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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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Presidents, the Tax Burden and Corruption – Explaining Economic Growth

by Mike Kimel

This post appeared in the Presimetrics blog.

Presidents, the Tax Burden and Corruption – Explaining Economic Growth

One of the topics we cover in Presimetrics is the relationship between the tax burden (i.e., the share of income going to taxes) and economic growth. As shown also in a recent post, Presidents who cut the tax burden tended to produce slower growth than Presidents who raised the tax burden.

In this post, I want to begin to address causality. As we stated in the book and as I’ve since said a few times, I don’t think higher tax burdens in and of themselves cause faster economic growth, but rather that increasing tax burdens are correlated with some other criteria that create conditions that help produce economic growth.

But let us start by addressing the issue of timing first. A number of people have indicated in comments or offline that perhaps the reason for the strong correlation between tax burdens and economic growth could be because when the economy is growing rapidly, Presidents feel comfortable boosting taxes.

I’ve pointed out a few a problems – theoretical and empirical – with this line of argument, but I think I can illustrate it best with a simple graph. Since 1929, the first year for which data is available from the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables, there have been five Presidents that have served an eight year or more term: FDR, Ike, Reagan, Clinton and GW. Additionally, there are several more “quasi-eight year terms.” These are instances in which a VP took over upon the death or resignation of the President and maintained a similar a policies similar to those of his predecessor (JFK/LBJ and Nixon/Ford), or in which a VP took over a mere few months into a new terms and thus could put his own stamp on just about the entire eight years (Truman).

The graph below shows the change in the tax burden in the first two years of each administration on one axis and the growth in real GDP per capita during the remaining six years of each administration on the other axis.

Figure 1

Notice… increases in the tax burden in the first two years of an administration tend to be followed by rapid growth during the remainder of that administration. Conversely, administrations that greatly decreased the tax burden during their first two years suffered from poor economic growth during their remaining six years. This relationship, at least, is very difficult to explain by insisting that administrations which enjoyed rapid growth simply were more able to raise tax burdens than administrations which grew more slowly. It is also impossible to explain by anything said by anything you hear out of the Austrians or the Chicago school.

(Incidentally – I have a simple explanation for why some administrations appear above the regression line and some below. I know that it applies to the administrations that begin in 1952 because I’ve written about it in the past. I’ll collect the data going a bit further back and some time in the future will write a post on that.)

So what is going on here? 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. Consider this graph that appeared in a post last week:

Figure 2

Notice that among the Presidents to increase the tax burden are some who raised marginal tax rates (FDR, Clinton), others who decreased it (LBJ), and others still under whom marginal tax rates didn’t change. Similarly, tax burdens fell under some Presidents who cut marginal rates (Reagan, GW), Presidents who raised marginal rates (Bush Sr.), and others who left it unchanged. And for tax burdens to fall at a time of increasing marginal rates really requires more people avoiding taxes they legally owe. Similarly, for tax burdens to rise at a time of decreasing marginal rates one would need more people paying the taxes they legally owe. Thus, enforcement.

Furthermore, an administration willing to turn a blind eye toward one set of laws and regulations is probably more than willing to turn a blind toward other rules and regulations. It is not a coincidence that aren’t keen on tax collection also tend to view the government as the problem and not the solution.

Now, corruption (and let’s call it what it is) is a tough thing for which to test. But I think I there are signs that often appear among corrupt regimes, and one of them is the displacement of private sector by the government. Running an honest business when the government is dishonest is very difficult. The government will side with its favorites and everyone else will have a tough time. It becomes easier to make a buck by playing legal technicalities than by actually doing something useful. This is not to say that some countries do not succeed in having large government sectors without remaining honest and transparent – I suspect Denmark and Singapore are examples of that, though I’m not all that familiar with data for those countries. But we are not Denmark, and if a regime populated with flacks who insist they believe in small government takes over a growing piece of the economy despite taking steps to “encourage the private sector” it probably isn’t a good sign.

So with that… the next graph shows changes in the tax burden in years 1 and 2 on the one hand, and changes in the size of the federal government’s expenditures as a share of GDP during the remaining six years on the other hand.

Figure 3

Notice that administrations that started off by cutting the tax burden also went on to increase the government’s share of the economy. That relationship is stronger and more evident if one looks at changes in the tax burden in the first four years of an administration against changes in the size of the federal government during the remaining four years.

Figure 4

Clearly, in general, the more an administration cut the tax burden in its early years, the smaller the private sector’s share of the economy it its later years, contradicting all rhetoric of the tax cutters, not to mention all Chicago or Austrian “economic theory.” After all, those folks will tell you that lower taxes are going to jumpstart the private sector, right? Not what happened in the real world, is it?

