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.