Taxes and Private Sector Investment – Evidence from the Real World

by Mike Kimel
Cross-posted on the Presimetrics blog.

Taxes and Private Sector Investment – Evidence from the Real World
Last week I had a post (which appeared both here and at Angry Bear). The post included the following graph:

Figure 1

The graph looks at every eight year period since 1929 (the first year for which National Accounts data is available from the Bureau of Economic Analysis) that can be thought of as a complete “administration.” It notes that there is a very strong negative correlation between the tax burden in the first two years of an administration and the economic growth that follows in the remaining six years of the administration. In plain English – the more the tax burden was reduced during the first two years of an administration, the slower the economic growth in the following six years. Conversely, the more the tax burden was raised during the first two years of each administration, the faster economic growth was during the following six years.

At this point I note… this is not my opinion, it is what the data shows. And there is no cherry picking – I went back as far as there was data and included every eight year stretch for which a single President occupied the Oval Office or in which a VP took over from a President in the middle of a term. And these real world results contradict just about everything that standard economic theory (Classical, Austrian, you name it) tells you.

So I tried providing an explanation:

Michael Kanell and I advanced several theories in Presimetrics but the one I think makes the most sense is that changes in the tax burden are a sign of the degree to which an administration enforces laws and regulations.

The logic is simple – (1) collectively, Americans cheat on their taxes and (2) whether the tax burden, the percentage of GDP that the government collects in taxes, rises or falls seems to have nothing whatsoever to do with whether marginal income tax rates rise or fall. Thus, one way for tax burdens to go up is increased enforcement, and one way for tax burdens to fall is decreased enforcement.

Now, to me that’s self-evident. But I’m starting to realize not everyone sees it this way, so let’s run a simple test. If a regime tolerates corruption or encourages companies to game the system rather than to be productive, we should expect growth in the private sector to be minimal at best. All else being equal, we should expect faster growth in the private sector the less rot there is in the system. I assume this is not remotely controversial. And it implies that if tax collections are indeed an indicator of an administration’s intolerance for shenanigans, then growing tax burdens should be followed by rapidly increasing private sector activity and falling tax burdens should be followed by relatively slow growth in private sector activity.

Crazy, right? Lower taxes leading to less private sector activity! Insanity! It defies economic theory. And common sense. But how does it fit with what happened in the real world? Extremely well, actually.

The graph below shows the change in the tax burden in the first two years of each 8 year administration on the horizontal axis, and the annualized change in real private investment per capita in the remaining six years along the vertical axis.

Figure 2.

Notice… administrations that cut the tax burden early saw mediocre increases in private investment later. On the other hand, administrations that started out by increasing the tax burden enjoyed big increases in private investment in the remainder of their term. This is yet another instance where real world results contradict just about everything that standard economic theory teaches, particularly the Chicago School, Austrian, and Libertarian variety. And sadly, that theory has so permeated our collective thought processes that it has come to be referred to as “common sense.” Just as it was common sense at one point that the earth was flat, and the center of the universe.

It’s worth pointing out, by the way, that the relationship between the tax burden and real private consumption is similar; administrations that raised the tax burden saw greater increases in real private consumption per capita than administrations that reduced the tax burden. The relationship, albeit a strong one, is slightly weaker than the relationship between tax burdens and investment. By contrast, the relationship between changes in the tax burden in years 1 and 2 and changes in real Federal Government spending per capita are much, much weaker.

So let me revisit once more the explanation that Michael Kanell and I put forward in Presimetrics and which is consistent with the data presented in both graphs above. Administrations that cut the tax burden tended to do so mostly by reducing enforcement of tax laws and regulations. But people who don’t believe in enforcing tax laws are also not particularly fond of most other forms of rules and regulations, preferring a laissez faire “pro-business” government in all walks of life. Sure, there may well be many private sector winners when the government allows a free-for-all. However, as the costs of exploiting loopholes, breaking laws and creating externalities falls relative to the costs of doing productive things, fewer truly useful productive activities take place, and that kills growth.

If you have a better explanation, let me know.

Data sources and comments.

The definition of the tax burden used in this post is Federal government current receipts from line 1 of NIPA Table 3.2divided by GDP from NIPA Table 1.1.5, line 1. Real economic growth was measured as the change in real GDP per capita, which was obtained from NIPA Table 7.1, line 10. Population came from the last row in the same table.

Real private investment came from line 7 of NIPA Table 1.1.6.

As always, the change in any series over the length of an administration is measured from the year before the administration took office (the “baseline” from which it starts) to its last year in office.

I intend to look at the relationships described in this post in a bit more detail going forward. However, expect the next post to cover another issue which seems to come up a lot – whether the results I’ve been posting are statistically valid or not.

Note also… if it’s not obvious, this post deals with the tax burden, the share of GDP going to the Federal government, and not marginal tax rates. Please do not insist on commenting on a topic unrelated to this post.

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