Wednesday, March 04, 2009

Ideology versus Reality: Taxes and Growth

The Obama administration announced its new budget framework last week. Opponents of that plan are focusing on, among other things, the tax increases that the plan would impose on upper-income taxpayers. In addition to allowing the Bush tax cuts to expire for the most advantaged taxpayers, President Obama proposes to phase out the value of tax deductions for couples with incomes above $250,000 and $200,000 for singles. The response from Obama's opponents is predictable: everyone knows that tax increases hurt the economy, so why increase them now? Of course, if one accepts the premise that tax increases hurt the economy, then there really is no good time to raise them; but that is ultimately the anti-taxers' point. "Don't raise taxes now" really means "Don't ever raise taxes." The premise, however, is wrong. There is no convincing evidence that tax increases (especially of the sort that Obama has proposed) harm the economy.

Is this not heresy?! Surely, tax increases hurt the economy. People who must pay higher taxes are discouraged from working and innovating. Taxes sap the competitiveness of U.S. corporations. Low taxes always lead to higher growth. We hear these assertions and variants on them so often that they have taken on the character of a mantra, a cherished set of beliefs that need not -- indeed, that must not -- be challenged.

Faith is a fine thing. The evidence, however, is just not there. Bruce Bartlett, a former advisor to Presidents Reagan and Bush the Elder, recently argued that "when Republicans claim that higher taxes will destroy the economy, they should be reminded that they made the same argument in 1982 and 1993 and that the actual economic results were the opposite of what they predicted." Similarly, the economics writer for the New York Times, David Leonhardt, put it this way: "Despite all the scary stories you've heard, the evidence that higher taxes necessarily cripple an economy is somewhere between thin and nonexistent."

Both Bartlett and Leonhardt make essentially the same reality-based case: Looking at post-WWII U.S. economic performance, not only does the economy not do better when taxes are cut, but it actually has performed best when tax rates were relatively high. The highest marginal personal income tax rate in the early 1960's was 91% (on annual income above roughly $2.8 million, in inflation-adjusted dollars), and the years of those high tax rates were also some of the best years of broadly-share economic prosperity the world has ever seen. Predictions of doom when taxes rise have turned out to be wrong, as have predictions of boom when taxes fall.

It is, of course, always possible that something else is going on that hides the true effect of taxes. Maybe high taxes have been levied when other factors were in place to make the economy grow, making any unexpected correlations (or lack of any correlations at all) spurious. This is what careful statistical research is all about, and it should surprise no one that this has been a major area of research for public finance economists.

Once we control for other relevant factors, can we find a negative correlation between tax rates and economic prosperity?
Back in 2005, another Times business reporter, under the headline "Do Taxes Thwart Growth? Prove It," wrote: "Over the last 30 years, economists have undertaken hundreds of studies to determine whether taxes hurt the economy. So far, they've turned up little to convict taxes of the charge. After reviewing the literature on the topic in 1993, two economists, William Easterly of New York University and Sergio Rebelo of Northwestern, concluded in a joint paper that 'the evidence that tax rates matter for growth is disturbingly fragile.'" "Disturbingly fragile" means, in the standard understatement of these types of academic articles, that a sufficiently motivated analyst could produce a statistical model showing the desired effect, but even mild changes in statistical methods would change the results. In other words, the affirmative claim that higher taxes cause economic harm is not supported by the evidence.

In a post on Febuary 19, I wondered whether it is possible to make progress in getting people to understand when the evidence really is one-sided, notwithstanding our deep-seated belief that there are two sides to every issue. I still do not have a general answer, but this is yet another example of the problem. The evidence fails to support the conventional wisdom, but some people insist that they know better. As the old saying goes, why let evidence get in the way of a good story?

-- Posted by Neil H. Buchanan

10 comments:

Michael C. Dorf said...

