Relevant and even prescient commentary on news, politics and the economy.

Issues Affecting Economic Growth – Gored Oxen Edition

I write about issues I believe affect economic growth. For example, over the years, I have written a lot about taxes. And here’s a simple graph showing why:

Tax Rates v Growth in Real GDP per capita

What we see is that tax rates at any given time seem to be related to the growth rate of real GDP per capita over the next decade. What is more, the correlation is positive. That is to say, growth tends to be faster when tax rates are higher, and not lower. This of course contradicts popular belief, particularly among Republicans. However, since economic growth is important for the quality of life of all Americans, getting this right matters. Unfortunately, over the past few decades, government policy has gradually moved us in a direction that inhibits growth.

Of course, it could be the relationship between tax rates and future growth shown in the graph is a spurious correlation. But that is unlikely, since it is very easy to explain why (up to a certain point) higher tax rates would lead to faster economic growth. Additionally, even people who get the direction of the correlation wrong are certain a correlation is there. But… if it ever does turn out that the relationship is spurious, we won’t find that out by keeping our head in the sand.

Another topic I have been writing on a lot lately is immigration. Here’s what a graph looking at the foreign born population in certain years and the growth rate of real GDP per capita over the next ten years:

Foreign Born Population v. Growth in Real GDP per capita

The correlation between the share of the population that is foreign born and the growth rate is negative, which indicates that as the foreign born share rises, growth falls. The correlation between these two variables, at least in the post WW2 era, is stronger than the correlation between tax rates and growth. This of course contradicts popular belief, particularly among Democrats. However, since economic growth is important for the quality of life of all Americans, getting this right matters. Unfortunately, over the past few decades, government policy has gradually moved us in a direction that inhibits growth.

Of course, it could be the relationship between the percentage of the population that is foreign born and future growth shown in the graph is a spurious correlation. But that is unlikely, since it is very easy to explain why (up to a certain point) having less immigration would lead to faster economic growth. Additionally, even people who get the direction of the correlation wrong are certain a correlation is there. But… if it ever does turn out that the relationship is spurious, we won’t find that out by keeping our head in the sand.

If it seems to you that I have written almost exactly the same thing about taxation and immigration, it isn’t your imagination.  I did a copy and paste of a big chunk of the first half of the post to the second half and changed a few words.  The fact is, the analysis is very similar. The only difference is whose ox is getting gored. A grown up is willing to look the data in the eyes and follow it where it goes.

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It’s about the nation’s equity. We are better than this… by Professor Edward Kleinbard

Videos below the fold.

I caught Edward Kleinbard the other morning on Cspan.  He is a professor of law and business at USC and a fellow at the Century Foundation.  His book: We are better than this: How Government Should Spend our Money.  If you google his name, articles will come up from October 2014.   It attracted my attention because of my thinking as expressed in my article back in February of 2013.   The rest of the dinner table deficit/debt discussion: Equity  His thesis is that we need to be spending more as it is investment that creates the capital needed to grow the nation.  Focusing just from the view summed up in the phrase “tax and spend” misses what government is about.  Government doesn’t tax, government “principally spends money” via investment and insurance.  Spending should be complimentary to the private sector.  When government “invests” the pie gets bigger not smaller.

He worked on Wall Street for “many decades” also.   How he kept his humanity as you will hear in the presentation while being on Wall Street…?

Let me start though with this short video as it is another business person like me who appears to get my posts regarding what is needed in this country to go along with the equity spending.   I first mentioned this position in 2010 regarding the SOTU address.  Here we are 2015 and we small business people are still saying the same thing.  Professor Kleinbard addresses small business too as part of understanding the overall condition and needs.

I give you Dave Boris, owner of Hel’s Kitchen Catering.

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Screw the Clinton tax rates. Lets party like it’s 1936!

 
Update: *Additional numbers added

Digby wrote a few days ago about the“grown-up” people coming to town to save America from the deficit. She listed a few of those people and their annual income.

 
Also, a few days ago the Senate had a vote on the tax cuts. Letting the Bush cuts go (I’m all for it and we can stop the payroll tax cut too as it is all stupid policy when the problem is declining wages/income going to labor) will return us to the Clinton years rates. People have noted just how little such a rise means to those at the top.
 
