A Simple Explanation for a Strange Paradox: Why the US Economy Grew Faster When Tax Rates Were High, and Grew Slower When Tax Rates Were
by Mike Kimel
A Simple Explanation for a Strange Paradox: Why the US Economy Grew Faster When Tax Rates Were High, and Grew Slower When Tax Rates Were Low
Cross 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.
Much of the value of making contributions to retirement accounts is based on the assumption that one will be in a lower tax bracket at retirement, despite the fact that regular IRAs and 401(k)s turn what would normally be capital gains that are taxed at a favorable rate into regular income. I’m better off to save outside retirement plans after I have made the maximum contribution to a Roth IRA and have contributed enough to my 401(k) to capture the employer match.
Christina Romer:
“The resulting estimates indicate that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. The large effect stems in considerable part from a powerful negative effect of tax increases on investment.”
http://www.econ.berkeley.edu/~cromer/RomerDraft307.pdf
Today is the 150 anniversary of South Carolina seceding from the Union.
Voodoo don’t work for ever.
There is a supply of money (fed takes care of that though a small number of elites). There is aggregate demand determined by: a large number of factors.
US can borrow forever if people will lend money (abstract value of money here) forever.
What happens in Bush II’s time is too much money, (abstract value of money here) stopped measuring M3 to hide the explosions, everyone can borrow, and the government allowed borrowing from people and exporters’ money (abstract value of money here) which should have been money (abstract value of money here) collected in taxes.
I think it all goes back to the ISLM stuff.
What tripped the party was……………………
$140/bbl oil. That showed money (abstract value of money here) had its limitatioins and voodoo was voodoo once a technical ceiling was met (commodities and the supply chain, ilsm).
Now, everyone is failing in green energy and renewables to unchain money (abstract value of money here) from a real world tripping point.
Stimulus money in energy developments, and infrastructure for energy efficiency is justified.
Disclaimer ilsm is not a dyslexia toward ISLM.
Mike, Aaron et al, the bottom line is business cycles happen. Trying to assign a causation on a more than weak correlation is fool hardy. Here is what BEA says:
“According to the NBER, there have been 19 recessions since 1913. They are as follows:
January 1913 to December 1914August 1918 to March 1919January 1920 to July 1921May 1923 to July 1924October 1926 to November 1927August 1929 to March 1933May 1937 to June 1938February 1945 to October 1945November 1948 to October 1949July 1953 to May 1954August 1957 to April 1958April 1960 to February 1961December 1969 to November 1970November 1973 to March 1975January 1980 to July 1980July 1981 to November 1982July 1990 to March 1991March 2001 to November 2001December 2007 to June 2009
What was the response as far as tax policy in these recessions? In twelve cases, the response was to do nothing to the top marginal rate. In four cases, the response was to cut taxes. …”
So Mike is basing his findings on ~ 1/3 of the available occurrances of recessions.
BEA concludes: “The bottom line is that throughout history, there have been just about as many tax increases during a recession as there have been tax cuts. And the net effect? It’s tenuous at best. In some cases, there is a drop in GDP. And in some cases, there is an increase in GDP. As is the case with the top marginal rate, there’s very little evidence to support the contention that tax policy during a recession does anything to affect the economy.”
If itax policy has little affect during recessions, then it is stretching logic to assume it has a stronger affect on positive growthe periods.
Weak correlation!
Article can be found here: http://open.salon.com/blog/tony_wang/2010/09/27/what_does_history_teach_us_about_recessions_and_taxes
So we have a weak correlation for marginal tax rates to recession, then Mike must be saying there is a strong correlation to marginal tax rates and positive growthe periods. But BEA has also studied that: http://open.salon.com/blog/tony_wang/2010/09/20/the_effect_of_marginal_tax_rates_on_gdp_growth
In it they say: “The bottom line, if you use history as your guide, is that there is no correlation between the top marginal tax rate and economic growth. We have a situation here where 80 years of history counters the arguments of ideologues. Of course, ideologues won’t let the facts dissuade them. But rational people should.”
I repeat: “Trying to assign a causation on a more than weak correlation is fool hardy.”
