The Effect of Changing Top Marginal Tax Rates

by Mike Kimel

The Effect of Changing Top Marginal Tax Rates – an op ed free to a good home
Cross posted at the Presimetrics blog.

I wrote most of what follows in the anticipation of trying to get it accepted as an op ed at a newspaper, but I guess the deal cut the other night means a bit of it needs rewriting…

On January 1, 2011, the “Bush tax cuts” will expire and individual marginal tax rates, the percentage of income individuals pay in taxes to the federal government, will return to Clinton-era levels. The political consensus seems to be that the tax cuts should be kept for most taxpayers, but there is disagreement about whether to let the highest marginal tax rate expire. That rate applies to the portion of a high-income earner’s revenues that are in excess of some large amount – $250,000 and $1 million have been recently floated as thresholds. But, aside from rhetoric about fairness peddled by both sides in the debate, what difference does it make to the economy whether the top marginal rate goes up or not? A little history can help make it easier to understand what is at stake.

When Ronald Reagan was elected president in 1980, the top marginal tax rate was 70%. By 1988, the top marginal tax rate had been reduced to 28%. More importantly, Reagan changed the longstanding political landscape when it comes to taxation. While the top marginal rate was never below 70% between 1936 and 1980, it has not gone above 39.6% in the years since Reagan left office.

But if Reagan’s philosophy prevailed, it is fair to ask: have his tax policies generated the promised results? Lower taxes were supposed to usher in an era of faster economic growth and increased prosperity. However, while the economy did better under Reagan than it did under the three presidents who preceded him, Reagan-era growth could hardly be called impressive. Real GDP (i.e., GDP adjusted for inflation) grew more slowly under Ronald Reagan than during the eight years presided by JFK and LBJ, and slower even than during any consecutive eight year period in which Franklin Delano Roosevelt was president. FDR, it should be noted, raised the top marginal tax rate four times, from 63% to 94%.

But perhaps it is unfair to compare Reagan to big-government types like Lyndon Johnson or Roosevelt, as they served during very different eras. Focusing instead on more recent periods, real GDP also grew faster under Bill Clinton, who raised taxes, than it did under Ronald Reagan. In fact, from 1981 to the present, the period in which Reagan’s philosophies have reigned triumphant, the correlation between the top marginal tax rate and the annual growth in real GDP has been positive. That is to say, higher top marginal tax rates have been associated with faster, not slower real economic growth. Conversely, lower top marginal tax rates have coincided with less economic growth.

The positive relationship between the top marginal tax rate and the growth in real GDP is very nearly bullet-proof. For instance, it extends all the way back to 1929, the first year for which the government computed GDP data. Additionally, higher marginal tax rates are not only correlated with faster increases in real GDP from one year to the next, but also with increases in real GDP over the subsequent two, three, or four years. This is as true going back to 1929 as it is for the period since Reagan became president. In fact, since the Reagan Revolution took hold, similar relationships have existed between the top marginal rate and several other important variables, like real median income, real private investment, consumer sentiment, the value of the dollar relative to other major currencies, and the S&P 500. Lower tax rates in any given year are associated with slower growth rates for each of these variables, whether those growth rates are measured over periods of one, two, three or four years.

On the flip-side, since 1981, unemployment rates have generally shrunk faster when tax rates were higher than when they were lower. As with the other economic measures, this relationship holds whether one is measuring the change in unemployment over a single year, over two years, over three years or over four years.

None of this means that higher taxes cause better outcomes. Still, it is clear that the supposed negative repercussions from higher taxes simply have not materialized, notwithstanding pronouncements from politicians, pundits and economists. The reason is simple: those who are both willing and able to engage in tax avoidance when subject to a 40% marginal rate are not likely to behave any differently when that rate changes to 50%, or 30% for that matter. But at a slightly higher top marginal rate, the government does get more revenue, and in this way can finance more spending on things that benefit the economy, such as infrastructure, public health, scientific research, education, alleviating poverty and of course, IRS audits. Thus, allowing the top marginal rate to rise from current rates (35%) to the level they were under Bill Clinton (39.6%) is unlikely to harm the economy, and may actually help.

As always, if anyone wants my spreadsheet, drop me a line at my first name (that would be “mike”) period my last name at gmail.com. If anyone wants the op ed (changed to reflect whatever deal conditions are applicable at the time), ditto.

And finally, one question – why didn’t I read any op eds like this in the newspapers in the last few weeks and months?

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