Cutting Both Ways

There’s a good sentence in Menzie Chinn’s post comparing effective tax rates for the different income quintiles that I wanted to bring to your attention. Here it is:

…there is no obvious correlation between the tax rate applying to the top quintile and per capita GDP growth.

I believe that to be true. I strongly suspect that Dr. Chinn intends that as part of an argument to increase the tax rates of the highest income earners but I think it needs to be emphasized that the finding cuts both ways. “No obvious correlation” is no obvious correlation, neither a positive nor a negative correlation. We didn’t get faster per capita GDP growth by cutting taxes and we won’t get faster per capita GDP growth by raising them. I can’t tell you how often I’ve heard and read the claim by PhD economists (including some Nobel prize winners) that the higher tax rates that prevailed during the Clinton Administration caused the faster growth during the Clinton Administration, a claim I have always found absurd.

We might get faster per capita GDP growth with either a tax cut or a tax increase if it were part of a greater, longterm strategy for doing that but we really don’t do strategy in this country. We do tactics and adjusting the income tax is a weak tactic for improving GDP growth and an awful strategy. More on the tactics/strategy issue later today if I get around to it.

11 comments… add one
  • steve Link

    My own gestalt from readings in this area is that taxes can matter, but they are secondary. Too much time is spent on tax policy and not enough on trade, regulatory and health care policy, just to name a few.

    Just a caveat. I dont think people usually claimed that the Clinton tax rates caused growth, but rather that they did not impede it. Maybe that is what I am reading into what they say since that is what I think.

    Steve

  • Sam Link

    I’m starting to doubt very much the incentive problem for high earners, especially at rates under 50%. It’s very hard to tease out JUST high marginal rates when comparing growth rates. I think the “free stuff” the government offers you is a much bigger work disincentive (and likely affects growth more than high marginal rates).
    Not only that, but the biggest marginal rate problems are closer to the bottom of the income distribution.

  • To my ear there’s a world of difference between saying that “we had faster growth during the Clinton Administration and taxes were higher” and “we had faster growth during the Clinton Administration despite taxes being higher”. They’re saying the former which I read as a claim of causality without feeling the need to establish causality.

  • Dave,

    I’m not sure it really matters either way since a lot of the growth under Clinton was due to a bubble.

    And the tax system is so complex, confusing and subject to individual circumstances I’m skeptical about any broad claims regarding small marginal rate changes. I think the whole debate over whether to raise marginal rates for those making more than $250k a year is a largely pointless exercise that will make little difference either way. It gives our political class the opportunity to grandstand about a side issue instead of working on more fundamental problems.

  • My own gestalt from readings in this area is that taxes can matter, but they are secondary. Too much time is spent on tax policy and not enough on trade, regulatory and health care policy, just to name a few.

    I think a better focus is not just on taxes, but overall fiscal policy. This is what is so messed up in this country. Problem is tackling fiscal imbalances is not something a politician will want to do, ever.

    Could we raise taxes as part of a medium to long term strategy to improve our fiscal outlook? Absolutely. Would it likely help with growth, probably. Large amounts of debt acts as a drag on the economy as it eventually means higher taxes and also raises uncertainty as to when those tax increases will occur. Also you have interest payments that go towards servicing the debt vs. going into productive activities.

  • Drew Link

    When things are generally good, you can have higher tax rates. When things are bad, you can’t. It’s not rocket science.

    BTW Clinton cut the cap gains rate, and we had a tech boom and the start of the housing boom. Taxes matter. It’s just a component of return on capital.

  • steve Link

    “When things are generally good, you can have higher tax rates. When things are bad, you can’t.”

    Who says Keynes is dead? More seriously, Clinton also raised income taxes. Which mattered more and how do you tell? Does cutting cap gains rates lead to bubbles? Wouldnt it be better to have real growth?

    Steve

  • jan Link

    ” Does cutting cap gains rates lead to bubbles? Wouldnt it be better to have real growth?

    And, what generates real growth? More money to invest? If you cut capital gains, people would be more inclined to move money around from their investments, wouldn’t they? And, they would also have more money to move into expansion of investments and business ventures, which would provide growth, jobs etc.

    We had a cousin call us today about selling a duplex in SF and moving it into a bigger apartment building. My husband recommended that if he was serious about this financial move to do it before the end of the year, partly because of the capital gains hit, unless he was to do a tax deferred 1031 exchange.

  • And, what generates real growth? More money to invest?

    This brings up a critical point. Investing in companies that make things and perform services that people want generates real growth in the economy. Investing in financial instruments makes the financial sector grow but, unless that money makes its way into the general economy, doesn’t help it to grow.

    Investing in the financial sector, taking some of the earnings from that out and spending it on cars made in Germany, electronics made in Japan, wine produced in France, and letting the government borrow money to spend on healthcare does not really do a great deal for the general economy of the United States. Basically, there are investments and there are investments.

  • steve Link

    ” If you cut capital gains, people would be more inclined to move money around from their investments, wouldn’t they? ”

    Capital gains rates are very low right now. Why dont low rates work?

    Steve

  • Drew Link

    C’mon Steve.

    Your biases are showing. Surely you have done cash flow forecasting. The cost of raw materials is a problem, higher employment cots a problem, higher interest costs a problem and, oh, higher taxes a problem.

    This is so fundamental it makes my head spin when people deny it out of political bias. You start with capital invested. Then you move to revenue, less every cost associated- raw materials, people, regulatory, interest from financing……. And yes, including taxes. To deny its a diminish,ent of r eturn on capital, and that it isn’t factored in, is quite frankly weird.

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