The Effect of Tax Cuts and Tax Hikes on Economic Expansions

by Mike Kimel
crossposted with Presimetrics blog

The Effect of Tax Cuts and Tax Hikes on Economic Expansions

Right about now, the U.S. economy appears to be recovering from a recession (and a nasty one at that). It’s not smooth sailing though; the recovery is still very fragile, and there are plenty of problems at home and abroad that can still derail the recovery. Depending on which economist or politician or pundit you ask, there are a number of prescriptions for what to do in times like these, but there’s one thing that just about all these worthies agree on, namely that lowering marginal income tax rates (or at least not raising them) is vital.

But the fact that everybody believes something doesn’t make it true. So in this post, I’m going to show three graphs. The first shows the length (in months) of every expansion since 1929. The second looks at the annualized growth in real GDP per capita for each expansion period, and the third looks at the total growth rate in real GDP per capita over the length of the expansion period. In each graph, recoveries are divided into three groups. Group 1 is composed of expansions following recessions in which the top marginal tax rate was cut or for which the top marginal rate was cut within one year of the end of the recession. Group 2 is made up of recoveries for which the top marginal rate did not change during the recession or within a year of the end of the expansion. Group 3 has the expansions that suffered from tax hikes, during the recession itself and/or within a year of the end of recession.

A bit of housekeeping before I get started… marginal tax rates are available from this fine table provided by the IRS’ Statistics of Income. Data on the starting and ending dates for recessions comes from the NBER, purveyors of recession and expansion dating for the U.S. economy. Real GDP per capita comes from the Bureau of Economic Analysis’ National Income and Product Accounts Table 7.1, updated on April of 2010. Real GDP per capita is available annually from 1929 to 1946, and quarterly thereafter.

One more wee bit of housekeeping before we get to the good stuff… for the sake of this post, I am going to assume that the real GDP per capita in any month is equal to the real GDP per capita for the quarter (or if prior to 1947, the year) in which it fits. In other words, the real GDP per capita (in 2005 dollars) for the first quarter of 2008 is $43,997, and I am assuming that the real GDP per capita in any of the three months in that quarter (i.e., January, February, or March of 2008) is equal to $43,997. That assumption shouldn’t cause any major changes in the results and it will keep me from having to go off on tangents about how the data was smoothed.

With that, here we go. The first shows the length of each expansion, in months.

Notice… the expansions that follow tax cuts (either during the recession itself or at the start of the recovery) have tended to be the shortest ones in our sample. And short expansions are definitely not a good thing; we’re all better off with expansions that go on for a while.
What about the speed of the expansion? The annualized growth (i.e., the speed per month) of real GDP per capita for each expansion since 1929 is shown below.

This graph also does not appear to mesh with popular wisdom (not to mention accepted economic theory) in America today. In general, when tax cuts occurred during or just after a recession, the resulting expansion has been slower than when the tax rates are kept unchanged. Expansions associated with early tax hikes are the fastest of all.
Which leads us to the overall growth of the economy during the entire length of each expansion, which is shown in the next graph.

Once again, the theoretical benefits of a tax cut do not seem to match what the data shows, which is that least impressive expansions are those that follow decreases in marginal income tax rates (either during the recession itself or at the start of the recession).

So where does this leave us? Well, simply put, the data and the theory/popular wisdom do not agree. Going as far back as there is official data on economic growth, what we find is that expansions associated with reductions in the top marginal income tax rate have been shorter and slower than expansions that did not involve tax cuts. Which means, simply put, that the theory is probably wrong, and we as a nation continue to buy into it at our detriment.


Graph 1

Notice… the expansions that follow tax cuts (either during the recession itself or at the start of the recovery) have tended to be the shortest ones in our sample. And short expansions are definitely not a good thing; we’re all better off with expansions that go on for a while.

What about the speed of the expansion? The annualized growth (i.e., the speed per month) of real GDP per capita for each expansion since 1929 is shown below.


Graph 2

This graph also does not appear to mesh with popular wisdom (not to mention accepted economic theory) in America today. In general, when tax cuts occurred during or just after a recession, the resulting expansion has been slower than when the tax rates are kept unchanged. Expansions associated with early tax hikes are the fastest of all.

Which leads us to the overall growth of the economy during the entire length of each expansion, which is shown in the next graph.


Graph 3

Once again, the theoretical benefits of a tax cut do not seem to match what the data shows, which is that least impressive expansions are those that follow decreases in marginal income tax rates (either during the recession itself or at the start of the recession).

So where does this leave us? Well, simply put, the data and the theory/popular wisdom do not agree. Going as far back as there is official data on economic growth, what we find is that expansions associated with reductions in the top marginal income tax rate have been shorter and slower than expansions that did not involve tax cuts. Which means, simply put, that the theory is probably wrong, and we as a nation continue to buy into it at our detriment.

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