Fast Growth and High Tax Rates Go Together

Mike Kimel Angry Bear December 20, 2010

by Mike KimelA Simple Explanation for a Strange Paradox: Why the US Economy Grew Faster When Tax Rates Were High, and Grew Slower When Tax Rates Were LowCross posted at the Presimetrics blog.If you are familiar with my writing, you know that for years I have been covering the proverbial non-barking dog: the textbook relationship between taxes and economic growth, namely that higher marginal rates make the economy grow more slowly, is not borne out in real world US data.Sure, there are a whole raft of academic studies that claim to show just that, but all of them, without fail, rely on rather heroic assumptions, and most of them throw in cherry picked data sets to boot. Leaving out those simple assumptions tends to produce empirical results that fail to abide by the most basic economic theory. This is true for data at the national level and at the state and local level.Making matters more uncomfortable (and thus explaining all the heroic assumptions and cherry picking of data in the academic literature) is that the correlations between tax rates and economic growth are actually positive. That is to say, it isn't only that we do not observe any relationship between tax rates and economic growth, in general it turns out that faster economic growth accompanies higher tax rates, not lower ones, and doesn't take fancy footwork to show that. A few simple graphs and that's that.Now, obviously I sound like a lunatic writing this because it goes so far against the grain, but a) I've been happy to make my spreadsheets available to any and all comers, and b) others have gotten the same results on their own. Being right in ways that are easily checkable mitigates my being crazy (or a liar, for that matter), but it doesn't change the uncomfortable fact that data requires a lot of torture before conforming to theory. And yet, that's the road most economists seem to take, which explains why economics today is as useless as it is. It also speaks poorly of economists. The better approach is come up with theory that fits the facts rather than the other way around.I've tried a few times to explain the relationship that I've pointed out so many times, but I never came up with anything that felt quite right. I think I have it now, and it’s very, very simple. Here goes.Assumptions:1. Economic actors react to incentives more or less rationally. (Feel free to assume “rational expectations” if you have some attachment to the current state of affairs in macro, but it won’t change results much.)2. There is a government that collects taxes on income. (Note – In a nod to the libertarian folks, we don’t even have to assume anything about what the government does with the taxes. Whether the government burns the money it collects in a bonfire, or uses it to fund road building and control epidemics more efficiently than the private sector can won’t change the basic conclusions of the model.)3. People want to maximize their more or less smoothed lifetime consumption of stuff plus holdings of wealth. More or less smoothed lifetime consumption means that if given the choice between more lifetime consumption occurring, with the proviso that it happens all at once, or a bit less lifetime consumption that occurs a bit more smoothly over time, they will generally prefer the latter. Stuff means physical and intangible items. People also like holding wealth at any given time, even if they don't plan to ever spend that wealth, because wealth provides safety, security, and prestige, and for some, the possibility of passing on some bequest.(If the first two look familiar, they were among 8 assumptions I used last week in an attempt to get where I'm going this time around. Note that I added two words to the second assumption. More on last week's post later.)Due to assumptions 1 and 3, people will want to minimize their tax burden at any given time subject provided it doesn't decrease their lifetime consumption of stuff plus holdings of wealth. Put another way - all else being equal, peoples' incentive to avoid/evade taxes is higher when tax rates are higher, and that incentive decreases when tax rates go down. Additionally, most people's behavior, frankly, is not affected by "normal" changes to tax rates; raise or lower the tax rates of someone getting a W-2 and they can't exactly change the amount of work they do as a result. However, there are some people, most of whom have high actual or potential incomes and/or a relatively large amount of wealth, for whom things are different. For these people, some not insignificant amount of their income in any year comes from "investments" or from the sort of activities for which paychecks can be dialed up or down relatively easily. (I assume none of this is controversial.)Now, consider the plight of a person who makes a not insignificant amount of their income in any year comes from "investments" or from the sort of activities for which paychecks can be dialed up or down relatively easily, and who wants to reduce their tax burden this year in a way that won't reduce their total more or less smoothed lifetime consumption of stuff and holdings of wealth. How do they do that? Well, a good accountant can come up with a myriad of ways, but in the end, there’s really one method that reigns supreme, and that is reinvesting the proceeds of one’s income-generating activities back into those income-generating activities. (i.e., reinvest in the business.) But ceteris paribus, reinvesting in the business… generates more income in the future, which is to say, it leads to faster economic growth.To restate, higher tax rates increase in the incentives to reduce one’s taxable income by investing more in future growth.---A couple acknowledgements if I may. First, I would like to thank the commenters on my last post at the Presimetrics and Angry Bear blogs, as well as Steve Roth for their insights as they really helped me frame this in my mind.Also, I cannot believe it took me this long to realize this. My wife and I are certainly not subject to the highest tax rate, and yet this is a strategy we follow. At the moment, we are able to live comfortably on my income. As a result, proceeds from the business my wife runs get plowed back into the business. This reduces our tax burden, and not incidentally, increases our expected future income.