Well, in keeping with my define rich series and my series looking at the purpose of taxation, I thought wouldn’t it be interesting to see just what these 1%’ers might be paying if we went back to the beginning of the last great period of mass prosperity: 1936.
 
Yes indeedy, I say go for the brass ring. Let’s show our maturity and actually implement the lesson learned from our history, that period from around 1906 to 1932 and then 1936 to 1979.
 
While we’re at it, let us stop pretending that global trade is something new with an unknowable to man exotic force that we just have to accept as part of the expression of our DNA. There is RNA also (look it up).

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Ernst and Young, Make-Up Artist*

A key but seriously underemphasized factor in the near-collapse of the financial system and economy in 2008 was the role that the two largest securities-ratings firms, Moody’s and Standard and Poors, played: The two agencies routinely and deliberately overrated the value of mortgage-backed securities. 

So I was momentarily (and naively) stunned to read this morning the specifics of the highly-publicized Ernst and Young report released yesterday claiming that Obama’s main tax proposal could cause the loss of 710,00 jobs. A Yahoo! News article summarizes:

On the official White House blog, senior Obama economic policy aide Jason Furman ripped the new study. Among his complaints:

-       The report, funded by pro-business groups generally hostile to Obama’s agenda, assumes that none of the revenue generated by raising taxes on the richest Americans goes to deficit reduction. Instead, it assumes the money would go to expanding government spending. But the president has called for the money to go to reducing the federal deficit and national debt.

-       The report omits Obama’s push for new tax cuts to spur private-sector hiring and investment. By ignoring the predicted impact on jobs growth, Furman argued, the study distorts the impact of the president’s agenda.

The article goes on to say that “Furman, whose title is Principal Deputy Director of the National Economic Council, also charged that the study’s conclusions are ‘dramatically out-of-line with estimates by other analysts’ like the Congressional Budget Office (CBO), the non-partisan standard for judging the economic impact of federal legislation.”  Furman also noted that the proposal would restore tax rates to their Clinton-era level, a time of significant jobs creation.

Good grace.  Ernst and Young is not an ideological think tank.  Not openly, anyway.  It is instead one of the very largest and most prestigious accounting firms in the world, and, like Moody’s and Standard and Poors, is relied upon by securities investors and merger-and-acquisition folks for honest evaluation of corporate value and the like in SEC filings and private deal-making. 

It also is generally considered a proverbial gold-standard firm in preparing tax documents for corporations and (wealthy) individuals.

Which brings me to the subject of the IRS.  Needless to say, the IRS’s investigatory powers cannot be used for political purposes.  For the most basic and obvious reasons, that would be illegal; it would undermine democracy itself.  (See, e.g., Richard Nixon; Watergate.)  But if this firm is simply altering or removing relevant facts from its computations in order to meet a client’s pre-calculation demand—which apparently is what happened in this instance—its very credibility is so undermined that the firm’s identification on IRS, or for that matter securities, documents, as having played a role in the preparation of the document, should begin to raise red flags for the relevant government agencies.  And for anyone reading a securities prospectus or considering the purchase of, or investment in, a particular business.

There’s simply a limit to the extent to which relevant facts can be manipulated or discounted and still have the financial representations not amount to fraud.  In the case of this Ernst and Young report, it’s fraud, but not illegal fraud.  But that’s only because the report itself was not part of a securities or IRS filing or some other financial transaction.  

—-
*Oookay.  Blogger is not letting me use the ampersand, saying it’s a character that’s not allowed. Thus, my use of “and” rather than the forbidden character in the corporate names.