I think we're seeing the emergence of a split on the right between utilitarians and Lockeans. Utilitarians are at least willing to consider redistribution if it can be accomplished efficiently. Typically, redistribution through tax and transfer is not efficient because it leads to dead-weight loss, but that's if we focus only on money (and assuming that the taxes are simply to raise revenue rather than Pigovian). If we focus on utility, redistribution can be warranted because of the diminishing marginal utility of money: a total pie of $ 12 trillion distributed evenly among 300 million people may lead to more aggregate utility than a pie of $14 trillion that is distributed very unevenly. In normal times, conservative utilitarians tend to argue that the dead-weight losses outweigh the utility gains from redistribution, but in extraordinary times such as those in which we live, they're willing to stomach more redistribution just to try to get things moving. This explains why, I think, some conservative but generally utilitarian economists have supported some substantial government spending, even if it will eventually lead to more taxes. By contrast, Lockean conservatives (think Grover Norquist) simply object to the notion that the government should be permitted to take "their money." Yet the end point of the modern Lockean argument (which Locke himself did not embrace) is to object to any progressivity in taxation, indeed, to object to anything other than a uniform head tax.

Neil H. Buchanan said...

Mike can correct me if I'm not reading his mind accurately, but I take him to be repeating the utilitarians' claims for the sake of clarifying the argument but not endorsing them. For example, whether or not a tax creates deadweight loss at all is an empirical question. Therefore, it's right to say that utilitarians take the idea that taxes --> DWL as a given. Similarly, the use of diminishing marginal utility of money is a useful dodge for utilitarians who want to get around the anti-egalitarian implications of their theory. It may or may not be "true," and I don't take Mike to be saying that it is true but only that some utilitarians act like it is.

Michael C. Dorf said...

Neil has basically read me correctly. My main point was to note that conservatives can be for redistribution, if they're utilitarians. Yet in recent times, any whiff of redistributionism has been condemned by the remaining Republican rump.

George Lowrey said...

Let us return to first principles. A flat tax is a highly progressive tax. At 10%, if one person earns $100,000 that person pays $10,000 in taxes. If another person earns $1,000,000 that person pays $100,000 in taxes or 10x as much as the first person. Yet there may well be no difference in the demands that both persons place on legitimate governmental services.

The second person earning $1,000,000 may live very modestly, drive little, take care to protect his home and belongings through private insurance, assume the entire responsibility to save for his own retirement and health care without Social Security and Medicare, and yet he pays 10x more income tax than the first person.

The first person may have many children attending public schools, drive an 18 wheeler and so use the interstate highways, and fritter away all his earnings, saving nothing for his old age and relying entirely on the Ponzi schemes known as Social Security and Medicare which already have created unbearable burdens upon future generations of Americans as the demographic ratio of retirees to workers approaches 1 to 1. Yet he pays 10% of the income tax paid by the second person.

From a moral standpoint, who should pay more taxes?

It is a fallacy to suggest that the person earning $1,000,000 is somehow depriving the other person of earnings or opportunities. The pie of wealth in the USA is not fixed but should grow at a rapid rate if taxes are lowered and incentives to work, innovate, save and invest are increased. The European model to which the new "Progressive" are so committed - high rates of unemployment, taxation and regulation and a low rate of productivity growth - is proof positive of this phenomenon by way of opposite example.

Yet those who promote higher and higher tax rates as income increases fall prey to the fallacy that income and wealth are a zero sum game (e.g. Thomas Malthus, Karl Marx and Lester Thurow) to be "equalized" in the name of "fairness" as determined by the members of Congress who are subject to perverse incentives to redistribute money at the behest of the best lobbyists and/or those who have themselves grown wealthy by making an industry out of yelling "discrimination" over 100 years after the Civil War - in which more Americans lost their lives than in all other American wars combined - was won, and almost 30 years after the triumph of the civil rights movement.

This zero sum game fallacy is the stock in trade of demagogues like President Obama. It encourages people to spend more time envying their fellow citizens and rent seeking from the Congress to redistribute wealth and less time sticking to their own knitting and working hard to get ahead and innovate so that overall productivity in the United States will increase more rapidly. It is the latter, and only the latter, that will increase the wealth of all Americans in the long run.

Ironically it is many of the most wealthy Americans who, through hard work, risk taking, innovation and finding more and better ways to do things who have made enormous contributions to this country not only by "building a better widget" to increase the productivity of their fellow Americans (think the personal computer) but also through charitable giving. Andrew Carnegie, the Rockefellers, Bill Gates, Sam Walton, and Warren Buffett all come to mind.

It is far better for the nation to allow these extraordinary entrepreneurs to distribute their wealth through giving to worthy private charities than to allow Congress to expropriate more and more of that wealth to distribute through a thoroughly corrupt political system in Washington.

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