Notice also that the relationship is stronger for the four post-War Presidents that served a full eight years than for the entire sample. A switch in administrations could lead to a break in our little “lower taxes as a sign of corruption shrinks the private sector” story. I note also something else… take a look at where FDR sits on the graph above. Does that fit with the accepted FDR narrative in this day and age?

Which leads me back to corruption. If cuts in the tax burden are a sign that the federal government is tolerating corruption, one would expect that administrations that start off by cutting that burden would end by seeing the private sector shrink relative to the public sector. And that is precisely what we have seen.

Do you have a better explanation?

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. The government’s share of the economy is measured the federal government’s current expenditures (line 23 of NIPA table 3.2) divided by GDP.

Note that in past posts I have tended to only consider the first eight years of the FDR administration to avoid even getting close to the war years. As noted in previous graphs, even leaving out the years after 1938, FDR oversaw the fastest economic growth or any President for whom there is reliable data available. However, in this post, I was trying to remain consistent by sticking to 8 year stretches of data. Note also that, as shown in the fourth graph, the federal government’s share of the economy actually shrunk from 1936 to 1940.

Growth rates are measured from the year before a President took office to his last year in office. Note also… if its 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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Presidents, the Tax Burden, and Economic Growth

by Mike Kimel

Presidents, the Tax Burden, and Economic Growth

This post also appears at the Presimetrics Blog. It contains some information that has appeared in a few different Angry Bear posts, but I think I’m starting to manage to put it into a more coherent narrative. And as I’m able to do that, I’m able to move slowly to the next part of the story.

A couple of weeks ago I had a post on the Presimetrics blog, also on the Angry Bear blog looking at economic growth rates and political parties. The post shows that from 1929 (that’s as far back as GDP goes) to 2009, growth in real GDP per capita was faster when the president was a Democrat than when the President was a Republican. Furthermore, growth was faster for Democratic Presidents who faced a Democrat-majority Congress during their entire term than for those who did not face a Democrat-majority Congress for at least part of their administration. Similarly, Republican Presidents facing Democratic majority in Congress during their time in office tended to better than Republican Presidents facing Republican majorities for most or all of their term. It isn’t a message you’ll hear very often, but it is the only one that is compatible with the data, as you can easily check yourself.

In this post, I want to look at one of the major distinctions between Democrats and Republicans, and that is tax policy. Let’s start by looking at the Federal tax burden (total Federal government current receipts / GDP) by President. The data comes from the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables. Federal government current receipts were pulled from line 1 of NIPA Table 3.2, and GDP comes from NIPA Table 1.1.5, line 1. (Note – this is slightly different than the way we do it in Presimetrics but it is nice to change things up now and make sure that results don’t change.)

The graph below ranks the Presidents by the annualized change in the tax burden. The change is measured from the year before a President took office (the “baseline” level) to his last year in office.


Figure 1.

(As is my practice in these posts I tend not to include the years through after 1938 for FDR because otherwise someone is going to claim that whatever happened while FDR was in office was due entirely to World War 2.)

The graph shows that there is some correlation between the parties and changes in the tax burden. Every single Republican president for whom there is data reduced the tax burden. Conversely, every Democrat except Truman has raised the tax burden. Obama, at least during his first year, is on track to follow Truman and lower the tax burden.

The next graph shows growth rates in real GDP per capita (obtained from line 10 of NIPA Table 7.1)


Figure 2.

The graph shows very clearly that Presidents who hiked the tax burden produced faster economic growth – by far – than the Presidents who cut the tax burden.

And should there be any tea-partiers reading this, yes, in his first year, Obama cut the tax burden. A lot. The so-called stimulus package involved a lot of tax cuts. But as I’ve already noted, to get out of a recession, government spending has historically been much more useful as a stimulus than tax cuts.

Here’s another way to look at things:


Figure 3.

The graph below repeats Figure 3., but it includes a few labels if you want to know which point represents which President.


Figure 4.

In any case, it’s pretty clear that if lower taxes provide any benefits to economic growth, those benefits are extremely well disguised. In fact, it appears that lower taxes are a prescription for slower, not faster economic growth. (Try reconciling the data with Republican, libertarian, or Austrian economic theory.)

Now… I do not believe that higher taxes, in and of themselves, are a cause of faster economic growth. In the book we suggest a few reasons why higher tax burdens might correlate with faster economic growth. But since the book went to press, I’ve had a bit of time to think about ways to test some of these ideas, and I’ve come up with a few new thoughts as well. I hope to try out a few of these ideas in blogs in future posts.

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