Finally, ECONOMER has this graph: http://economer.wordpress.com/2010/04/18/fiscal-policy-review-raising-lowering-taxes-in-war-and-recession-1913-present/
Can you see correlations?
I would just gently point out that there is (with a very few exceptions) no “one” cause of anything in economics.
For example, taxation of income has two effects, the income and the substitution effects. All people some of the time and some people all of the time (and yes, even some people some of the time but not all, all) will react to a rise in income taxes by working more hours to get the after tax living that they desire. And similarly, all/some will react by taking more leisure as the relative costs of leisure and work have changed. And of course the long and the short term effects will be different. What happens in aggregate with a tax change depends upon hte interplay of these two effects: which is where we derive the Laffer Curve from of course.
On to the specifics of your point:
“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.”
OK, let us abandon our sophistication above and say that this is, if not the only, then at least the major, driving force. And let us look at the implications. You’ve just argued for the complete abolition of the corporate income tax.
It’s investment within a business, past earnings being ploughed back in, that leads to economic growth. With company profits we have two possible destinations, reinvestment within the company or the paying of dividends (stock repurchases are the same as dividends here). So, in order to attain economic growth we want to maximise profits reinvested and minimise dividends paid out.
To do which we would say that reinvested profits are tax free while dividends attract tax. See, we’re now arguing for the abolition of the corporate income tax and the simply taxation of dividends as income to their recipients.
Now, if you’re prepared to follow that logic of your argument, well, well done to you.
But I do have this feeling that you’ll shy away from the implication……
This is ridiculous. Businesses don’t invest for the tax writeoff, they invest for the return. If you reduce the returns via taxation, you reduce the incentive to invest.
Any business expense is a “write off.” if anything, investment is less impacted by income tax policy because the “write offs” are spread out over a long period of time.
What we need now is investment in future growth.
Then lower the taxes on investment. Tax less what you want more of, tax more what you want less of
Mike, the answer is there is little correlation between taxes and business cycles. Tax policy appears to be a reaction to business cycles and not drivers. This crash was similar to many others. A bubble burst.
“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.”
So, so sad. For much of what is now a lengthy episode of writing about economic issues, you have avoided the silly-assed slanging that characterizes so much of what passes for discourse on economics in web-world. Now, you decide to stoop. Why? Here you are, claiming iconoclasm, and smack in the middle of making the claim, parrot a claim, with all its flaws, that has been around as long as there have been economic blogs. The flaws? If the best you can do is claim that “most economists seem” then how do you get to an unequivocal condemnation of economics and a “speaks poorly of economists”. If you are stuck at “seems”, then you don’t know enough about the positions taken by economist to reach such conclusions. Oh, and by the way, most economists don’t publish on the relationship between taxes and growth, so most economists aren’t really in the game which “speaks poorly of economists”.
You’ve done well over time in keeping your tone civil and your arguments based on data. Why lower yourself to this commonplace nonsense here?
Feeling? Um, why not just ask?
At the same time, you could ask whether Mike agrees with your analysis, since if he doesn’t, he has not reason to agree based on your analysis.
What the chart says to em:
1925 to 1933 suggest low marginal tax rates lead to blowing up the economy.
High marginal tax rates 1933 until 1941 suggest US was following austerity model like Ireland today. Just why it took blowing up the world to give US unharmed industry and edge during post WW II reconstruction, however, Bastiat would argue all those trillion would have better been spent running the world than blowing it up.
High marginal tax rates from 1942 through 1960’s were paying off war and austerity losses from depression.
2002 to present suggest low marginal tax rates that lead to the economy blowing up.
tim, my wife & i are doing it now. eliminate taxes on our company profits and our incentive to consume more today rises.
Nice CoRev,
Mike – you once again are trying to find a single factor in a incredibly complex system. This goes back to your post about the Fed Rate determining the recessions in the early 1920s that I demolished with 5 minutes on Wikipedia. The US/world economies are incredibly complex mechanisms that the voodoo we call economics can’t even describe at the macro level let alone with any detail.