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Guest post: Top 1% Reduced Taxes in Last 3 Years but Probably Gained Income Share

Guest post by Kenneth Thomas

Top 1% Reduced Taxes in Last 3 Years but Probably Gained Income Share

Citizens for Tax Justice came out with a nice report today showing that the overall U.S. tax system is just barely “progressive,” which is to say that as your income goes up, so does your tax rate. While the federal income tax is progressive in this sense, many state and local taxes, such as sales and property taxes are regressive in that lower income people pay higher percentages of their income than do higher income people. The following table from CTJ makes this crystal clear:
   

As the right-hand portion of the table shows, as income rises federal taxes (individual and corporate income, estate tax, etc.) increase as a percentage of income, from 5.0% of income for the lowest 20% of earners to 21.1% for the top 1% of taxpayers. Meanwhile, state and local taxes move in exactly the opposite direction, from 12.3% of income for the lowest 20% to 7.9% for the top 1%. As CTJ further points out, for every income group the share of total taxes they pay is extremely close to their share of total income (in fact, the biggest difference is 1.7 percentage points).

We already knew, thanks to Emmanuel Saez, that in 2010, the top 1% got 93% of all income gains. With the new 2011 data, we find that the top 1% has continued to make out like gangbusters. As I reported in August, using data from the conservative Tax Foundation, in 2008 the top 1% earned 20.00% of all income. As we see in the table above, just three years later that has grown to 21.0%. Considering that the 2011 data is estimated, perhaps this change is not too significant. But what is really striking is that the top 1% paid only 21.1% of its income in all federal taxes in 2011, whereas in 2008 it paid at a rate of 23.27% for personal income tax alone.

Since the top 1% gets an even more disproportionate share of corporate income and taxable estate income than it does of personal income, this is solid evidence that it’s a real reduction we are seeing. I hate to sound like a broken record, but it’s really true that there is one tax system for the 1% and another one for the rest of us.

crossposted with  Middle class political economist

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Explaining Why Low Tax Rates are Correlated with Slower Economic Growth, Once Again

by Mike Kimel

Explaining Why Low Tax Rates are Correlated with Slower Economic Growth, Once Again

One of the regular mysteries facing economists is why the US economy fails to display evidence of a relationship that everyone seems to accept implicitly, namely that lower taxes lead to (or even are correlated with) faster economic growth. Sure, the argument is sometimes made by academics using rather heroic assumptions. The paper everyone seems to cite these days uses the assumptions made by politicians before a change in the tax rate as the “effect” that actually occurred after the change in the tax rate. Non-academics rely on other heroic assumptions. My favorite is attributing the rapid growth during the three years of the Kennedy administration to a cut in tax rates that occurred the year after he died. (Actually, even Alan Greenspan made this one well before he made the transition from Maestro to goat.)

I’ve taken a crack at explaining that puzzle, most recently here:

people will want to minimize their tax burden at any given time subject provided it doesn’t decrease their lifetime consumption of stuff plus holdings of wealth. Put another way – all else being equal, peoples’ incentive to avoid/evade taxes is higher when tax rates are higher, and that incentive decreases when tax rates go down. Additionally, most people’s behavior, frankly, is not affected by “normal” changes to tax rates; raise or lower the tax rates of someone getting a W-2 and they can’t exactly change the amount of work they do as a result. However, there are some people, most of whom have high actual or potential incomes and/or a relatively large amount of wealth, for whom things are different. For these people, some not insignificant amount of their income in any year comes from “investments” or from the sort of activities for which paychecks can be dialed up or down relatively easily. (I assume none of this is controversial.)
Now, consider the plight of a person who makes a not insignificant amount of their income in any year comes from “investments” or from the sort of activities for which paychecks can be dialed up or down relatively easily, and who wants to reduce their tax burden this year in a way that won’t reduce their total more or less smoothed lifetime consumption of stuff and holdings of wealth. How do they do that? Well, a good accountant can come up with a myriad of ways, but in the end, there’s really one method that reigns supreme, and that is reinvesting the proceeds of one’s income-generating activities back into those income-generating activities. (i.e., reinvest in the business.) But ceteris paribus, reinvesting in the business… generates more income in the future, which is to say, it leads to faster economic growth. To restate, higher tax rates increase in the incentives to reduce one’s taxable income by investing more in future growth.

Restating again: when the tax rate is 75%, a business owner has a strong incentive to reinvest all his/her profits in the business rather than take those profits out and consume them. This is because reinvesting in the business means the profits aren’t pulled out and thus aren’t recognized as income by the IRS. Reinvesting in the business also increases the business’ chances to do well in future years, which generates growth for the economy. On the other hand, when the tax rate is 15%, there is more of an incentive to take out profits and engage in consumption of the type that does not generate much growth.

