Myth: Tax cuts spur economic growth.



Fact: High tax rates are correlated with economic growth.







Summary



There is no historical evidence that tax cuts spur economic growth. The highest period of growth in U.S. history (1933-1973) also saw its highest tax rates on the rich: 70 to 91 percent. During this period, the general tax rate climbed as well, but it reached a plateau in 1969, and growth slowed down five years later. Almost all rich nations have higher general taxes than the U.S., and they are growing faster as well.







Argument



Before examining the effect of tax cuts on growth, it should be pointed out that the very premise of this conservative myth -- that growth is good -- is false. The population explosion is adding approximately 1 billion people to this planet every decade. That's nearly the entire population of China. Under the attendant threats to the environment, including global warming and ozone depletion, economists and environmentalists today are increasingly calling for a sustainable economy. It is a sign of how backwards we actually have it that we consider an economy healthy only if it grows, and the faster the better.



Even so, examining this issue is important, because conservatives see growth as an economic goal, and tax cuts as the best way to achieve that goal. So we should study tax cuts for their efficacy in achieving desirable outcomes.



A review of American history makes the opposite case that conservatives would like it to make: high growth usually coincides with high taxes. During both world wars, taxes soared to record heights. And the supercharged economies that resulted produced high growth for decades afterwards. World War I was followed by the Roaring 20s; World War II was followed by the boom times of the 50s and 60s. The reason why wars are good for the economy is a matter of controversy -- one likely theory is that war compels government to invest heavily in manufacturing. Whatever the reason, the point is that these economic boosts occur during a period of unusually high taxation. Hate taxes though they may, people resort to them when their survival is on the line.



The following chart shows economic decline and growth during the Great Depression:

Year %Change in GNP President ---------------------------------- 1930 - 9.4% Hoover 1931 - 8.5 Hoover 1932 -13.4 Hoover 1933 - 2.1 Hoover/Roosevelt 1934 + 7.7 Roosevelt 1935 + 8.1 Roosevelt 1936 +14.1 Roosevelt 1937 + 5.0 Roosevelt 1938 - 4.5 Roosevelt 1939 + 7.9 Roosevelt

As you can see, the Depression worsened under Hoover's watch, and recovered during Roosevelt's. By the beginning of Hoover's presidency, the bottom 80 percent of all American income-earners were off the tax rolls entirely, and the rich were taxed at a record low 25 percent. By the end of 1932 this top rate was raised to 63 percent, and by 1936 it was 79 percent. Roosevelt instituted a vast new array of taxes, including corporate taxes, inheritance taxes, dividend taxes, gift taxes and excise taxes. And he raised them at a faster rate than any president in U.S. history:

Annual Growth of Tax Collections by President (1) President Tax Growth ---------------------- Roosevelt 121.3% Truman 3.7 Eisenhower 2.4 Kennedy 4.8 L Johnson 6.9 Nixon 0.3 Ford 6.4 Carter 3.0 Reagan 2.4 Bush 0.0

During World War II (from 1940 to 1945), the size of the U.S. economy roughly doubled -- the fastest period of growth in U.S. history. And during this era, the top tax rate soared to 91 percent, and the bottom rate to 18 percent -- again, the highest in U.S. history. In 1944, federal taxes reached 21.7 percent of the GDP -- again, the highest in U.S. history.



The U.S. emerged from World War II as the world's only economic superpower. From 1947 to 1973, it experienced phenomenally high growth; the GDP grew at an average of 3.4 percent a year. The top tax rate remained between 88 and 91 percent until 1964; afterwards, the rate was reduced to 70 percent, still stratospheric by today's standards.



The economy slowed down after 1973, for reasons that economists are still debating. But what is not debatable is that taxes started falling for the rich in 1978 (with a capital gains tax cut). Reagan accelerated these cuts with a vengeance: the top income tax rate was slashed from 70 to 28 percent. Bush and Clinton raised them somewhat, to 39.6 percent today. But that is still roughly half of what it was during the 50s and 60s.



