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I had a post the other day noting that the correlation between top marginal rates and real GDP per capita is positive. Depending on how you look at it (i.e., growth over several years, growth over one year, going back to 1929, focusing only on the period since Reagan took office, etc) that correlation might be small or it might go above 50%, but it is positive. That is to say, higher top marginal income tax rates have not caused with slower real economic growth in this country. Not the message you’ll get from most economists, but the data says what the data says, and where economists disagree with the data, its a sign that something is seriously wrong with the profession, not the data. (Note – the post appeared at the Presimetrics blog and at Angry Bear, and was in response to an op ed piece by Greg Mankiw noting that higher marginal income tax rates would dissuade him from working.)

Now, in that post I didn’t explain why higher top marginal income tax rates haven’t reduced growth, and may have, at times, dare I say it, actually been a force for faster real economic growth. So I’m going to cover that here.

To start with, there is no question that if you tax someone’s efforts enough, they will reduce their efforts. Any answer that is true will have to be consistent with both that statement and the facts (i.e., the positive correlation between top marginal income tax rates and real GDP per capita growth). I can think of several such answers, and I believe all are true to some extent. Now, before I lay out these answers, there is something I should note. I’ve listed these answers in order, from more believable and less important to less believable and more important. The reason I think most people will find the most relevant explanations most believable is that they don’t quite believe that pesky fact, that the correlation between top marginal income tax rates and real GDP per capita is positive. With that warning, here goes:

1. Top marginal tax rates are simply not high enough to induce people who pay it to reduce their efforts. That’s an answer a number of bloggers (Mark Thoma is a good example) gave in response to Mankiw; raising the top marginal tax rate from 35% to 39.6% shouldn’t change Mankiw’s behavior much at all as the difference probably amounts to peanuts for Mankiw. That may be true, but it does nothing to explain why growth rates were highest during periods when marginal tax rates were in the 70% range and up.

2. Dissuading people from putting in certain efforts doesn’t prevent others from putting in the same efforts. Linda Beale is one of several bloggers to note that others might happily step in to do Mankiw’s job should he choose. I’m sure this is not what Linda Beale had in mind when she wrote it, but finding people willing to give policy advice that contradicts the known facts and results in sub-part growth shouldn’t be all that difficult, frankly.

3. Rising top marginal tax rates may dissuade some people from working, but generally won’t dissuade those doing productive work. This is related to explanation 2, but it is subtly and importantly different. Simply put, most people are easily replaceable. Charles De Gaulle famously said “The cemeteries of the world are full of indispensable men.” By that, I imagine he meant that in general, most people are easily replaceable. That holds even for folks who are deemed irreplaceable; I suspect if you replaced almost everyone working for the Fortune 100 or the Ivy League tomorrow, the change would be un-noticeable pretty quickly. (An exception appears below.) Now, there are some people that genuinely are irreplaceable, that genuinely do change things, but there aren’t many of these people, and beyond a certain point, they aren’t motivated by money. Heck, most of them don’t end up all that wealthy despite being irreplaceable, and those few unique innovators that do accumulate vast fortunes (Steve Jobs would probably be an example) would happily do what they as long as they were making enough to meet some relatively basic needs. The few people who can’t be replaced if they upped and quit because the big bad gubmint raised their taxes aren’t the sort of people to go Galt in the first place.

4. A substantial percentage (and no, I don’t know what percentage that is) of people who are motivated enough by money that they might reduce their output in the face of even small changes to the top marginal rates are engaged in activities that are not good for society. For example, they might be Harvard professors who peddle theories that are 180 degrees opposed to reality. Or perhaps they develop or implement financial instruments that help bring down the world economy. There is a bit of a self-selection bias at play; people who care enough about money to become homo universitus of chicagus are also the kind of people willing to generate massive negative externalities with nary a thought to the victims (except perhaps to call them “losers”). Loss of their services is to be encouraged, not decried.

5. At the margin, the gov’t can be more efficient with resources than many people whose needs are sated. The primary motivation for such folks may be not risking what they accumulated and paying as little in taxes as possible. The result, in many cases, is paying vast sums to accountants and keeping the money parked or hidden rather than in productive use.

Anyhow, that’s what I came up. Your thoughts?

6 Responses to “Discouraging Greg Mankiw From Working Would be Good for the Economy, Part 2: Why the Correlation Between Top Marginal Rates and Real Economic Growth is Positive”

  1. Kaleberg says:

    You missed the most obvious argument. The people in the higher tax brackets spend a much lower percentage of their income than people in the lower tax brackets. Spending in this case includes business investment as well as personal spending. This should be obvious. Profitable companies take in more money than they spend. Well paid individuals tend to earn more than they spend so they can accumulate wealth. (There are exceptions, but they are rare.)

    Since the government will likely spend every cent it can get its hands on, lowering marginal tax rates removes money from the effective economy, that is the economy of goods and services, and moves it into the world of finance, symbols and bubbles. Tax cuts for the rich basically has a multiplier of less tha one. Raising marginal tax rates puts that money into the economy of goods and services and effectively has a multiplier much larger than one.

    If you think of the economy as a system, the money flows around and around, but like many systems it can be characterized by its internal resonances. Think of those input-output models developed during WW2. Now take the eigenvalues of one of those model matrices. Those are the model growth rates. When taxes are too low, the eigenvalues are less than one and the system runs down. This happens in rich countries and poor ones. In fact, it happens more often in poor countries and explains a lot about the third world and various societies in history. Money is the ability to command goods and services. When there isn’t enough flowing at all levels of the economy, the economy suffers heat death and eventually shuts down.

    This argument is an old one. It was used a lot to justify the New Deal. I agree at least in part with your other arguments, but I am surprised that this one is missing. You’ll notice that it also explains the red state-blue state wealth paradox

    P.S. You should consider the ratio of GDP per capita to the median wage to get a sense of an economy’s health. The GDP per capita isn’t really a useful number.

  2. Mike Kimel says:

    Kaleberg,

    The MPC arguement is often given, but it misses a point, namely that unless its kept in cash money that isn’t used is essentially loaned out whether its kept in a money market fund, the bank, or in bonds. The borrower then uses the money for something. Thus, it becomes an issue of having a slower velocity (i.e., it takes a while for that money to get used for the “first time” for something more than just being exchanged for other paper), which is fine but I suspect it isn’t as big of an effect as people think.

    As to the health of the economy – I think you may be right, but then I’d have an argument about the value of that measure on my hands. Most people accept that growing the whole economy is a good thing.

  3. [...] Discouraging Greg Mankiw From Working Would be Good for the Economy, Part 2: Why the Correlation Between Top Marginal Rates and Real Economic Growth is PositiveCross posted at the Presimetrics blog. [...]

  4. Peter van der Linden says:

    > “consider the ratio of GDP per capita to the median wage
    > to get a sense of an economy’s health. The GDP per capita
    > isn’t really a useful number.”

    Normalizing for inflation should take care of this. Inflation adjusted GDP per capita is the number you want.

  5. Ryan F. says:

    I did something similar to what you did with top marginal income tax rates for the long-term capital gains tax rate for the period 1981-2009. Conservatives often place particular emphasis on cutting taxes on capital income.

    http://workingsocialism.blogspot.com/2010/10/capital-gains-rate-and-economic-growth.html

    The results get weaker if you use effective tax rates instead of top rates and if you go back to 1954 (the first year the Tax Policy Center provides a number for). But almost any way you slice it, there’s at least a small positive relationship between capital gains rates and economic growth. I wouldn’t say these results prove anything, but they do give conservatives even more explaining to do.

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