David Glasner has another (albeit complementary) suggestion:

The connection it seems to me is that doing the kind of research necessary to come up with information that traders can put to profitable use requires very high cognitive and analytical skills, skills associated with success in mathematics, engineering, applied and pure scientific research. In addition, I am also positing that, at equal levels of remuneration, most students would choose a career in one of the latter fields over a career in finance. Indeed, I would suggest that most students about to embark on a career would choose a career in the sciences, technology, or engineering over a career in finance even if it meant a sacrifice in income.  

If for someone with the mental abilities necessary to pursue a successful career in science or technology, requires what are called compensating differences in remuneration, then the higher the marginal tax rate, the greater the compensating difference in pre-tax income necessary to induce prospective job candidates to choose a career in finance. So reductions in marginal tax rates in the 1980s enabled the financial sector to bid away talented young people from other occupations and sectors who would otherwise have pursued careers in science and technology. The infusion of brain power helped the financial sector improve the profitability of its trading operations, profits that came at the expense of less sophisticated financial firms and unprofessional traders, encouraging a further proliferation of products to trade and of strategies for trading them.

Comments?

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The Effect of Individual Income Tax Rates on the Economy, Part 6: 1981 – 1993

by Mike Kimel

The Effect of Individual Income Tax Rates on the Economy, Part 6: 1981 – 1993

This post is the sixth in a series that looks at the relationship between real economic growth and the top individual marginal tax rate. The first looked at the period from 1901 to 1928, the second from 1929 to 1940, the third from 1940 to 1950, the fifth looked at 1950 – 1968, and the sixth from 1968 to 1988. Because the Reagan era is so pivotal in the American psyche, though it was covered in the last post, I intend to focus on it again. The last post included the lead in to Reagan’s term, this post contains the follow-up to his term. In this post I’ll look at the period from 1981 to 1993.

Before I begin, a quick recap… both the 1901 – 1928 period and the 1929 – 1940 failed to show the textbook relationship between taxes and growth. In fact, it seems that for both those periods, there was at least a bit of support for the notion that growth was faster in periods of rising tax rates than in periods when tax rates were coming down. It is worth noting that growth from 1933 to 1940 was generally quite a bit faster than at any other peacetime period since data has been available, both on average and for individual years. Not quite quite what people believe, but that’s what it is.

In the 1940 – 1950 period, we did observe slower economic growth following a tax hike and faster economic growth followed a tax reduction. However, that happened when the top marginal tax rate was boosted above 90%.
Interestingly enough, though the so-called “Kennedy Tax Cuts” are often used as one of the prime exhibits on the benefits of cutting taxes, a look at the 1950 – 1968 period yields no such conclusion. Growth rates were already rising before the tax cuts occurred in 1964 and 1965, reached a peak when the tax cuts took place, and started shrinking immediately afterwards. The other period that is always pointed to as evidence that tax cuts spur growth is the Reagan years, which showed up in the 1968 – 1988 post. It turns out that put into context, the Reagan years produced one year of rapid but not particularly extraordinary growth a few years after tax cuts began. That’s it.

Real GDP figures used in this post come from Bureau of Economic Analysis. Top individual marginal tax rate figures used in this post come from the IRS. As in previous posts, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate. Let me stress this point again as I’ve been getting people e-mailing me to tell me I’ve got the growth rates shifted a year. That is correct, and is being done on purpose (and is shown on the graph labels). To avoid questions of causality, the growth rate in year X used in this post is the growth rate from year X to year X+1. And when I say “to avoid questions of causality” – you’d be amazed at how many people write me when I don’t do this and insist that sure, higher tax rates seem to be correlated with faster growth, but that’s because when growth is faster governments feel more willing to charge higher tax rates.

With the preliminaries out of the way, let’s get started. The first graph shows the tax rates from 1981 to 1993 along with the t to t+1 real GDP growth rates.

Figure 1.