I made a similar point at Asymtosis the other day. Simply stated, a higher tax rate increases the value of the tax write off resulting from investment. This encourages ratherthan discourages investment.Cheers!JzB

Very good, Mike! I would mention, though, that your plausible explanation needn't be an exclusive one. In fact, I would argue that your explanation is parallel to the one I suggested, regarding the hours of work and productivity, in comment on your previous post. Taking more of present productivity in the form of leisure contributes to larger future increases in productivity. Thus leisure, too, is a form of investment.

Now here all this time i thought high taxes meant i had to go out and get a second job just to pay my taxes.btw... i think i heard either reagan or bush say exactly that, except of course they weren't using it as an argument for raising taxes.

so all those people buying big screen TV's before the housing bubble burst were actually saving money as well because it will eventually lead to a renewed and inspired self.

"...but all of them, without fail, rely on rather heroic assumptions, and most of them throw in cherry picked data sets to boot. Leaving out those simple assumptions tends to produce empirical results that fail to abide by the most basic economic theory."This recalls Jack's First Law of Validation. That is: Assumption Squared Results in Error to the Third Power. This is the most common flaw in the Social Sciences. A little knowledge of statistics is a dangerous thing. The purpose of a research study is to confirm an assumption through empirical data collection and analysis, not to support an ideology through assumptions about the phenomenon required to be measured.

Relevance?

Great minds think alike! Sadly, mediocre ones do too. Which are we?

Sandwichman,Agreed. I think there are multiple explanations. I like the one I wrote last week as well, and I liked yours. But what is needed, I think, to finally put a halt to folks on one side of the aisle perpetually ignoring the real world data is an explanation that fits their philosophy. Simply put, the folks who ignore data have won the political debate, even if they are wrong. That is very costly in terms of growth, and as a result, leads to huge losses in quality and length of life for all of us collectively. That is to say, its vital for the outcome of this particular policy debate to match the real world data, and we aren't going to get to that outcome without bringing the conservatives onboard. We need explanations that fit the data, and that conservatives accept.

Jack,For a number of years, I made my living designing statistical software. Complicated techniques have their place, mostly in teasing out small effects. But when a lot of different simple graphs built using a number of data sets all show the same thing, using complex tools to force a desirable conclusion that is opposite the straightforward one is an obvious no-no, except to economists.

"...higher tax rates increase in the incentives to reduce one’s taxable income by investing more in future growth."This should be engraved over the doorway of every Congressperson's office. What we need now is investment in future growth.

Sigh!!! In 2009 the stimulus should have been a marginal tax increase? We would be out of this recession and living in tall cotton. St. Bill's tax increases were passed as we entered into a deep recession that immediately changed to a huge and long economic up tick.Wait, wait, is there a pattern here? We raise taxes when we can best afford them, and we lower them when we need them to stimulate? Could that be the hidden correlation in the data? Taxes raised because of a rising economy and NOT causing that rise? Oh, and vice versa? There, correlation and causation.

You need to review the actual data before you claim to have found a pattern. It doesn't support your off-the-cuff explanation at all.

Ok CoRev, where is you data set to disprove

Excellent analysis--makes me think of a couple follow-on questions and implications. Does the data and theory combined mean we should have top marginal rates like in the 1960s, to have high economic growth? If not, why not? Also, when you speak of "investing more" do you include investing in employees, thereby reducing turnover, increasing individual talent/training/motivation/commitment in the organization?

Hey Mike, good post and thanks for the link love. Couple of comments:First, I like that you put "investment" in quotes. I thought of pointing out the distinction in my post between financial investments and investments in productive assets. Linked, but still completely different. Another post on that anon.Second, I think this thinking needs to be fleshed out re: those who have businesses (especially s corps, s-elected LLCs, sole propietorships, etc., who can choose whether to leave the money in or take it out), and those who simply put their money in financial investments. How big a component of the economy is each group? How important a component?

Hey Mike, good post and thanks for the link love. Couple of comments: First, I like that you put "investment" in quotes. I thought of pointing out the distinction in my post between financial investments and investments in productive assets. Linked, but still completely different. Another post on that anon. Second, I think this thinking needs to be fleshed out re: those who have businesses (especially s corps, s-elected LLCs, sole propietorships, etc., who pay taxes on profits whether they're left in the business or taken out), and those who simply put their money in financial investments.

