One of the topics we cover in
In this post, I want to begin to address causality. As we stated in the book and as I’ve since said a few times, I don’t think higher tax burdens in and of themselves cause faster economic growth, but rather that increasing tax burdens are correlated with some other criteria that create conditions that help produce economic growth.
But let us start by addressing the issue of timing first. A number of people have indicated in comments or offline that perhaps the reason for the strong correlation between tax burdens and economic growth could be because when the economy is growing rapidly, Presidents feel comfortable boosting taxes.
I’ve pointed out a few a problems – theoretical and empirical – with this line of argument, but I think I can illustrate it best with a simple graph. Since 1929, the first year for which data is available from the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables, there have been five Presidents that have served an eight year or more term: FDR, Ike, Reagan, Clinton and GW. Additionally, there are several more “quasi-eight year terms.” These are instances in which a VP took over upon the death or resignation of the President and maintained a similar a policies similar to those of his predecessor (JFK/LBJ and Nixon/Ford), or in which a VP took over a mere few months into a new terms and thus could put his own stamp on just about the entire eight years (Truman).
The graph below shows the change in the tax burden in the first two years of each administration on one axis and the growth in real GDP per capita during the remaining six years of each administration on the other axis.
Notice… increases in the tax burden in the first two years of an administration tend to be followed by rapid growth during the remainder of that administration. Conversely, administrations that greatly decreased the tax burden during their first two years suffered from poor economic growth during their remaining six years. This relationship, at least, is very difficult to explain by insisting that administrations which enjoyed rapid growth simply were more able to raise tax burdens than administrations which grew more slowly. It is also impossible to explain by anything said by anything you hear out of the Austrians or the Chicago school.
(Incidentally – I have a simple explanation for why some administrations appear above the regression line and some below. I know that it applies to the administrations that begin in 1952 because I’ve written about it in the past. I’ll collect the data going a bit further back and some time in the future will write a post on that.)
So what is going on here? Michael Kanell and I advanced several theories in
Notice that among the Presidents to increase the tax burden are some who raised marginal tax rates (FDR, Clinton), others who decreased it (LBJ), and others still under whom marginal tax rates didn’t change. Similarly, tax burdens fell under some Presidents who cut marginal rates (Reagan, GW), Presidents who raised marginal rates (Bush Sr.), and others who left it unchanged. And for tax burdens to fall at a time of increasing marginal rates really requires more people avoiding taxes they legally owe. Similarly, for tax burdens to rise at a time of decreasing marginal rates one would need more people paying the taxes they legally owe. Thus, enforcement.
Furthermore, an administration willing to turn a blind eye toward one set of laws and regulations is probably more than willing to turn a blind toward other rules and regulations. It is not a coincidence that aren’t keen on tax collection also tend to view the government as the problem and not the solution.
Now, corruption (and let’s call it what it is) is a tough thing for which to test. But I think I there are signs that often appear among corrupt regimes, and one of them is the displacement of private sector by the government. Running an honest business when the government is dishonest is very difficult. The government will side with its favorites and everyone else will have a tough time. It becomes easier to make a buck by playing legal technicalities than by actually doing something useful. This is not to say that some countries do not succeed in having large government sectors without remaining honest and transparent – I suspect Denmark and Singapore are examples of that, though I’m not all that familiar with data for those countries. But we are not Denmark, and if a regime populated with flacks who insist they believe in small government takes over a growing piece of the economy despite taking steps to “encourage the private sector” it probably isn’t a good sign.
So with that… the next graph shows changes in the tax burden in years 1 and 2 on the one hand, and changes in the size of the federal government’s expenditures as a share of GDP during the remaining six years on the other hand.
Notice that administrations that started off by cutting the tax burden also went on to increase the government’s share of the economy. That relationship is stronger and more evident if one looks at changes in the tax burden in the first four years of an administration against changes in the size of the federal government during the remaining four years.
Clearly, in general, the more an administration cut the tax burden in its early years,
Notice also that the relationship is stronger for the four post-War Presidents that served a full eight years than for the entire sample. A switch in administrations could lead to a break in our little “lower taxes as a sign of corruption shrinks the private sector” story. I note also something else… take a look at where FDR sits on the graph above. Does that fit with the accepted FDR narrative in this day and age?
Which leads me back to corruption. If cuts in the tax burden are a sign that the federal government is tolerating corruption, one would expect that administrations that start off by cutting that burden would end by seeing the private sector shrink relative to the public sector. And that is precisely what we have seen.
Do you have a better explanation?
Data sources and comments.
The definition of the tax burden used in this post is Federal government current receipts from line 1 of NIPA Table 3.2divided by GDP from NIPA Table 1.1.5, line 1. Real economic growth was measured as the change in real GDP per capita, which was obtained from NIPA Table 7.1, line 10. The government’s share of the economy is measured the federal government’s current expenditures (line 23 of NIPA table 3.2) divided by GDP.
Note that in past posts I have tended to only consider the first eight years of the FDR administration to avoid even getting close to the war years. As noted in previous graphs, even leaving out the years after 1938, FDR oversaw the fastest economic growth or any President for whom there is reliable data available. However, in this post, I was trying to remain consistent by sticking to 8 year stretches of data. Note also that, as shown in the fourth graph, the federal government’s share of the economy actually shrunk from 1936 to 1940.
Growth rates are measured from the year before a President took office to his last year in office.
Note also… if its not obvious, this post deals with the tax burden, the share of GDP going to the Federal government, and not marginal tax rates. Please do not insist on commenting on a topic unrelated to this post.
Posted by Mike Kimel, June 20, 2010.
Update… “Growth rates are measured from the year before a President took office to his last year in office.” added June 21, 2010.
Cross posted at Angry Bear.