A Few Graphs on Real GDP Growth Rates versus Taxes and the Size of Government

by Mike Kimel

A Few Graphs on Real GDP Growth Rates versus Taxes and the Size of Government
Cross posted at the Presimetrics blog.

This post has a few simple graphs showing the relationship between the growth in real GDP and a few other variables: the top marginal tax rate, spending by the federal government as a share of GDP, and non defense spending by the federal government as a share of GDP. I also plan to link the three graphs together into a bit of a story, a story which extends from my recent posts, and which I intend to build on over the next few weeks.

One note before we begin – all of the data in this post comes from the National Income and Product Accounts (NIPA) tables which go back to 1929, or the IRS (tax rates go back to 1913), so the graphs will all begin in 1929.

Figure 1 shows the % growth in real GDP from one year to the next on the primary vertical axis and the top marginal income tax rate for that year on the secondary vertical axis.

Figure 1.

A couple things to notice… to the naked eyeball, there doesn’t seem to be all that much of a relationship between marginal rates and growth, despite the commonly accepted story line about how higher marginal rates lead to slower economic growth. Making matters worse for conventional wisdom, the correlation between the top marginal tax rate in any given year and the growth rate from that year to the next has been positive for every time period in the little table that is pasted in the graph. In other words, for all the years for which official data exists, higher tax rates have been accompanied by faster economic growth and lower tax rates were accompanied by slower economic growth. (Regular readers know this also applies at the state and local level.) Anyone telling you that lower tax rates lead to faster economic growth in the U.S. either should begin by explaining why this time it’s different or has nothing useful to say about the subject. (And I guess it is becoming a tradition, but let me ask – please don’t bother me with Romer and Romer. It doesn’t say what you think it says. It doesn’t even say what Romer and Romer think it says.)

Now, the American mythos circa 2011 also tells you that that the bigger the government, the slower the economic growth. (Note – since the tax rates I showed are federal tax rates, I am going to use the federal government here rather than “total” government. If I went with the entire government it wouldn’t change all that much of the verbiage below.) Figure 2 shows the % growth in real GDP from one year to the next on the primary vertical axis and the size of the federal government relative to GDP for that year on the secondary vertical axis.

Figure 2.

Well, for most of the sample, it seems the correlation between growth rates and the size of the Federal government is positive. That is to say, the larger the federal government’s role in the economy in any given year, the faster the growth rate from that year to the next. However… the correlation turned negative in the tail end of the sample. (See the note at the bottom of the graph – the federal government shrunk under Bill Clinton (in fact, it shrunk every single year of his term, which means you can’t credit Newt Gingrich, at least not if you’re honest), and then rose in six of the eight years GW was in office.)

Figure 3 is similar, but instead of the Federal government’s entire piece of GDP, it shows non-defense Federal spending as a share of GDP:

Figure 3.

Now, the non-defense piece of government spending is the stuff Republicans and libertarians really hate – welfare, fighting epidemics, infrastructure, etc. And it turns out that for much of the sample, in years when that bad stuff has made up a bigger part of the economy, the economy went on to grow more quickly from that year to the next.

Now… let me repeat a few facts (in a slightly different order than they came up):

1. The top marginal tax rate is positively correlated with real GDP growth over the coming year. The correlation dips a bit in the ‘70s and ‘80s, though it never goes negative.

2. Non-defense federal spending as a share of GDP is positively correlated with real GDP growth over the coming year until the 1980s.

3. The size of the federal government is positively correlated with real GDP growth over the coming year until the 1990s.

So what’s a story that fits these and other known facts? I think it’s one where the economy was growing rapidly for many of the years from 1933 to about 1973. That year, due to a combination of various forms of incompetence* malaise and fat sideburns started setting in. A story line started making the rounds: the tax rate is too high and government is too big. The tax rate is too high thing caught on with the public first – after all, nobody likes to pay taxes. The historic relationship between tax rates and growth began to fray, but it never quite died. Nevertheless, it led to a political groundswell and tax rates were, in fact, cut tremendously in the 1980s. Growth rates subsequently fell.

However, the 1980s brought with it something else, another political change in public perceptions. The government is not solution, or even a help, but rather a problem. (Truth be told, the cachet of the government had been falling for a while, but St. Ronald the Reagan and his acolytes really opened the floodgates.) The military excluded, of course. The result: in many fields, competent people who in earlier years would have gone to work for the government instead went into such value-adding enterprises as market manipulation and financial arson. The correlation between non-defense government spending as a share of GDP and real growth went negative. The problem with maligning the non-defense portion of the government is that ill-will doesn’t stay contained. Eventually, the correlation between even defense spending and the economy flipped.

So where are we now? Some of the very things that created the very rapid growth from 1947 to 1973, who’s kidding who, make that from 1933 to 1973, were taken apart, first in the public perception and second on the ground. And we’ve been growing more slowly, and at times, not at all, ever since.

As always, anyone who wants my spreadsheet is welcome to it. Drop me a line at my first name (mike) period my last name (there’s only one “m” in my last name) period gmail.com. Because I’m getting requests for a lot of different files, be clear about which post for which you want the spreadsheet.

Data sources:

Real GDP from NIPA Table 1.1.6.

Federal gov’t spending, federal non-defense gov’t spending, and nominal GDP from NIPA Table 1.1.5.

Top marginal tax rates from IRS SOI historical table 23.

Incidentally – I mentioned last week I intended to cover the fact that a number of the graphs I’ve been putting up are bimodal. That’s still on my radar screen. I just realized I want to build my narrative in a slightly different order.

* Incompetence by the Nixon administration (too much spending, an adherence to the gold standard, and price controls), incompetence by the Arthur Burns led-Fed (inflation, which only got exacerbated by Burns’ attempts to ensure Nixon’s re-election in 1972), incompetence by the USSR (failure to keep the Arab countries from realizing that regardless of their advantage in numbers and materiel, they were too ridiculously incompetent to expect success from attacking a second rate local power yet again), and incompetence by Henry Kissinger (reigning in the Israeli military when it was 60 miles from Cairo and about the same distance from Damascus… which eventually led to the Oil Embargo, not to mention the Middle East we see today).

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