All take a shot here: “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. “
Because the low rates could not overcome all the myriad other effects from the war, global wage arbitrage, capitals relatively easy ability to move in such large chunks as to swamp even large nations economies (see George Soros as an example), to China’s growing economy, to the slow decline of manufacturing in the US, the residual effects of the dot-com bubble bursting, and the Clinton deregulation of the banks bringing on the bubble in the housing market which brought the entire house of cards down.
Bottom line – US tax rates were just one small input to the incredibly complex global economy.
You keep going back to Clinton. So will I. Since Clinton underperformed the economy vs. LBJs performance (by your numbers) how much more should Clinton have raised taxes to get LBJ’s performance? 10% 15% 20% more? Would the economy performed better or worse if Clinton had left taxes the way they were after Bush Sr raised them? Show your work.
What effect did the end of the Cold War (and the psychological and economic effects this had) and the world entering the information age have on the economy?
Economics and you can’t answer these questions. At all, even with 20/20 hindsight. Yet you now want us to believe that the key to growing the US economy is raising taxes? On what basis? Or are you trying to once again tell me the US/World economy of the 1930s is the same as today so we can compare them?
Why not cut the size and reach of the federal government to increase individual liberty and allow people to decide how to spend their money and time? Get the Feds out of their lives. I considered your idea that leveling the playing field by equal enforcement of tax policy (the old hire more IRS auditors) and eliminating congressional corruption in the form of tax breaks that let the Fed pick winners would do far more to increase growth than anything else.
But you back to raising taxes in a recession. Exactly how many politicians in Congress and the White House believe in this again? Don’t go join ilsm out in the cold.
Islam will change
eliminate taxes on our company profits and our incentive to consume more today rises
Mike,
You are simply pulling forward your expenses for the tax year, probably by only a few months, which will be offset by lower spending by an identical amount over the next few months. So, no incremental increase in spending.
What would give your company incremental spending/investing power is sending less to the government.
True!
401k is somewhat of a scam for the financial industry.
Only works to double your money from employer contribution, only.
Since I have no employer contribution the IRA is only to get my current year tax bill lowered.
Any future return is a gamble and I know it.
I will not convert to the roth because my IRA is for reducing this years’ tax, and only that.
I do 1099 work for occupying my time and keeping off the blogs all day.
Mike,
Here is US GDP growth chart for the past 200 years. Please show how changes in taxes had a noticable effect on the line. Only the horrendous world wide great depression and WWII seem to have much effect at all….
Islam will change
Actually, I think Mike is right on and it filters through in several other respects. I have made the point that if tax rates increase, people will be more inclined to put money away in 401Ks because the government share of the contribution increases. More money in 401Ks means not only more money available for investment, but a greater sense of security by the owners which may increase current spending. On the business side, I would argue that higher tax rates means not only more investment, but greater hiring and wages for employees. If you assume that the folks who run businesses are not complete sociopaths–a difficult assumption, I grant you–they will feel some sense of responsibility toward their employees. The less it costs them in after tax income –ie the higher the taxes they pay on after tax income–the more likely they are to pay decent wages or take on the cost of a new employee rather than trying to work their existing employees to death. Even if they are complete sociopaths the desire to maintain a stable work force could produce the same results.
buff,
Merry Christmas,
“But you back to raising taxes in a recession. Exactly how many politicians in Congress and the White House believe in this again? Don’t go join ilsm out in the cold. “
CoRev shows in his chart above that low tax rates lead to blowing up the economy: 1929 ands 2008.
I am wearing a wool vest. Wood stove stoked.
ilsm will not change!
Cheers
Min
actually i read somewhere that that’s why Alexander Hamilton created the national debt. said that without taxes us or’nry folk would just lay around and make moonshine and shoot feral pigs.
jack
strictly speaking, the purpose of research is to disconfirm assumptions.
CoRev
I am not sure i completely understand what you are saying here. But if you mean that we can/ought to raise taxes in good times and lower them in bad times, that sounds a bit Keynesian, and I agree with it. Trouble is, we have been lowering taxes good times and bad and have bought ourselves a huge debt, and the good times are nowhere to be seen. I think that this is the one time that higher taxes may be needed to fight a recession. I believe… no historian here… that Roosevelt raised taxes during the Depression and that seemed to help… alleviate the symptoms if nothing else.
ilsm,
Merry Christmas to you to!
