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.
Return to Overview
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.