It goes without saying that what the graph does not, repeat, does not show is that lower tax rates have much to do with faster economic growth. In fact, some of the slowest sustained economic “growth” that occurred during the Reagan-Bush years coincided with the lowest tax rates: 28% and 31%. The one standout year occurred when tax rates were at 50%, and had been at 50% for a few years. And yet, somehow this period has entered the public consciousness as Exhibit A that Tax Cuts Work.

That said, I’d like to point out that unlike the folks who venerate Reagan today, Reagan himself did have a reason, an excellent reason, in fact, to try tax cuts… at least the first round of tax cuts. Looking back from the vantage point of 1980 and leaving out the WW2 years, real economic growth when tax rates were in the 90% + range was lower than it was when tax rates were in the 80% to 89.9% range, and that was slower than when tax rates were in the 70% to 79.9% range, and that in turn was slower than when tax rates were in the 60% to 69.9%. That is shown in the graph below.

Figure 2.

Note that all the information contained in Figure 2 was available by the time Reagan took office. If the information in Figure 2 is all you have, it isn’t unreasonable to wonder whether further reductions in the tax rate will lead to faster economic growth. Of course, Reagan did have a bit more information available. He also had growth rates from the last time tax rates were in the 24% and 25% range (i.e., the start of the Great Depression) which were negative… and which might have tipped him off that the relationship between tax rates and growth is actually quadratic. But I guess its a bit much to expect any of Reagan’s advisors to consider anything like a quadratic relationship.

In any case, we can combine Figures 1 and 2 to put the Reagan – Bush rates into context:

Figure 3.

If you’re wondering, during seven of the 12 Reagan-Bush years, growth rates were actually below the average rate observed when top marginal tax rates were above 90%… and the really slow growth during the Reagan – Bush era occurred disproportionately when tax rates were at the 28% and 31%. That is to say, when tax rates were at their lowest levels in the Reagan – Bush era, growth rates were also at their lowest. And as the graph also shows, every single year, repeat, every single year of the Reagan Bush had a lower average growth rate than when tax rates were in the 60% to 69.9% range.

So… what we don’t from the Reagan – Bush era is anything that supports the notion that lower tax rates correlate with faster economic growth. (Note… correlation does not imply causality, but lack of correlation certainly does imply lack of causality.) We do see that it could have been a rational experiment for Reagan to cut tax rates from 70% to 50%. It was not a rational experiment, based on what happened at 50%, to cut rates further, and the result was easily predictable.

And speaking of rational… the story the data tells is strongly at odds with what is commonly believed. And this isn’t ancient history. Most of us lived through this. It isn’t rational for us to believe things that aren’t true. But collectively, we do. And its leading to crummy growth rates. What a surprise.

Next post in the series… 1993 to the present.

As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel (note that I’m not from the wealthy branch of the family that can afford two “m”s – make sure you only put one “m” in there) at gmail period com.

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The Effect of Individual Income Tax Rates on the Economy, Part 5: 1968 – 1988

by Mike Kimel

The Effect of Individual Income Tax Rates on the Economy, Part 5: 1968 – 1988
This post is the fourth in a series that looks at the relationship between real economic growth and the top individual marginal tax rate. The first looked at the period from 1901 to 1928, the second from 1929 to 1940, the third from 1940 to 1950, and the fifth looked at 1950 – 1968.

Before I begin, a quick recap… both the 1901 – 1928 period and the 1929 – 1940 failed to show the textbook relationship between taxes and growth. In fact, it seems that for both those periods, there was at least a bit of support for the notion that growth was faster in periods of rising tax rates than in periods when tax rates were coming down. In the 1940 – 1950 period, we did observe slower economic growth following a tax hike and faster economic growth followed a tax reduction. However, that happened when the top marginal tax rate was boosted above 90%. Interestingly enough, though the so-called “Kennedy Tax Cuts” are often used as one of the prime exhibits on the benefits of cutting taxes, a look at the 1950 – 1968 period yields no such conclusion. Growth rates were already rising before the tax cuts occurred in 1964 and 1965, reached a peak when the tax cuts took place, and started shrinking immediately afterwards.

