reach the 50% rate that held during the first Reagan administration, and possibly until the 70% rate of the 1970s.”

Diamond and Saez argue that high tax rates tend to “go with higher economic growth.” As evidence, they note that per capita GDP growth averaged 1.68% between 1980 and 2010 when top tax rates were “relatively low,” while growth averaged 2.23% between 1950 and 1980 when rates were at or above 70%. In addition, they find “no clear correlation between economic growth since the 1970s and top tax-rate cuts across Organization for Economic Cooperation and Development countries.”

There are a number of serious problems with this analysis:

1. The high growth rates of the 1950s and 1960s occurred at a time when the U.S. had a tremendous competitive advantage over other advanced economies that were still recovering from World War II. 

A National Bureau of Economic Research study describes the situation this way: “At the end of World War II, the United States was the dominant industrial producer in the world. With industrial capacity destroyed in Europe—except for Scandinavia—and in Japan and crippled in the United Kingdom, the United States produced approximately 60 percent of the world output of manufactures in 1950, and its GNP was 61 percent of the total of the present (1979) OECD countries. This was obviously a transitory situation.” Indeed, it was “transitory.” Europe recovered and was eventually joined by Japan and China as advanced economies and fierce competitors.

2. Effective tax rates were far lower than the statutory ones Diamond and Saez point to. When the official top rate was 91% in the 1950s, for instance, the top effective tax rate was probably closer to 50%. What Diamond and Saez want to do, of course, is raise tax rates to historically high levels while also eliminating ways of avoiding those rates. As such, effective tax rates would be far higher than any time in our nation’s history. The U.S. economy would be in uncharted territory.

What’s more, high tax rates during the 1950s and 1960s didn’t produce more revenue than lower ones in the Reagan Era. Income tax revenue as a share of GDP was 7.7% from 1951-1963, a bit lower than was it was from 1982-1992.

3. Economic growth slowed almost everywhere after 1973. Thus, as economist Scott Sumner has pointed out, we need to look at relative economic performance in order to identify the effect of pro-market policy reforms such as deregulation, privatization, and, yes, the lowering of marginal tax rates. Sumner found that nations which pursued such pro-market policies slowed less and outperformed those nations that didn’t. As he said in an interview, “Countries that didn’t reform very much, like Italy and Greece, their growth rates slowed from 7% to 2% in recent decades. The United States and Great Britain have actually slowed much less than the more statist economies. The growth slowed a little bit in the United States, but not dramatically.”

4. Look at what just happened in Great Britain. Their Independent Fiscal Oversight Commission—which reviews all of the budgetary assumptions—just ruled that cutting the top rate of tax from 50 to 45 was revenue neutral, implying the revenue maximizing rate is in that range. The Brits don’t have state income taxes, which implies by extension that our revenue maximizing federal rate is lower than theirs.

5. And recall the 1993 Clinton tax hikes. Those took the top income tax rate to 39.6%, where President Obama wants it to return. But in 1995, President Clinton admitted he had raised taxes too much. Indeed, those tax hikes only raised a third of the amount the Treasury Department had predicted.

6. Raising investment taxes is the wrong way to go. To “reduce tax avoidance opportunities,” Diamond and Saez argue that tax rates on capital gains and dividends should increase along with the rate on labor income. This pushes the tax code in an anti-growth direction in the name of fairness.

Really, though, we shouldn’t want to tax capital at all. As an AEI study on consumption taxes explains: “The income tax’s penalty on saving is an undesirable distortion of consumer choice. It also causes less capital to be accumulated in the United States. The reduction in capital accumulation reduces labor productivity and lowers real wages throughout the economy, depressing the standard of living of future generations. Some studies have found that a switch to consumption taxation would increase the size of the U.S. economy by as much as 9 percent in the long run, although other studies estimate smaller gains.”

And a study from Colgate University found the following: “Lower financial income taxes stimulate innovation and enhance labor productivity in the long run.” As JFK put it: “The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential growth of the economy.”

7. Diamond and Saez show a profound lack of academic humility. In a 2012 paper, Saez and his coauthors conclude that ”there are no truly convincing estimates of the long-run” impact of tax rates on behavior. So they just take an average of the various estimates and plug in the number. Voila! Time to go back to 70% marginal rates (and record high effective rates). I will take history and experience over ballpark guesstimates any time.

Bottom line: I want a tax code where tax rates are as close to the growth maximizing rate—not the revenue maximizing rate—as we can get while still funding a lethal military, an efficient and effective safety net, and basic science research. Doing that does not require tax rates of 50% or higher. In fact, it demands rates much lower.

6 thoughts on “7 reasons why higher tax rates hurt economic growth (A response to Diamond and Saez)

  1. Slam dunk with seven excellent reasons. Didn’t those guys learn anything from Coolige, JFK, Reagan and Clinton about tax cuts?

    Could you fix the link within #5?

  2. Bravo,I was perplexed on why the WSJ printed this insulting garbage-but then I saw that one of it’s authors was a Nobel laureate- like Obama and Al Gore.

  3. YOU’RE the folks with no academic humility!
    The study you’ve attacked is actually modest in its own conclusions: the high growth rates of the mid-century was not only correlated with the high taxes, but also the studies strongly suggest CAUSATION.
    You see, the taxes financed huge public investments that structured our economy in profoundly marvelous ways. Increased funding for public education, infrastructure, and research expanded our middle class and dramatically enhanced our quality of life.
    What’s more, inequality was the lowest then in American history. When too much income is concentrated at the top, the middle class and the poor don’t have the purchasing power to buy back the goods/services being produced. This deters businesses from investing more in its own capacity to meet that demand, meaning less output, employment, and economic growth.
    Between 1950-1981, for example, GDP growth averaged 3.6%. Since 1982, growth has averaged a pathetic 2.3%.
    You regressive conservatives have no evidence to disprove any of this: just ridiculous nonsense that is getting old and weak; and there’s far too much that you continue to ignore…

  4. “But in 1995, President Clinton admitted he had raised taxes too much.”

    Clinton may have believed that, but he was wrong. If anything, he didn’t raise them enough.

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