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