Real GDP figures used in this post come from Bureau of Economic Analysis. Top individual marginal tax rate figures used in this post come from the IRS. As in previous posts, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate. Let me stress this point again as I’ve been getting people e-mailing me to tell me I’ve got the growth rates shifted a year. That is correct, and is being done on purpose (and is shown on the graph labels). To avoid questions of causality, the growth rate in year X used in this post is the growth rate from year X to year X+1. And when I say “to avoid questions of causality” – you’d be amazed at how many people write me when I don’t do this and insist that sure, higher tax rates seem to be correlated with faster growth, but that’s because when growth is faster governments feel more willing to charge higher tax rates.

So let’s get started below the fold:

Let’s put up a diagram showing growth rates and tax rates for the period from 1968 to 1988. But we almost don’t have to do it. We all know what happened. We’ve been told so many times. Tax rates were very high in the late 60s and 70s. And then came the Lone Ranger Reagan, and, and lo, Reagan cut taxes. The result is that the economy began to grow like never before. Sure, the story is strikingly similar to the one about the tax cuts in the 1960s, and we know from the last post how that turned out. But still, the Reagan story is even more widely accepted, so here’s the graph that accompanies the story:

Figure 1.

Wait. That can’t be right. Something is wrong with the data because it doesn’t match the narrative!!! Yes, there was a tax cut and the economy started growing. But the only growth that was unusually strong for the time period occurred in one single year, from 1983 to 1984. And immediately afterwards it dropped and kept dropping.

In 1987, there was a small pickup in growth which accompanied a further tax cut (50% to 38.5%), but the year after, when the top marginal tax rate dropped further (to 28%), growth fell again.

Strip away the rhetoric, and it would seem the “evidence” for the benefits of Reaganomics, for the most part, are that following the small tax cut in 1981 (70% to 69.25%) and the bigger one in 1982 (69.25% to 50%), there was one seemingly extraordinary year of growth from 1983 to 1984. I could swear the narrative usually isn’t stated in this way.

But let’s take a close-up of the Reagan years and put them (and the one extraordinary year) in perspective. In the next graph we have the 1980 -1988, but for comparison, I’ve included the growth rate from 1938 to 1939. That happens to be the third slowest year of the pre-WW2 New Deal era. Here’s what it looks like:

Figure 2

Now, you may be able to noodle out why I picked the third slowest year of FDR’s first 8 years from the graph – see, it turns out that Reagan’s best year was faster than FDR’s worst, and FDR’s second worst pre-WW2 years, but that’s about it.

Redoing Figure 2 and adding in FDR’s best pre-WW2 New Deal year: 1940 to 1941, produces this graph:

Figure 3.

Doesn’t look at all like what you learn in school, eh? How about what you hear on Fox? Or from El Rushbo? What about from Rick Perry? Heck, you don’t even hear about this from liberals.

What you will hear is denial, and on the rare occasions where someone is willing to accept the data, excuses. Now, I’m sympathetic to the idea that FDR and Reagan were Presidents at very different times, that perhaps FDR had higher potential growth due to a bounceback effect (I don’t buy it, but I’m sympathetic to the idea). I also don’t find it offensive if someone states that times and laws were different, and even if Reagan had FDR’s approach to government in mind, he could never have enacted the same policies that FDR applied. What I am not sympathetic to are people who tell us about how well Reagan’s policies worked and who also insist that FDR ruined the economy or made it worse. People who make such claims can only fall into two categories, the “good” one being the misinformed.

So to sum up… so far in this series… it seems the evidence has been at least weakly against the idea that tax cuts lead to faster economic growth in the 1901 – 1928, 1929 – 1940, and 1950 – 1968 periods. The 1940 – 1950 period does seem to behave consistently with that notion, though it is worth noting that it happened when tax rates were above 90%. The period from 1950 – 1968, despite the frequent obfuscatory comments from certain sectors, also completely fails to support the notion that lower tax rates are followed by faster economic growth. And frankly, the 1970s and 1980s don’t help the cause either.

Because the Reagan years play such an important role in the way we do economic policy in this country, we’ll revisit them in the next post in the series.

As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel (note that I’m not from the wealthy branch of the family that can afford two “m”s – make sure you only put one “m” in there) at gmail period com.

