Nominal Tax Rates Mean Nothing

Peter Diamond and Emmanuel Saez have an op-ed in the Wall Street Journal in which the two economists advocate for a higher top tax rate in the United States. How high? 50 to 70%. In essence their argument is that the higher tax rate won’t reduce economic growth. Here’s the meat of it:

In the postwar U.S., higher top tax rates tend to go with higher economic growth—not lower. Indeed, according to the U.S. Department of Commerce’s Bureau of Economic Analysis, GDP annual growth per capita (to adjust for population growth) averaged 1.68% between 1980 and 2010 when top tax rates were relatively low, while growth averaged 2.23% between 1950 and 1980 when top tax rates were at or above 70%.

Neither does international evidence support a case for lower growth from higher top taxes. There is no clear correlation between economic growth since the 1970s and top tax-rate cuts across Organization for Economic Cooperation and Development countries.

For example, from 1970 to 2010, real GDP annual growth per capita averaged 1.8% and 2.03% in the U.S. and the U.K., both of which dramatically lowered their top tax rates during that period, while it averaged 1.72% and 1.89% in France and Germany, which kept high top tax rates during the period. While in no way does this prove that higher top tax rates actually encourage growth, there is not good evidence from the aggregate data supporting the view that higher rates slow growth.

Frankly, I’m skeptical of their reasoning. After World War II the United States was the only major nation with a functioning industrial economy. The damage from war was still evident in the UK, France, Germany, and Japan for nearly two decades after the war had ended. That the U. S. should grow robustly while these economies rebuilt would be expected. That the growth would slow after these economies had recovered should also be expected.

American industries didn’t have a great deal of competition from British, French, German, and Japanese competitors for decades after the war and no competition whatever from Chinese competitors until after 1980. The circumstances really are different today than they were when the top rate at which we taxed income was 90%.

Additionally, the pattern of U. S. growth is drastically different from that of the UK, France, or Germany. I’ve published this information previously: U. S. growth has been remarkably steady over an amazingly long period while British, French, and German growth have waxed and waned. International comparisons are truly irrelevant.

Nowadays economics seems to be about telling a story. Drs. Diamond and Saez’s story is that high marginal tax rates produce growth. Note that the correlation they point out could also mean that higher marginal tax rates are more tolerable when growth is robust. That’s clearly not the story they’re telling so, consequently, they’re saying that high marginal tax rates produce growth.

Here’s my story. U. S. economic growth has grown incomparably throughout its history. However, on average over the last 50 years U. S. growth has been slowly but steadily slowing. From now on each additional bit of growth will require more investment in capital, time, energy, and so on than the bit that came before. Growth hasn’t stopped but it will be harder. The inference I draw from this is that government, like industry, will need to learn to do a lot more with a lot less and we’ll need increasingly more private investment and incresaingy more productive private investment as time goes on. I do not see how a very high, 70%, top tax rate fits into that picture.

Still, the federal government can’t go on as it has indefinitely without debasing the currency or causing people to lose confidence in it entirely. A higher nominal top tax rate may be necessary but that alone won’t be enough to right our fiscal ship. Healthcare spending, which is ruining not only the federal government but state and local governments, must not only be slowed but reversed. And the effective tax rates, particularly on the highest income earners, must be increased. Nominal tax rates mean nothing. A high nominal rate that nobody pays is just public relations not practical policy.

The two prospective targets for increasing the nominal tax rate are to limit the ways in which income can be shielded from the tax and reducing or eliminating tax expenditures. The Great White Whales of tax expenditures are the home mortgage interest deduction and the exclusion of employee benefits from income for the purposes of taxation.

As contentious as the top marginal rate is tax expenditures are even more so. That’s where the work is and where the solutions are to be found. Not in raising the top marginal tax rate as window dressing.

51 comments… add one

  • michael reynolds

    Steve:

    Don’t you understand that the 1% are the true victims?

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