Mike PJR
i vote for a 3% increase in the tax rates… enough to pay for the deficit created by the bush tax cuts that were going to pay for themselves but didn’t. then play it by ear.
of course Our President and Congress don’t see it that way.
Terry,
I’ll make it simple for you: it is a mathematical impossibility that if you take more money in taxes, that people will be have MORE to spend or invest, without borrowing.
Arne
i am not nearly as knowledgeable as you but one thing that always bothered me about economic models is that all economics happens in the transition from one “steady state” to another.
ilsm
since the employer contribution is “really” your money, and the employer would have to pay it to you if he wasn’t contributing to your IRA (sound familiar?) there is no benefit to the IRA plan.
the reason to make contributions to an retirement account is not tax avoidance, but inflation avoidance and the theory that the money is safer in the investment than it would be under the mattress (safer from you at least
of course I have never been in a tax bracket where it paid to game the system.
Worstsll
one value of statistics is that it allows you to average all of the causes and effects and say what is the net effect. i have trouble with reasoning that goes from “a measurable effect on the margin” to “therefore let us do away with one factor entirely.”
may i humbly suggest that the reason for taxes is to get the money that the government needs to do the work that private enterprise or individuals cannot do for themselves but need done nevertheless. what “needs done” is the subject of politics. arguing for “no taxes” or “no government” is just brain damage.
kharris
it’s called language. and it works by making points that address a particular issue, not necessarily being universally true and fair to all concerned at all times in all places.
most of us know what Mike meant by “most economists” and “economics.” It’s a kind of shorthand for “current policy under the guise of economics, promulgated by people pretending to be non partisan experts.” which is to say those economists who work as public prostitutes.
that is not ALL economists.
sammy
but the government needs the money. without it bridges would crumble and your business would fail utterly.
buffy,
Mike has already done that. He published a book showing the results. He has published a number of pieces on this site doing the same. You were here for the blog posts. Why are you pretending otherwise?
ILSM, CoRev’s chart show low correlation. You are making anecdotal/coincidental observations.
Again, SIGH!
LSM, CoRev’s chart show low correlation. You are making anecdotal/coincidental observations.
Again, SIGH!
Oh, and Merry Christmas to you and everyone visiting here!
Merry Christmas.
E.g. a correlation can be a coinidence……………..
It is however possible for statisticians to contrive.
As well as economists.
Sammy, I will make it simple for you: for every dollar a person ends up with she has 3 choices–spend it, save it or give it away. Mike’s theory is that at higher tax rates, there is greater saving which produces more growth in the future. I suggested that this did not just apply to business, but to individuals as well. Given the tax breaks for charitable giving, tuition payments, and labor costs, you can also argue that higher tax rates lead to more giving whether to strangers, your children or your employees–all of which gets spent. Anything going to the government gets spent too and then some. What is your point other than unhappiness with living in a society?
Investments are taxed at lower rates than income. That said ‘investments’ today are mostly via financialization, which is at minimum one step removed from literal investment in capital or labor. Better than nothing, I suppose.
Also, higher top marginal rates always sit atop progressive tax tables. And this recycles incomes down the pyramid (via lower rates for the bottom of the tax table). Which in turn supports demand etc. etc. yada, yada = stronger economies.
So there’s two reasons why reasonably progressive tax tables won’t tank an economy. Might even help it. But my take away is that tax tables (as long as they aren’t confiscatory, or zero) are way overestimated in their effects on economies. Other dynamics are far more important, IMO, for erecting and sustaining robust economies.
Full employment policies are more important. Fair and balanced trade is more important. Economic composition is more important. Population growth is more important (anyone for more immigration?). Policies aimed at building and maintaining industrial ecologies are more important. Competitive industries are more important (as opposed to oligopolic ones). Strong pensions and strong health care distribution systems are more important.
I’m sure the commentators here can come up with more, or better described, dynamics than that of progressive tax tables.
