Magazine | October 29, 2012, Issue

The New Tax Myth

Higher rates do not cause growth

Just in time for the 2012 election, a Congressional Research Service study has concluded, amid the usual waffles and syrup of caveats, that tax cuts retard economic growth — but that tax hikes spur it. Thomas L. Hungerford, a specialist in public finance at the CRS, has thus offered some highly welcome support for the policy prescriptions of President Obama and his Democratic party.

The report is part of a new consensus — one that includes such luminaries as former president Bill Clinton, Nobel laureate Paul Krugman, and New York Times economic writer David Leonhardt — that what causes economic growth is high tax rates, particularly on large incomes. Baffled by the upsurge of economic growth in the post–World War II era, when government spending dropped by two-thirds, these Keynesian experts have identified that era’s top marginal tax rate of 91 percent as a key source of growth and equality. They also look back nostalgically at the Clinton era, when a 10 percent tax hike on incomes (and an unmentioned tax cut of almost 30 percent on capital gains) seemed to bring the dot-com and telecom booms and balanced the federal budget.

Hungerford and his team map out the numbers since 1945 and show that the postwar and Clinton surges were not anomalous — that higher tax rates were often associated with higher per capita economic growth. Also important, according to the CRS, was a total lack of correlation between tax cuts and per capita growth. When pressed, the nonpolitical CRS even disclosed some evidence that tax cuts can plunge the economy into stagnation — in all likelihood, as telecom pundit Henry Blodget shrewdly suggested, by concentrating incomes at the top, where they are saved rather than spent. Among Keynesians, it is universally accepted that savings stifle growth, even though the fastest-growing countries (China and Singapore, for example) have world-beating levels of savings, as did Japan and Germany during their earlier growth booms and Hong Kong and Switzerland for decades.

All this deep thinking about the menace of tax cuts evoked what might be termed discreet jubilation among the Washington elite. David Leonhardt rushed to confront Republican VP nominee and tax-cut enthusiast Paul Ryan with the inconvenient data, which showed a devastating crash following Bush’s famous “tax cuts for the rich,” a correlation as striking as the growth surge after World War II with a 91 percent top rate. Ryan responded with “I wouldn’t say that correlation is causation” — a statistical truism that left the Timesman unimpressed.

The discovery that tax cuts were a possible growth retardant and that tax hikes might be a stimulus was a wondrous, almost thaumaturgical finding: To foster growth and job creation, there would be no need to rein in the taxing and spending of big government. During the early days of the Reagan administration, some supply-siders, such as Arthur Laffer and I, caused a stir by claiming that marginal-tax-rate reductions usually pay for themselves through faster growth of the economy and the tax base; now economics could return to the comfortable Keynesian proposition, lately broached by Krugman and by President Obama, that government spending pays for itself. Government spending is said to counteract private-sector savings and bring added growth, compounded multiplier effects, expanded employment, and confectionary reflux from an always-shovel-ready Federal Reserve. The more government spends, so imply these Keynesian experts, the more funds pour in to be spent.

This view should be addressed quite seriously, because the “Taxmageddon” in January will force serious choices on the issue. Taxmageddon is the date on which all the Bush tax cuts will expire at once — almost doubling the capital-gains tax, nearly tripling the dividend tax, and (in conjunction with Obamacare fees and other imposts on imprudently lofty earnings) pushing marginal rates in the highest brackets to some 50 percent in many localities. A 50 percent rate fatefully gives these crucial taxpayers a greater incentive to hide income than to earn it. (That 91 percent rate on dividends, for example, garnered almost no revenues because it virtually extinguished this form of corporate payout, restricting any dividends to non-profit recipients.) But under the theory promoted by the CRS study, these multiple simultaneous tax hikes would constitute such an abrupt and acute Keynesian stimulus for U.S. growth that it would endanger the equilibrium of the global economy — a notion that may not pass the laugh test even on Capitol Hill.

#page#In trying to appraise the real effects of tax cuts and hikes, we should look beyond the mixed effects of tax-rate hikes and reductions under the two Bushes and Clinton shown in the Leonhardt graphs, which begin in 1987, and consider also the growth surges after the Harding and Coolidge cuts in the 1920s; the Truman cuts after World War II (chiefly the 50 percent cut implicit in the new policy of joint tax returns, enacted in 1946 over Truman’s veto); the Kennedy cuts in the 1960s; and the Reagan cuts in the 1980s. There are also hundreds of episodes of tax policy around the globe that we could scrutinize. A 1983 study by World Bank economist Keith Marsden, extended and updated by Polyconomics in 1992, compared scores of countries with high or rising tax rates with countries with low or declining tax rates. The analysis discovered that the low-tax countries increased their government spending three times as fast, because they grew their economies six times as fast as the high-tax countries did.

Over the two decades since the Marsden/Polyconomics study, some 25 countries have adopted low, flat tax rates, beginning with the Baltic states in 1994 and 1995. Virtually every flat tax has engendered accelerated growth and attracted increased foreign investment. After low-flat-tax enactments, with rates dipping below 20 percent, real economic growth in Estonia, Latvia, and Lithuania averaged some 8 percent for a decade. Poland (which flattened and lowered corporate rates), Hungary, and Bulgaria followed with similar if less dramatic results. Of the 25 flat-tax countries, report economists Daniel Mitchell and Chris Edwards in their book Global Tax Revolution, none has experienced unusual revenue problems, and none has rescinded the flat structure. In fact, their average personal flat rate has fallen to 16.6 percent, and their average corporate flat rate has dropped to 17.9 percent, about half the U.S. federal levels.

Meanwhile, at federal and state levels, the U.S. has allowed a steady updrift of corporate and personal tax rates to world-leading levels, with higher rates than the average in Asia, Africa, Latin America, and Eastern Europe. For the first time since the Carter years, the U.S. is suffering net capital flight.

So the CRS study is highly misleading. But it is also very significant, as a warning of what might happen should President Obama be reelected. If the administration and its cheerleaders really believe that increased taxes cause — rather than retard — economic growth, voters can count on lots and lots of them. The messages will be clear.

“What you need to get a job, Joe, is a big tax increase from Washington!”

“What you drivers need is more ethanol in your tank funded by taxes, to raise the price of gasoline and food and gunk up your motor.”

“What you venture capitalists need for new investment and innovation is more guidance from Sarbanes-Oxley regulators and a further ‘fairness’ hike in capital-gains taxes.”

“What you want for your diabetes and other health-care needs is two aspirin and 16,000 new IRS agents from Obamacare.”

It makes sense in Washington, and the academic experts and the mainstream media do not even think it’s funny. For them, the correlation of high tax rates with high growth rates can open the way to new Nobel and Pulitzer prizes. But the rest of the economy will think otherwise. Tax hikes chiefly facilitate government, which in excess is reliably a retardant of real growth. Nothing in the CRS study or the rest of the new anti-tax-cut fervor disproves this persistent historical correlation.

– Mr. Gilder is a founder of Seattle’s Discovery Institute and the author of Wealth & Poverty: A New Edition for the 21st Century.

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