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The Effect of Individual Income Tax Rates on the Economy, Part 3: WW2 and the Immediate Post-War Recovery

by Mike Kimel

This post is the third in a series that looks at the relationship between real economic growth and the top individual marginal tax rate. The first looked at the period from 1901 to 1928, the second from 1929 to 1940. This one will look at the period from 1940 to 1950.

Before I begin, a quick recap… both the 1901 – 1928 period and the 1929 – 1940 [link fixed] failed to show the textbook relationship between taxes and growth. In fact, it seems that for both those periods, there was at least a bit of support for the notion that growth was faster in periods of rising tax rates than in periods when tax rates were coming down. There were also a few other findings that might be surprising – the so-called Roaring 20s were a period in which the economy was often in recession. The New Deal era, on the other hand, coincided with some of the fastest economic growth rates this country has seen since reliable data has been kept. As we will see in this post, the period from 1940 to 1950, encompassing WW2 as well as the immediate post-war recovery, also is subject to a lot of popular misconceptions.

Real GDP figures used in this post come from Bureau of Economic Analysis. Top individual marginal tax rate figures used in this post come from the IRS. As in previous posts, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate.

The following graph shows the growth rate in real GDP from one year to the next (black line) and the top marginal tax rate (gray bars) for the period from 1940 to 1950.




Finally, in the fourth decade we looked at in this series so far, we see a graph that doesn’t contradict textbook economics: growth seems to slow down as tax rates rise, reaching its lowest point (on the graph) when tax rates peaked. Then, after tax rates begin to fall, growth picks up again. So why do we see this negative correlation between tax rates and subsequent growth rates during the 1940 to 1950 period when we saw the opposite in the previous periods?

Well, as I’ve pointed out many times in the past, there is a quadratic relationship between tax rates and subsequent growth rates (kind of like the Laffer curve, but with real GDP growth taking the place of tax collections), and the fastest growth tends to occur when the top marginal rate is somewhere around 65%. (At this juncture I have to point out things can be true whether we like them or not. If you’re looking for a micro-foundations reason why raising tax rates can create faster economic growth, try this.)

In any case, tax rates in 1940 were at 79%, and they reached a high of 94% in 1944 and 1945. Clearly, at 79% the top marginal tax rates were already above optimum, and raising them simply moved them even farther away from the optimum growth rate. Conversely, cutting tax rates down to the low 80% following the end of WW2 moved tax rates closer to optimum.

But growth does not live by tax rates alone and the graph above hints at a few other misconceptions. Let’s start with a big one shared by folks on the left and the right, namely that World War 2 led to faster economic growth. In fact, many folks go so far as to say the economy suffered very slow growth until the outbreak of WW2, which as we saw in the last post in the series, is a comical claim. The graph below shows growth rates from 1938 to 1944. (Remember – for our purposes, growth is from t to t+1… thus, growth in 1938 is the percentage change between the 1938 real GDP and the 1939 real GDP.) As with Figure 2 in the previous post, the best ever year of the Reagan administration is also included for comparison purposes.




Notice… growth was already fairly quick from 1938 to 1939, and from 1939 to 1940… and then it really jumped from 1940 to 1941. Pearl Harbor was December 7, 1941, so most of that latter jump came before the American entry into the war. Now, one might say that somewhere around 1938 was the beginning of US involvement in WW2, what with Liberty Ships and the Arsenal of Democracy and all. Put another way, that big jump in growth came before the US was in the war, but as an administration whose policies had already generated several years of very rapid growth since 1933 took an increasing role in the economy. Apparently the economic policies followed were good enough to overcome even tax rates that were significantly above optimum.

Growth peaked between 1941 and 1942 and then began to shrink. In part, as we saw, that was because tax rates got too far above optimum. In part, on the other hand, it is because too much of the country’s labor pool was shipped abroad to fight in the war. But regardless… if the war had been a catalyst for jumpstarting the economy, the peak would not have occurred when it did… and growth would not have started accelerating so many years before the country’s entry into the war..

