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I wrote most of what follows in the anticipation of trying to get it accepted as an op ed at a newspaper, but I guess the deal cut the other night means a bit of it needs rewriting…

On January 1, 2011, the “Bush tax cuts” will expire and individual marginal tax rates, the percentage of income individuals pay in taxes to the federal government, will return to Clinton-era levels. The political consensus seems to be that the tax cuts should be kept for most taxpayers, but there is disagreement about whether to let the highest marginal tax rate expire. That rate applies to the portion of a high-income earner’s revenues that are in excess of some large amount – $250,000 and $1 million have been recently floated as thresholds. But, aside from rhetoric about fairness peddled by both sides in the debate, what difference does it make to the economy whether the top marginal rate goes up or not? A little history can help make it easier to understand what is at stake.

When Ronald Reagan was elected president in 1980, the top marginal tax rate was 70%. By 1988, the top marginal tax rate had been reduced to 28%. More importantly, Reagan changed the longstanding political landscape when it comes to taxation. While the top marginal rate was never below 70% between 1936 and 1980, it has not gone above 39.6% in the years since Reagan left office.

But if Reagan’s philosophy prevailed, it is fair to ask: have his tax policies generated the promised results? Lower taxes were supposed to usher in an era of faster economic growth and increased prosperity. However, while the economy did better under Reagan than it did under the three presidents who preceded him, Reagan-era growth could hardly be called impressive. Real GDP (i.e., GDP adjusted for inflation) grew more slowly under Ronald Reagan than during the eight years presided by JFK and LBJ, and slower even than during any consecutive eight year period in which Franklin Delano Roosevelt was president. FDR, it should be noted, raised the top marginal tax rate four times, from 63% to 94%.

But perhaps it is unfair to compare Reagan to big-government types like Lyndon Johnson or Roosevelt, as they served during very different eras. Focusing instead on more recent periods, real GDP also grew faster under Bill Clinton, who raised taxes, than it did under Ronald Reagan. In fact, from 1981 to the present, the period in which Reagan’s philosophies have reigned triumphant, the correlation between the top marginal tax rate and the annual growth in real GDP has been positive. That is to say, higher top marginal tax rates have been associated with faster, not slower real economic growth. Conversely, lower top marginal tax rates have coincided with less economic growth.

The positive relationship between the top marginal tax rate and the growth in real GDP is very nearly bullet-proof. For instance, it extends all the way back to 1929, the first year for which the government computed GDP data. Additionally, higher marginal tax rates are not only correlated with faster increases in real GDP from one year to the next, but also with increases in real GDP over the subsequent two, three, or four years. This is as true going back to 1929 as it is for the period since Reagan became president. In fact, since the Reagan Revolution took hold, similar relationships have existed between the top marginal rate and several other important variables, like real median income, real private investment, consumer sentiment, the value of the dollar relative to other major currencies, and the S&P 500. Lower tax rates in any given year are associated with slower growth rates for each of these variables, whether those growth rates are measured over periods of one, two, three or four years.

On the flip-side, since 1981, unemployment rates have generally shrunk faster when tax rates were higher than when they were lower. As with the other economic measures, this relationship holds whether one is measuring the change in unemployment over a single year, over two years, over three years or over four years.

None of this means that higher taxes cause better outcomes. Still, it is clear that the supposed negative repercussions from higher taxes simply have not materialized, notwithstanding pronouncements from politicians, pundits and economists. The reason is simple: those who are both willing and able to engage in tax avoidance when subject to a 40% marginal rate are not likely to behave any differently when that rate changes to 50%, or 30% for that matter. But at a slightly higher top marginal rate, the government does get more revenue, and in this way can finance more spending on things that benefit the economy, such as infrastructure, public health, scientific research, education, alleviating poverty and of course, IRS audits. Thus, allowing the top marginal rate to rise from current rates (35%) to the level they were under Bill Clinton (39.6%) is unlikely to harm the economy, and may actually help.

As always, if anyone wants my spreadsheet, drop me a line at my first name (that would be “mike”) period my last name at gmail.com. If anyone wants the op ed (changed to reflect whatever deal conditions are applicable at the time), ditto.

And finally, one question – why didn’t I read any op eds like this in the newspapers in the last few weeks and months?

9 Responses to “The Effect of Changing Top Marginal Tax Rates – an op ed free to a good home”

  1. tony o says:

    I will just answer your last question…

    “And finally, one question – why didn’t I read any op eds like this in the newspapers in the last few weeks and months?”

    do you know any people making less than $200K or $ 1 million who own newspapers? that’s why.

    great blog btw.

    • Mike Kimel says:

      tony,

      Yes, but many newspapers have a reputation as being liberal. And some published op eds against extending the top marginal rate. I think the problem is that the people who can write an op ed like this – namely, people with a bit of knowledge of statistics and some experience with economic data (i.e., economists and some fellow travelers) do not write op eds of this nature. Why not?

  2. Darrin says:

    Mike,
    Great blog. I would like to add one other important thing that Reagan did while in office. Under his leadership, he was able to transition conventional wisdom from a “stick it to the rich” philosophy to a “stick it to the poor” philosophy. Ever since it has been acceptable to state implicitly or explicitly that the poor are lazy and the rich create jobs. He also introduced the intellectually lazy argument that it is not the consumer that drives the economy, but the supplier (supply-side economics). Even in today’s debate, we are to believe that business will hire workers and expand operations not due to increases in demand for their goods or services (from increased consumer spending), but because of lower taxes and confidence that the government will not regulate them in the future. And as long as the arguments stay ideological, there is no need for actual data or your spreadsheet.

    In addition to GDP, I would love to see your data on debt spending as correlated to the top marginal tax rate. I have a feeling we will see similar results.

    • Mike Kimel says:

      Thanks for the kind words. And I agree with your first paragraph.

      As to debt… it may take a bit for it to work its way to the top of the to do list. That said, there’s a reason I didn’t play with debt data for this post – I have had a lot of posts on debt in the past at the Angry Bear blog. They were not related to taxes, but there were enough of them to get a feel for the data. My suspicion is that things are a bit more complex with timing when you’re talking about debt. To use words of a former boss and friend of mine about some data sets, debt is big, fat and slow moving. It doesn’t change trajectory quickly – you’d think the change in debt = surplus or deficit, but the accounting is a bit more complicated. In other words, I suspect the lags relating taxes to debt are longer and more variable than for some of the other variables I checked in the post.

  3. John Burbank of the Economic Opportunity Institute has a column in today’s Everett Herald that touches on your point: http://www.heraldnet.com/article/20101208/OPINION04/712089954

    ~Aaron Keating, Communications Director, EOI

  4. [...] stuff we’ve been led to believe over non-cherry picked data sets. Recent examples include this look at the effect top federal marginal rates on various measures of growth, this look at the effect of top federal marginal rates on tax revenues, a different look at federal [...]

  5. [...] results that fail to abide by the most basic economic theory. This is true for data at the national level and at the state and local level. Making matters more uncomfortable (and thus explaining all the [...]

  6. [...] growth, but rather with faster increases in real GDP. In fact, raising top marginal tax rates doesn’t have many of the effects many people seem to expect (And incidentally, its worth noting that state level data also produces results the Chicago school [...]

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