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On Taxes and Theories

There’s a popular theory about taxes and economic policy that has been so effectively espoused (primarily by Republicans) since the early 1980s that it has been accepted as fact to many in America. It’s a pretty simple theory: lower taxes equal higher growth; higher taxes equal slower growth.  It’s a pretty common sense theory.  It’s based on sound mathematics.  I’m an economics major, myself. I’ve personally done multiple calculus problems that indicate that higher taxes are bad and lower taxes are good.

However, those math problems are extremely limited, and their results are theory, not fact.  You see, in basic economics, incomplete models are used. Models that are based on a lot of assumptions about reality that rarely hold true. I’m not saying that economists are hacks. Heck, I’m spending thousands of dollars in order to become a bit of one, myself.  What I am saying, however, is that math problems give you models and theory. Observations give you evidence and facts.  And it doesn’t take a very thorough examination of the evidence to see that this theory is not even close to a universal truth.

Take a look at this chart for instance.

I’m sorry if you have to click on it or zoom in for clarity, but it’s pretty simple. The top line is the top tax rate at the time.  The bottom line is the economic growth in terms of GDP adjusted for inflation. The GDP data comes from the World Bank and the historic tax rates come from the Tax Policy Center.

What you’re looking for here is how changes in the tax rate–the top line–affect changes in the growth rate–the bottom line. Anything above zero on the lower line represents economic growth. You’ll see that in the 1960s, the tax rate was anywhere between 70 and 91%. That’s astromonically high, and yet throughout the 1960s, there was positive economic growth.  The 1970s are a bit trickier, as the energy crisis hit in the middle of the decade.  But aside from that, you’ll see that on either side of the energy crisis downturn, growth was positive and high, despite high tax rates.  The 1980s are interesting. The first round of massive tax cuts under President Ronald Reagan did indeed fuel a jump in economic growth.  The second round, in 1986, however, seemed to have the opposite impact, as they were followed almost immediately by an economic slowdown.  In the 1990s, the tax rate went up, and so did economic growth. And finally, in the 2000’s, tax rates were again lowered, and the economy did not experience growth.

Here’s a quick and easy breakdown by decade. Notice that despite MUCH higher taxes, the average annual growth rate was higher in the 1950s and 1960s than it has been since.

Of course, there are other factors at play than just tax rate. But it’s pretty clear that the cut-and-dry relationship of “high taxes: bad, low taxes: good” simply does not exist. My own theory is that the idea of lower taxes and higher growth applies at some levels and then reaches a point of diminishing returns (economists love diminishing returns). This just means that when the tax rate was very high, a drop in taxes did, in fact, spur growth.  However, as the rate was lower, you could achieve less growth via a cut–and it possibly could get to the point at which lowering taxes actually inhibits growth (this is because it leads to higher deficits, but I won’t get into all of that). This might explain why, in the 1960s and 1970s, tax cuts and tax hikes do indeed appear to match up with growth spikes or growth slow-downs, but after the 1980s, when the tax rate had already been lowered beyond its useful level, the correlation between tax rate and growth rate seems to evaporate.

I don’t want this to get too wonky or bore readers with charts and numbers like an old Ross Perot campaign video. But I do want to present this simple economic history as a counter to the prevailing belief in the aforementioned economic tax theory. While my data does not conclusively prove any specific relationship between tax rate and growth rate, it does conclusively disprove the rhetoric that economic growth will be slow or negative if tax rates are high and that lowering tax rates will automatically lead to greater economic growth.

I’m not suggesting that the tax rates should go back up to 70% or anything. But when a country is experiencing this amount of debt and deficit while collecting a historically low amount of tax revenue (as a percentage of GDP), I think it is worth putting out there that the benefits of lower taxes are not as advertised, and the detriments of higher taxes may be incorrect or exaggerated, as well.

So the next time you hear a Republican tell you that evolution is “just a theory,” make sure he or she knows that their party’s tax policy is just a theory, as well–and unlike evolution, the tax policy theory is defied by the facts rather than supported by them.

Categories: Politics Tags: , , , ,
  1. Mike
    April 16, 2012 at 1:26 pm

    Great Post! Even better closing.

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