Terry,
for every dollar a person ends up with she has 3 choices–spend it, save it or give it away.
If they “end up with” with less money because of taxes, they have less to spend, save, or give away. You see………oh, never mind.
sammy,
Reread what I wrote, especially the bit about my wife and I. Or think of it this way… when the price of ice cream sundaes goes up, you substitute toward veggies, and veggies are better for you in the long run even if less satisfying today.
CoRev,
Over the years you’ve gone from defending a non-existent negative correlation between tax rates and growth to insisting that there is no correlation at all. I guess that’s progress… provided that isn’t a stance limited to just this site. I hope you aren’t taking your original stance elsewhere.
kharris,
Listen, I’m an economist too. And frankly, its pretty evident that a big piece of our training is learning BS that isn’t true, and is easily demonstrable as not true. Now, I don’t do macro (for the most part) in my day job, but given I have the title “economist” the bS is still a piece of the toolchest I have that people expect me to use productively. Having broken tools is harmful, particularly when you don’t know they’re broken, because every so often you will use them.
I’m not, and I read the book. My point still stands….tax rates are just a very small part of the equation. Raising rates or lowering by the amounts we are talking is just noise in the system.
To say that raising taxes, AND NOTHING ELSE, will cause grand economic growth is nonesense.
There is no silver bullet.
Islam will change
Mike & Terry, c’mon guys. You’ve gone far afield from economics into pop psychology.
Sheesh!
Mike, you again jump to conclusions saying: “Over the years you’ve gone from defending a non-existent negative correlation between tax rates and growth to insisting that there is no correlation at all.”
No, I said you are taking very weak correlations and building a castle from that foundation without any evidence of causation. That has been my gripe about your analysis from the beginning.
I don’t have to take my original stance anywhere else, few are using the same data to explain what you try to do. Might be a solid reason for that.
I had a similar observation back in October:
We’re taught to think of monetary policy, fiscal policy, industrial policy and tax policy as four completely different things. In fact, they are each part of a complex political topography that manipulates the human nature of individuals to produce a collective result in the broader political economy.
The focus of this “checkpoint” post is tax policy, which many claim redistributes wealth. This is incorrect. Tax policy, against the broader background established by monetary, fiscal and industrial policies, does not so much affect one’s wealth as how one’s wealth is distributed among wages, entrepeneurship and rent-seeking.
The current policy of relatively low tax rates for the highest wage earners and favorable capital gains treatment for financial speculation exaltts non-productive rent-seeking over true investment in the productive economy. If the goal is to encourage investment in the real economy (domestic entrepeneurship), one way to do that is to discourage rent-seeking by providing relative incentives for investing in domestic businesses that create jobs in the United States, which would funnel unneeded earned income into productive businesses as opposed to non-productive financial speculation. Both productive businesses and non-productive financial speculation throw off wealth, if managed properly (and losses, if not), so no wealth or opportunity is lost by choosing to invest in productive businesses over non-productive speculation. Indeed, as we’re learning with the continuing collapse of our debt-financed speculative economy, speculation is actually destructive in the long term.
The point is that we need to think of these various policies together and not in isolation. I’d go further to say that we need to reconstruct these policies in parallel to provide the appropriate incentives for creating a self-sustaining political economy that is not subject to the boom-bust cycles caused by debt-financed speculation.
I made a similar observation back in October:
We’re taught to think of monetary policy, fiscal policy, industrial policy and tax policy as four completely different things. In fact, they are each part of a complex political topography that manipulates the human nature of individuals to produce a collective result in the broader political economy.
The focus of this “checkpoint” post is tax policy, which many claim redistributes wealth. This is incorrect. Tax policy, against the broader background established by monetary, fiscal and industrial policies, does not so much affect one’s wealth as how one’s wealth is distributed among wages, entrepeneurship and rent-seeking.
