Debunking the claim that higher income-tax rates reduce GDP.

Making government work better.
Feb. 23 2010 3:39 PM

Tax Fraud

Debunking the claim that higher income-tax rates reduce GDP.

The American debate over taxes is ferocious and highly partisan. Some, mostly Republicans, reflexively oppose all taxes. Others, mostly Democrats, decry the lack of progressivity and fairness in the tax system and favor higher tax rates for the wealthy.

This debate isn't new. The same arguments have been repeated, with the same passion, since our income tax system was created—first during the Civil War and then—after its initial rejection by the Supreme Court—following the ratification of the 16th Amendment in 1913.  A wonderful book by Steven Weisman, The Great Tax Wars, brings this history to life.

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But as Weisman makes clear, one thing has changed in a spectacular manner, and that is the American public's—and American politicians'—willingness to defend high marginal income-tax rates as an essential and proper way to pay for the cost of government. Until a generation ago, many Americans and their representatives argued vehemently that the wealthy ought to pay more in taxes, but that position has drastically declined in popularity. Weisman sets the debate in the context of the battle between those who invoke justice—progressive taxes create equity and hence justice—and those who invoke virtue—the belief that hard work should be rewarded and taxing higher income at an elevated level creates a disincentive to the hard work we should promote.

Leaders of a century ago invoked justice in remarkable language that is unimaginable today. President Woodrow Wilson called paying taxes "a glorious privilege." Supreme Court Justice Oliver Wendell Holmes Jr. observed that "taxes are what we pay for civilized society." In 1942, President Franklin Roosevelt said, "In this time of grave national danger, when all excess income should go to win the war; no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000." That $25,000 is the equivalent of $323,208 in today's dollars. Can you conceive of a modern president suggesting that no American should earn more than $323,000 after taxes?  (President George W. Bush went to war twice without once calling for such a common sacrifice to pay for it.) And President Harry Truman in 1948 vetoed a broad-based tax cut, even in the face of an expected and eventual congressional override, and then asked for a tax increase following his upset victory.

But President Ronald Reagan transformed our conversation about government and turned taxes into the enemy of progress. It is commonly thought that President George H.W. Bush's violation of his "read my lips" pledge cost him re-election and President Bill Clinton's 1993 tax increases cost him control of Congress.

Central to the intellectual debate about marginal tax rates has been the question of whether higher rates discourage people from working. President Reagan is famously reported to have observed that, as an actor, once he hit the top marginal rate—then 91 percent—he stopped making movies for the rest of the year. The result of sky-high marginal rates, this anecdote was supposed to prove, was declining productivity and economic growth.

Is this true? Let's look at a graph of the nominal top marginal tax rate in any given year and GDP growth in that year.

86_marginalgrowth

A caveat—obvious but critical—is in order. Simultaneity does not equal causation. Annual growth rates are a consequence of many factors, macro and micro, and the isolated impact of marginal tax rates on growth is hard, if not impossible, to discern from these numbers alone.

That said, it's obvious that there is no correlation between higher marginal tax rates and slowing economic activity. During the period 1951-63, when marginal rates were at their peak—91 percent or 92 percent—the American economy boomed, growing at an average annual rate of 3.71 percent. The fact that the marginal rates were what would today be viewed as essentially confiscatory did not cause economic cataclysm—just the opposite. And during the past seven years, during which we reduced the top marginal rate to 35 percent, average growth was a more meager 1.71 percent.