And growth since 1973? It has remained stuck in low gear, dropping from 3.4 to 2.5 percent a year. Individual worker productivity has taken an even more severe hit, dropping from 2.8 percent in the postwar years to about 1 percent after 1973. Some point to the Reagan expansion (that is, the upturn in the business cycle that occurred between 1983 and 1989) as proof that low taxes result in boom times, but this claim is easily disproven. Reagan's expansion averaged 3.6 percent annual growth; earlier postwar expansions averaged 4.5 percent. Correlation is not causation, of course, but the point is that lower top rates on the rich have done nothing to revive the extraordinary growth of the postwar years.



But if changes in the top tax rate apparently have no effect on the economy, what about general rates? Since World War II, federal tax collections have remained surprisingly stable, fluctuating within a few points of 18 percent of the GDP. However, this is not the complete picture. State and local taxes have been steadily rising since World War II, which resulted in a steadily growing tax burden until 1969, when tax collections reached a plateau that has not changed since. Interestingly, the economy slowed down 5 years later:

Government Receipts, Combined, Federal, State and Local (Percentage of GDP) (2) Year Combined Federal State and Local ------------------------------------------ 1947 22.9% 17.3% 5.6% 1948 22.6 16.8 5.8 1949 21.1 15.0 6.1 1950 21.4 14.8 6.6 1951 22.7 16.5 6.3 1952 25.7 19.4 6.2 1953 25.5 19.1 6.4 1954 25.7 18.9 6.7 1955 23.9 17.0 6.9 1956 25.0 17.9 7.0 1957 25.6 18.3 7.3 1958 25.4 17.8 7.6 1959 24.2 16.5 7.7 1960 26.2 18.3 7.9 1961 26.6 18.3 8.4 1962 26.4 18.0 8.4 1963 26.8 18.2 8.6 1964 26.7 18.0 8.7 1965 26.1 17.4 8.7 1966 26.6 17.8 8.8 1967 27.5 18.8 8.8 1968 27.4 18.1 9.4 1969 29.8 20.2 9.6 < tax plateau reached 1970 29.7 19.6 10.2 1971 28.1 17.8 10.3 1972 28.9 18.1 10.9 1973 29.0 18.1 10.8 1974 29.5 18.8 10.7 < economy slows down 1975 29.3 18.5 10.8 1976 28.5 17.7 10.8 TQ 28.3 18.3 10.1 1977 29.4 18.5 10.9 1978 29.2 18.5 10.7 1979 29.1 19.1 10.0 1980 29.6 19.6 10.1 1981 30.2 20.2 9.9 1982 30.0 19.8 10.3 1983 28.6 18.1 10.5 1984 28.6 18.0 10.5 1985 29.1 18.5 10.6 1986 29.0 18.2 10.7 1987 30.1 19.2 10.9 1988 29.6 18.9 10.7 1989 29.9 19.2 10.7 1990 29.5 18.8 10.7 1991 29.5 18.6 10.9 1992 29.5 18.4 11.1 1993 29.6 18.4 11.2 1994 30.0 19.0 11.1 1995 30.4 19.3 11.0

Conservatives might interpret this chart to mean that the tax burden became so heavy that the economy stumbled. However, another explanation is entirely plausible. Recall E.H. Carr's analogy about road systems: at the turn of the 20th century, there were so few road signs and traffic laws because there were so few cars. However, as roads became more heavily traveled, more traffic lights and laws became necessary to maintain safety and smooth functioning. And this has happened to our economy as well: it has become larger, faster, more complex and interdependent. As long as government could grow to provide it with the traffic lights and laws to ensure smooth functioning, it could continue to grow. Once government stopped growing, the economy followed suit five years later, as indicated by the above chart.



Another explanation, less partisan but certainly as plausible, is that economies grow quickest when they are undeveloped, and when they mature they slow down. A good analogy is that of an infant growing faster than a teenager. But what constitutes "development" in an economy? Many economists believe it is the utilization of technology. For example, World War II saw a burst of scientific inventions and productive technology. That would increase productivity, much like inventing a sewing machine would increase a seamstress' work from one to five shirts a day. But there are upper limits to technology. Once a seamstress hits five shirts a day, she will not be able to increase her number much more than that, due to the limitations of the sewing machine. This may have been what happened in the U.S. in 1973; the thousands of technologies created during World War II played themselves out suddenly, and growth slowed down dramatically.



