Taxes and Economic Growth: Real World & Simulations

by Mike Kimel

Taxes and Economic Growth: Real World & Simulations

Over the past few years, I’ve posted many times on an unpleasant reality: despite the fact that so many people believe otherwise, in general, lower taxes do not result in faster economic growth. It is really too bad, because we could all be better off if only lower tax rates led to faster economic growth. However, the association between slower econoimc growth and lower tax rates is something we can see in data from the US, whether we use national level data, state and local data, or anything in between.

Here’s a post I wrote not that long ago noting that when top marginal tax rates are below about 65% or so, cutting taxes is associated with slower economic growth and raising taxes is associated with faster economic growth. Here’s something a bit more academic showing the same thing.

As I’ve noted before, there’s a logical reason why lowering top marginal rates slows economic growth (except when top marginal rates are very high), and it should be obvious to anyone who has ever run a business: the easiest way to avoid, or at least postpone paying taxes for is not to show taxable income. If your business looks like it will show a profit, reinvest the revenues, pushing up costs and voila, you don’t have any profits for the IRS to tax. But, by doing so, you are also strengthening the company, which means setting the stage for faster growth in later years. And you’re more likely to follow this strategy, rather than consume your profits, the higher the tax rate.
Notice that this little story depends entirely on the self-interest of people in the economy. Money collected in taxes could be put in a big hole and burned, and the story would still work. (Of course, the story works better if whatever is collected in taxes is actually used productively, but that isn’t a requirement.)

The response I’ve gotten via e-mail and commentary comes overwhelmingly in two flavors: a. You lie about the data and you don’t understand how people react to changes in tax rates. b. That may be what the data shows, but it can’t possibly work in theory so it must be wrong.

I can’t help the group folks in group a – I’ve offered up my spreadsheets, and frankly, anyone should be able to replicate it – this stuff ain’t rocket science. But this post is for the folks in the second group.

For grins and giggles, yesterday I made a simple little simulation tool in Excel which is intended to look at the behavior of a very wealthy person reacting to changes in tax rates. In any given period, the person consumes some percentage of the wealth they happen to have. The remainder, the savings, are allowed to grow. Individuals get a benefit from both consumption and holding wealth.

 Their goal is, given the tax rate, to maximize the discounted weighted consumption & wealth over all the periods of their working life. I set tax rates at 0%, 10%, 20%, … 90%, and used Excel’s solver tool to determine the percentage of wealth they will select under each tax rate.

Results are as follows:

Figure 1

Given the parameters selected, here’s what we find: the higher the tax rates, the lower the less of their wealth people consume in any given period and overall. However, the greater the wealth they accumulate… which is essentially the story I’ve been telling to explain the data. As noted previously, in general, higher taxes lead to faster economic growth.

A few additional comments:
a. The simulation is simplistic, and it does not show the quadratic relationship between taxation and growth we see in the real world data. I believe that this can be resolved simply by taking into account satiation resulting from consumption.
b. The simulation indicates that increasing tax rates makes people worse off (the discounted sum of the weighted wealth and consumption tends to be lower for higher tax rates).
b. i. However, they leave behind more wealth. Put another way – individuals in any given period are made worse off, but their descendants are made better off.
b. ii. A more realistic scenario probably shows increased returns as wealth increases. (Mr. Romney, to use one example, has investment options available to him that you and I do not, and Mr. Buffett has options available to him that Mr. Romney does not.) Higher taxes might very well make a person worse off today but better off in the long run. Its great to live during the Gilded Age, a period during which tax rates fell from 75% to 24%… provided you die before the effect of the Gilded Age spits out the Great Depression.
c. Because of the way taxes are defined in this model, they play a similar role to compulsory savings. Put another way: this model can also explain countries with relatively low taxes but compulsory savings, such as Singapore.
d. The model also explains Tyler Cowen’s Great Stagnation.
e. Government spending does produce a benefit, though that is ignored by this model.

I haven’t decided whether I want to spend time improving the simulation tool, but, as usual, if anyone wants my spreadsheet, drop me a line. I’m at my first name (mike), my last name (kime), at gmail.

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