I'm very intrigued by this thinking. Pondering...

coberly: "Now here all this time i thought high taxes meant i had to go out and get a second job just to pay my taxes."Ah! Taxes create jobs. ;)

Mike Kimel: "But when a lot of different simple graphs built using a number of data sets all show the same thing, using complex tools to force a desirable conclusion that is opposite the straightforward one is an obvious no-no, except to economists."The best statistical test is the Interocular Traumatic Method: It hits you right between the eyes. ;)

"all of them, without fail, rely on rather heroic assumptions"Perhaps not so herioc. Their model indicates what will happen when steady state is achieved after you change the tax rates. That is what we do with micro models of supply and demand, so it is not heroic.An unstated assumption in these models is that you can/will get to steady state. But an assumption in your hypothesis is that taxpayers do not believe that the new state is permanent. If rational actors expect more changes, and the expectation causes them to move away from the steady state condition, then the model is unstable. If a core assuption of a their models is just wrong, then all the results are so much garbage.

A thought experiment. If you can train taxpayers that taxes will never be raised again, then the rational behavior you describe becomes not so rational. After enough time the behavior could change and start to match their model.

CoRev,In March of 08, before most people realized we were in recession or in serious trouble, I had a post asking conservatives to explain why, eight years into tax cuts of all sorts, relative low current rates and lots of deregulation, the economy was in danger. The question stands.

PJR,I suspect the "optimum" rate changes over time. We might have gotten socialized into believing that rates in the 70%s aren't appropriate any more. Also, the miracle of transfer pricing might throw a damper into things. Thus, not 100% sure what the tax rates should be, but I'm pretty sure they should be higher.As to your second question, I suspect the answer is yes.

Steve,I agree with the distinction. I don't have that reasoned out yet.

Arne,I'm not sure I agree that its all a steady state assumption; its not what I think of when I read Romer and Romer or, say, that latest piece Tyler Cowen linked to. Perhaps I'm not seeing it. But I agree, if that's the approach, its clearly wrong.As to your thought experiment... I disagree to some extent. I think the model works better if you assume rates move up and down over time, but I don't think you take away incentives if rates stay the same because of the benefits of holding wealth. You have given me food for thought.

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_WidgetManager._RegisterWidget('_BlogListView', new _WidgetInfo('BlogList1', 'sidebar-left', null, document.getElementById('BlogList1'), {'numItemsToShow': 0, 'totalItems': 1}, 'displayModeFull')); _WidgetManager._RegisterWidget('_GadgetView', new _WidgetInfo('Gadget1', 'sidebar-left', null, document.getElementById('Gadget1'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_BlogArchiveView', new _WidgetInfo('BlogArchive33', 'sidebar-left', null, document.getElementById('BlogArchive33'), {'languageDirection': 'ltr'}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML1', 'sidebar-left', null, document.getElementById('HTML1'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_LinkListView', new _WidgetInfo('LinkList4', 'sidebar-left', null, document.getElementById('LinkList4'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_LinkListView', new _WidgetInfo('LinkList5', 'sidebar-left', null, document.getElementById('LinkList5'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML4', 'sidebar-left', null, document.getElementById('HTML4'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML8', 'sidebar-left', null, document.getElementById('HTML8'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML5', 'sidebar-left', null, document.getElementById('HTML5'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_LinkListView', new _WidgetInfo('LinkList34', 'header-tabs', null, document.getElementById('LinkList34'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML2', 'header-tabs', null, document.getElementById('HTML2'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HeaderView', new _WidgetInfo('Header1', 'header')); _WidgetManager._RegisterWidget('_NavbarView', new _WidgetInfo('Navbar1', 'navbar')); _WidgetManager._RegisterWidget('_BlogView', new _WidgetInfo('Blog1', 'main', null, document.getElementById('Blog1'), {'cmtInteractionsEnabled': false, 'commentInteractionIframeUrl': 'http://www.blogger.com/comment-interaction-iframe.g?blogId\0755048766', 'showBacklinks': true, 'postId': '1978678758178775776', 'mobile': false}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML13', 'main', null, document.getElementById('HTML13'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_GadgetView', new _WidgetInfo('Gadget2', 'main', null, document.getElementById('Gadget2'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML3', 'main', null, document.getElementById('HTML3'), {}, 'displayModeFull')); _WidgetManager._RegisterWidget('_HTMLView', new _WidgetInfo('HTML9', 'main', null, document.getElementById('HTML9'), {}, 'displayModeFull'));

Dan Crawford (Rdan) Linda Beale Spencer England Ken Houghton Mike Kimel Robert Waldmann Bruce Webb Rebecca Wilder

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