The current policy of relatively low tax rates for the highest wage earners and favorable capital gains treatment for financial speculation exaltts non-productive rent-seeking over true investment in the productive economy. If the goal is to encourage investment in the real economy (domestic entrepeneurship), one way to do that is to discourage rent-seeking by providing relative incentives for investing in domestic businesses that create jobs in the United States, which would funnel unneeded earned income into productive businesses as opposed to non-productive financial speculation. Both productive businesses and non-productive financial speculation throw off wealth, if managed properly (and losses, if not), so no wealth or opportunity is lost by choosing to invest in productive businesses over non-productive speculation. Indeed, as we’re learning with the continuing collapse of our debt-financed speculative economy, speculation is actually destructive in the long term.
The point is that we need to think of these various policies together and not in isolation. I’d go further to say that we need to reconstruct these policies in parallel to provide the appropriate incentives for creating a self-sustaining political economy that is not subject to the boom-bust cycles caused by debt-financed speculation.
So, are you advocating that we all be taxed higher so that by necessity we put more money into our pension plans or businesses? Do you not understand the Orwellian aspect of that?
These types of discussions always miss the point about govt and taxation. The stated goal is to raise more funds for govt stuff. The reality is it’s all about building constituency groups so politicians can amass power and be reelected. Why else would subsidies continue for ethanol? The more taken (or attempted to be taken) by governments, then the less control we have over our money. Never advocate for higher tax rates regardless of claims of higher growth (BTW – why don’t you look at the raised rates during the 30’s to refute the claim). Allowing govt to take ever larger bites of our money always leads to bigger govt. They never reduce.
Language is normative. Much of what we consider “invetments” today are, in fact, bets placed in a casino (the secondary markets). They are not investment but speculation, which is one of the reasons the BEA does not count stock market “investments” as investment for the purposes of calculating GDP.
Stock market winnings should never be given long term capital gains treatment. They should be treated no differently than winnings at the casino. The fact that stock market winnings receive favorable tax treatment is a major reason why there is no real investment in the American economy any longer. If you remove the pro-speculation tax break for stock gains and replace it with a similar tax break for real investment, well, good things are likely to happen.
From what I’ve seen, when it comes to how much or how hard they work, is that people do not really care how much they pay in taxes. They care about their after-tax income and consumption levels. From that point of view, higher taxes, lowering take-home pay, would cause them to work more, especially if a large share of their consumption is fixed – homes & cars. People will do things to avoid paying taxes, but not working is generally not one of them.
Actually higher taxes lead to smaller government.
Mark,
I’ve been here already: http://www.angrybearblog.com/2009/01/further-critique-of-romer-and-romer.html
So have other Bears (here’s Robert Waldman): http://www.angrybearblog.com/2009/03/more-on-romer-and-romer-2007.html
Tim W,
I thought I responded to this, but apparently it didn’t come up. Forget about the word taxes – that seems to be throwing you off.
Say I had to pay a fee if I took money out of my business. I’d be more likely to reinvest.
Say I had to pay a fee if I consumed stuff, whether I paid for that consumption from earnings from my business or any other source. Once again, I’m more likely to reinvest.
It really doesn’t matter whether its a tax on corporations or not – if I have to pay a tax, I am more likely to reinvest. And incidentally – double taxation makes me even more likely to reinvest.
Which means… you have the argument reversed.
Tim W,
I thought I responded to this, but apparently it didn’t come up. Forget about the word taxes – that seems to be throwing you off.
Say I had to pay a fee if I took money out of my business. I’d be more likely to reinvest.
Say I had to pay a fee if I consumed stuff, whether I paid for that consumption from earnings from my business or any other source. Once again, I’m more likely to reinvest.
It really doesn’t matter whether its a tax on corporations or not – if I have to pay a tax, I am more likely to reinvest. And incidentally – double taxation makes me even more likely to reinvest.
Which means… you have the argument reversed.
buff,
Tax rates may be a small part of the equation. But one side insists they’re a big part, and insists the effect is X. I’ve spent years pointing out the effect is not X, but rather negative X. Now I’m explaining why. I am not, however, insisting the effect is so overwhelming that this is the only thing we should be paying any attention to, unlike many of the folks who insist on tax cuts, I might add.
A little copy checking would make this argument and this selected quote clearer. Get that “in” out of the phrase “higher tax rates increase IN the incentives …” There are extra words throughout.