There’s one more myth that is worth tackling. That myth is that there was some sort of stupendous economic boom following WW2. And it only makes sense that there would be such a boom – the GIs came home, tax rates were cut in 1946 and again in 1948, government spending dropped, and rationing and price controls went by the wayside. And as Figure 1 shows, real GDP had a post-war nadir (I always wanted to use that word!!!) in 1947, and recovered after that. But it is important to put that recovery into context.

The graph below shows the rate of growth from 1947 (the bottom) to 1950 – the post-war miracle, as it were – and it compares it to the rate of growth from 1933 (the bottom of the Great Depression) to 1936, the heart of the New Deal.




As Figure 3 shows, there really is no comparison between the two recoveries. Whereas during the post war recovery, the economy grew almost 13% over three years following the bottom, it grew almost three times faster following the bottom in 1933. And from the previous post, we saw what happened during the rest of the 1930s. We’ll see what followed the post-War recovery in the next post on this series.

As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel at gmail period com.

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The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940

by Mike Kimel

The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940

This post is the second in a series that looks at the relationship between real economic growth and the top individual marginal tax rate.

Last week I had a post looking at the relationship between the state of the economy and the top individual marginal tax rate from 1913, the first year for which there were individual income taxes, to 1928. Because there is no official data on GDP for that period, I used recessions as a proxy for how well (or poorly) the economy was doing. I note that there was no sign whatsoever that the economy did better during periods when income taxes were non-existent (the post also looked back to 1901), or were low, or were falling, than when tax rates were high or were rising between 1901 and 1928.

This post extends the analysis to the period from 1929 to 1940, 1929 being the first year for which official real GDP data is available from the Bureau of Economic Analysis. 1940 is the end of FDR’s first eight years in office, and serves as a decent bookend to the New Deal era given America’s entry into WW2 in 1941. Top individual marginal tax rate figures used in this post come from the IRS.

The following graph shows the growth rate in real GDP from one year to the next (black line) and the top marginal tax rate (gray bars). In case you’re wondering, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate.

Notice that tax rates fell from 77% in 1920 and 1921 to 24% in 1929, the year the Great Depression began. (As noted in the last post, the so called Roaring 20s was a period when the economy was often in recession.)

Figure 1

In 1932, tax rates rose to 63%, and by 1933, the economy was growing quickly. That doesn’t match with what people believe, I know. It seems these days its commonly accepted that FDR, who took office in 1933, created the Great Depression or at least made it worse, and that only WW2 saved us. In part to address that issue, the graph below shows growth only during the New Deal era, 1933 – 1940 (no WW2!!!). To put the growth in perspective, I’ve added two lines. One represents the fastest single year growth during the Reagan administration, and the other shows the average of the single year growth rates during the Reagan administration. I figured it would be a good comparison, the Reagan administration being today’s gold standard for all that is good and pure.

Figure 2.

As the graph shows, in all but two years from 1933 to 1940, the t to t+1 growth rate was faster than in every single year of the Reagan administration. In fact, the average of the yearly growth rates during this period was about a percent and a half faster than Reagan’s best year.

And yes, there was a sharp downturn shortly after the tax hike in 1935, but its hard to credit that tax hike with the downturn when immediately after the economy continued on a rocket trajectory.

Now, whenever I point something like this out, I get told the same thing (at least by folks who are smart enough not to argue with the data): the rapid growth in the New Deal era occurred simply because the economy was slingshotting back from the Great Depression, and if anything the New Deal policies slowed the recovery. The problem with that argument, of course, is that because the unfortunate events of 2007-2009 witnessed the biggest economic decline since the end of WW2, the economy should be primed for the fastest spurt of growth in the past 60 years. After all, the policies we’ve been following before, during and since that decline have not been very New Dealish at all: top marginal tax rates are 35%, not 63% or 79%, there are no work relief programs, and Glass Steagal Act, passed as part of the New Deal, borders on irrelevant. Yet I think its safe to say just about everyone is in agreement that sort of growth isn’t going to happen anytime soon.

It is also safe to say that for the first two periods covered in this series (i.e., 1901 – 1928 and 1929 – 1940), we once again haven’t seen any sign of the purported relationship between higher lower marginal tax rates and faster economic growth. No doubt that relationship shows up later on. Next post in the series: WW2 and the immediate post-War era.

As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel at gmail period com.

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