There is excellent evidence to this effect. When the U.S. emerged from World War II, it had the largest and best-functioning economy in the world. The other industrialized nations lay destroyed, and had to start rebuilding from scratch. Although the U.S. has remained the most prosperous nation in the world ever since, these other nations have been growing faster than the U.S. And they have been doing so with far higher tax rates! Consider:

Tax collections (percent GDP, 1991) (3) Country % GDP ---------------------- Sweden 53.2% Denmark 48.3 Norway 47.1 Netherlands 47.0 Germany 39.2 Finland 37.7 Canada 37.3 Japan 30.9 United States 29.8 Individual worker productivity, comparison of other nations to U.S. (U.S. = 100 percent) (4) Percent of U.S. individual worker productivity (U.S. = 100%) Country 1950s 1960s 1970s 1980s 1990 ------------------------------------------------ United States 100% 100 100 100 100 Canada 77.1 80.1 84.2 92.8 95.5 Italy 30.8 43.9 66.4 80.9 85.5 France 36.8 46.0 61.7 80.1 85.3 Germany 32.4 49.1 61.8 77.4 81.1 United Kingdom 53.9 54.3 58.0 65.9 71.9 Japan 15.2 23.2 45.7 62.6 70.7

What all this shows is that growth is not absolutely correlated with taxes, and both liberals and conservatives have problems in trying to make a case. Far more serious factors affect growth, although, in truth, economists do know exactly what they are. Nobel laureate Robert Lucas, one of the world's most famous conservative economists, has spent over a decade looking for the secret to economic growth, and has not found it. Nobel-bound Paul Krugman, one of the world's most famous liberal economists, admits that the mystery of growth is "deep and poorly understood." People who claim that tax rates affect growth are not serious economists; more often they are journalists, radio-talk show hosts, politicians and other types of snake oil salesmen with easy solutions to complex problems. You can dismiss their bumper sticker slogans with perfect confidence.



Fortunately, there is a policy implication in all this. If taxes have such a weak effect on growth, then we should consider tax cuts or hikes for their other effects, like income distribution or alleviation of poverty. Conservatives can no longer decry these programs on the basis that they will harm economic growth, since these assertions are completely unfounded.



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Endnotes:



1. Here is the expanded version of this chart, showing how the figures are derived:

President Years # Prev yr Last yr Increase Inflation Adjusted Revenue Revenue average Roosevelt 34-46 13 $ 2.0 $ 39.3 1865.0% 50.8% 121.3% Truman 47-53 7 39.3 69.6 77.1% 36.9% 3.7% Eisenhower 54-61 8 69.6 94.4 35.6% 11.9% 2.4% Kennedy 62-64 3 94.4 112.6 19.3% 3.7% 4.8% L Johnson 65-69 5 112.6 186.9 66.0% 18.4% 6.9% Nixon 70-75 6 186.9 279.1 49.3% 46.6% 0.3% Ford 76-77 2 279.1 355.6 27.4% 12.6% 6.4% Carter 78-81 4 355.6 599.3 68.5% 50.0% 3.0% Reagan 82-89 8 599.3 990.7 65.3% 36.4% 2.4% Bush 90-93 4 990.7 1153.5 16.4% 16.5% -0.0%

Source: U.S. Office of Management and Budget, Historical Table 2.1, Budget for FY 1997. Chart derived by Steve Casburn.



2. Office of Management and Budget, Budget of the United States Government, Fiscal Year 1997, Historical Table 15.1



3. Organization for Economic Cooperation and Development, Paris, France, Revenue Statistics of OECD Member Countries, 1991.



4. Where We Stand, by Michael Wolff, Peter Rutten, Albert Bayers III, eds., and the World Rank Research

Team (New York: Bantam Books, 1992), p. 143.