No, I’ve not got it reversed. Your argument is that if I am taxed on consumption but not taxed on reinvestment then I will reinvest more and thus the economy will grow.
Yes?
Thus we should stop taxation on reinvestment. That is, abolish the corporate income tax and only tax that portion of corporate profits which are paid out in dividends for consumption.
Your argument also justifies a consumption tax (which can be as progressive as you like). All savings are tax free, all income from savings which is reinvested is tax free. All consumption is taxed, whether you are consuming as a result of income which you did not save or you are drawing down savings in order to consume.
Note that this consumption tax can be done through something akin to the current income tax system, it’s not necessary to have a VAT.
But the implications of such a system are that Buffett’s billions can carry on multiplying because they are being reinvested. He only gets taxed (as does Paris Hilton) on that portion of his savings which he draws down to finance consumption.
As I say, I’m not sure you’ve considered the implications of your finding nor would you like them once you have.
But that’s not what you’ve said. By reinvesting you are avoiding (or postponing) the tax due on your taking money out of the business to finance consumption.
But you still have to pay the corporate income tax on the profits you are reinvesting, even if not the dividend tax. So your motivation to reinvest would be even greater, and the economy would grow even faster, if the government wasn’t taking a lsice of what you can reinvest.
Mike,
I agree tax rates are just a small part of the equation. But that was not what you posted. You basically stated we could start the engine of growth by increasing taxes some marginal amount during a recession.
I have no problem with the statement that tax rates have some input to US GDP growth. As does China’s currency manipulations, Mexico’s drug problems, the war Afghanistan, the housing bubble problem, Fed rates, EU debt problems, and the price of oil – plus dozens more inputs. Some more some less effect than US marginal tax rates.
But no one knows how much of an effect. Economics is much closer to astrology than astronomy. You can’t even make predictions of the past. Economics can’t answer a simple question: Would the economy grown faster or slower if Clinton had raised rates another 10%? You don’t know. All you can do is show pretty charts of what happened.
And the only thing I have seen that can be verified is that countries that are more economically free, have strong property rights, low corruption, and a strong rule of law do much better than countries who do not. We see that now and throughout history. We see that even in the US comparing between between states (California/Illinois vs. Texas) and cities (Detroit vs. Austin).
So if I was going to vote for a policy it would be for the policy that heads more toward those ideas and away from command economy, heavy government involvement in companies, high corruption, Kelo type takings, and courts that change law based on some PC sense of justice.
Writing a law that kills Kelo type takings would do more for economic growth than repeal of the Obama-Bush tax cuts (IMHO) YMMV
Islam will change
sammy
i think you don’t understand this. it is not only economics, but most of the natural world does not have “steady state” arithmetic. More often than not the more you spend the more you get.
You might think of it this way. If you have three dollars and you don’t spend it on investments you will have more money than if you do…. oh, wait…
Government spending is a kind of investment… or it should be. Hard to tell when your government is in the hands of people who are either stupid or insane or just criminal. But those are the people that people like you always vote for because they promise to cut your taxes.
I believe that the idea is that you will reinvest to REDUCE your current profit (and tax burden). You reinvest instead of taking the money as profit.
tim worstall,
Yes, this argument would justify a consumption tax, but not a reduction in a tax relating to investment. The latter is essentially zero when it comes to reinvestment of income in this example.
But… the problem with the consumption tax is that the example I provide applies to investments that may be out of reach for most people, and the consumption tax presumably affects everyone. If you want to use a tax to shape behavior, which is what you’re implying, you want to make sure your target with that tax pretty accurately.
The year the Bush tax cuts went into effect, business investment fell off the cliff. The fact is, if you don’t need business deductions to shelter your income, you are more likely to save it or gamble it..which is exactly what happened. And spending on business *is* sheltering income, as you have increasing returns from that investment. In the US especially, businesses rarely regard taxes as much of an issue–if you’re in business in the US and paying taxes, you aren’t trying very hard. But with higher taxes, at least they have to work at it a little. Without them, the temptation to spend windfalls on inflating bubbles is simply overwhelming.