The Corner

Re: Murray: Raising Taxes ‘On Its Own’ Doesn’t Grow The Economy

You have to give credit to the Democrats in the Senate: They had about four years to think about what would you make for a good budget, and when they finally come out with a plan, they revert to the same old idea of  more spending and more taxes. 

It is also bold for Murray to cite the alarmist warnings coming from conservatives 15 years ago in trying to make the case that higher taxes were at least partially responsible for the economic boom in the Nineties. Sure, there were some alarmist warnings that didn’t materialize. It is also true that raising marginal rates on the rich, as Clinton did in the 90s and as the fiscal-cliff deal just did in January, doesn’t have much of an impact on the labor supply in the short run. It is true that these taxpayers don’t immediately change their behavior after a tax hike, and the economy doesn’t get a hit as a result. But that definitely doesn’t mean that raising tax on the rich is good for the economy–with or without the implementation of other policies. 

More important, there absolutely are some longer-term impacts of raising taxes on the economy. For instance, the work of Nobel Prize winner Edward Prescott shows that that people work more hours when marginal income tax rates are lower, especially when they are starting out and when they are nearing retirement. This effect is particularly pronounced when you have a generous welfare state that provides benefits when people’s incomes are lower. His findings were released in a now-famous 2004 paper from the Minneapolis Federal Reserve entitled “Why Do Americans Work So Much More Than Europeans?”

Democrats who always think of themselves as pro-women also should know that economists have shown that women, and secondary earners more generally, are much more responsive to changes in income-tax rates. A 2011 paper published in the Journal of Economic Literature by University of South Wales economist Michael Keane finds that females respond more to higher tax rates on household earnings because they, unlike most men, are willing to leave the labor force entirely rather than simply adjusting their hours. As taxes go up, more women are likely to stop working. There’s nothing wrong with not working, of course, but ideally womens’ decision to work or not work should not be made because of the tax system.

#more#There are also another very problematic consequences to raising taxes on the rich. Even if higher taxes don’t discourage the efforts of those who are already wealthy, they decrease the incentive for individuals to become wealthy in the future through entrepreneurship, human-capital accumulation, and career choices. I explained this point in an article for Reason a few months ago:

Economists Aparna Mathur, Silva Slavov, and Michael Strain at the American Enterprise Institute give a few examples of such behavioral effects in an article published in Tax Notes in November 2012 called “Should the Top Marginal Income Tax Rate Be 73 Percent?” They write: “Imagine a high school student who graduates in a world where the top marginal income tax rate is more than 70 percent. He may decide not to pursue his dream of becoming a college-educated engineer because the government will take a large share of the returns to his college investment—that is, much of the extra money he will earn because he is a college-educated engineer will be seized by the government, so he may conclude that going to college isn’t worth it. He is worse off because of the high top income tax rate. And so is society, because we now have one less engineer.” 

The authors offer more examples, such as a medical student who decides to become a pediatrician rather than a heart surgeon and an entrepreneur who decides not to expand his business. These examples jibe with a much talked about 2012 article in the Journal of Economic Literature by Keane and Princeton University economist Richard Rogerson. Keane and Rogerson conclude that factors such as investments in education, occupational choice, and business creation and development are more important when thinking about the long-run effects of high marginal rates than most economists had previously realized.

By calling for radically increased taxes on the wealthy, Warren Buffett and his fellow “patriotic millionaires” are creating an environment in which it will be much, much harder to become the next Warren Buffett. Increasing taxes on the wealthiest earners may raise some revenue for the government in the short run, but the long-term costs may be substantial. 

The whole thing is here.

Moreover, if Senator Murray is interested in raising taxes to reduce the debt, she should know that her plan is very likely to fail. First, if history is our guide, any new revenue that will be raised will go to more spending rather than debt reduction. Second, fiscal-adjustment packages based on tax increases tend to fail to reduce a nation’s debt burden (measured as a percentage of GDP). It is also much more likely to have negative consequences for the economy. In this new paper, Harvard University’s Alberto Alesina and I review the academic literature on fiscal adjustment and we find that:

The consensus in the academic literature is that the composition of fiscal adjustment is a key factor in achieving successful and lasting reductions in debt-to-GDP ratio. The general consensus is that fiscal adjustment packages made mostly of spending cuts are more likely to lead to lasting debt reduction than those made of tax increases.

There is still significant debate about the short-term economic impact of fiscal adjustments. However, as we will show in this paper, important lessons have emerged. In section 2, we show that fiscal adjustments and economic growth are not impossible. In section 3, we show that, while fiscal adjustments may not always trigger immediate economic growth, spending-based adjustments are much less costly in terms of output than tax-based ones. In fact, when governments try to reduce the debt by raising taxes, it is likely to result in deep and pronounced recessions, possibly making the fiscal adjustment counterproductive. 

We also had an op-ed for Forbes on this issue looking at the case of Italy here. It’s important to remember that this research is consistent with the work of Christina Romer, Obama’s former top economic adviser, and her economist husband, David Romer, which shows that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. 

For a good summary about whether fiscal adjustments done through tax increases or spending cuts hurt the economy the most, check out Garett Jones’s piece here.  

The bottom line: Maybe it’s time for Democrats to get behind a new policy idea.

Update: You can read the post by Cato Institute’s Dan Mitchell on Murray’s comments where he shows that the 1993 tax hike shouldn’t be credited for balancing the budget and explains the role played by spending restraints during that time. 


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