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Buffett Rule rejected by Senate

by Linda Beale

Buffett Rule rejected by Senate

The Senate rejected the effort to make tax policy commensurate with the slogans about American values that we parrot freely–opportunity, paying fair shares, etc. Given the now rigid “phantom” filibuster rule requiring a supermajority to pass anything in the Senate, the Republicans –especially if joined by a few of the right-leaning Democrats–can defeat just about any attempt at reasonable taxation.

So Senate 2230 got only a majority of the SEnate (51 votes) in support of the effort to move the Buffett Rule–calling for a phased in increase to 30% minimum tax on taxpayers with income in excess of a million a year.


Minority Whip Jon Kyl (radical rightist Republican from Arizona) said Congress should instead be focussing on the economy. BNA Daily Tax RealTime (Apr. 16, 2012 at 7:35pm). Shows how completely out of tune with reality the Republican right is. Focusing on the divide between rich and poor is the best way to focus on the economy these days. We are so busy redistributing upwards through tax and fiscal policies that we are rapidly driving the middle class into extinction and depriving those who are disadvantaged by income and other demographics (like location in inner cities) of a fair opportunity to live a decent life. Watch Angela Grovers Blackwell on Bill Moyers PBS program (4/15/12) for more on what equity really means and how our policies are ignoring the real equity issues surrounding us.

crossposted with ataxingmatter

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American Enterprise Institute Economists Redux

by Mike Kimel

American Enterprise Institute Economists Redux

The other day I wrote a post about economists at the American Enterprise Institute (AEI), a prominent conservative think-tank. The post began with this paragraph from a story in the NY Times

Politicians sometimes say that lower tax rates lead to higher economic growth, which in turn leads to higher overall tax revenue. This may have been true in the early 1960s, when the top tax rate was 91 percent, but the top tax rate today is 35 percent. For decades, lower tax rates have led to lower government revenues, says Alan Viard, an economist at the American Enterprise Institute, a conservative policy group. “The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”

I noted that while Viard is right about tax cuts reducing federal revenue, he is wrong about “There is no dispute among economists about that.” As evidence, I pointed to a piece by his sometime co-author, Kevin Hassett and another by Glenn Hubbard, the first Chair of the Council of Economic Advisors under GW Bush. Both, I might add, are with the AEI (Hubbard as a visiting scholar). It wouldn’t take long to point to other quotes by other AEI economists disputing what Viard said is not disputable (and which, not incidentally, shouldn’t be disputable given the data.) At the AEI’s blog, James Pethokoukis responded to my post. There is no polite way to say this, so I’ll just state it as it is: his post is riddled with errors. Let me cover several of them. Of my post, Pethokoukis says this:

I have read it several times but I am not exactly sure of its Big Point other than to say nasty things about economists who either work at AEI or are affiliated with AEI. What I think author Ken Houghton is trying to say, maybe, is that supply-side economics doesn’t work.

There are three errors here, all of them concentrated in the last sentence:

1. The author of the piece is not Ken Houghton. It is Mike Kimel. As it says, “Posted by Ken Houghton” but “by Mike Kimel.”

2. The piece is not trying to say that supply-side economics doesn’t work. Alan Viard of the AEI is quoted as saying something which translates as follows: at least since Reagan took office, the tax cuts we have seen have led to lower revenues. I don’t know if Viard is willing to go further and endorse the implication of his statement about taxes and revenues, which is this: since the top marginal tax rate was at 70% before Reagan took office, and tax cuts from that 70% level and below have led to reduced revenues, if the Laffer curve is more than just a theoretical construct, unless we have a reason to believe that the last thirty two years of US history are an aberration, it turns out that we will not get an increase from revenue from a tax cut unless the top marginal tax rate is somewhere in excess of 70%. Like I said, that’s an implication of Viard’s statement.

That is not a point of the post, although in the post I did note that it seems Viard had seen data and was being honest about what the data stated. But that is only a point of the post in the sense that stating “the New York Times quoted AEI Economist Alan Viard” is a point of the post, which is to say, it isn’t a point of the post at all.


3. The point of the post is that while one AEI economist is willing to state the obvious about tax cuts, and though he may state that no economist disputes the obvious, his more prominent colleagues at the AEI do dispute what the data so obviously shows. I went further, and noted that Viard had to know that his own institute is a big part of the problem. Pethokoukis’ next sentence:

 “Supply-side economics is simply a school of economic thought that believes a) incentives matter, b) high tax rates are bad for growth, and b) inflation is fundamentally a monetary phenomenon.”

4. I’ll ignore the grammatical error toward the end of the sentence – there are enough substantive issues in the post – and merely point out: “incentives matter” is not something that defines supply-side economics any more than having two arms and two legs is a defining property of people of Swedish extraction.

I have yet to meet an economist of any stripe who doesn’t believe incentives matter, just as I cannot think of any country whose citizens don’t typically come equipped with four limbs. Its just that typically different schools of thought think incentives matter in different ways.

Let’s take Marxism as an example. I’m no Marxist, nor do I personally know any Marxists, but Marx can be summarized as: “those with capital have an incentive to exploit the workers to increase their profits, and the workers have an incentive to throw off their shackles, leading to a revolution. As long as there as a division of people due to ownership, those incentives persist. Peace, happiness, and prosperity can only exist by getting rid of those incentives, but only a revolution followed by a dictatorship of the proletariat can achieve that.” Now, whether Pethokoukis or I agree with this story (for the record, I don’t, and I’m pretty sure Pethokoukis doesn’t either), there is no question that incentives are part of the story. And I think I can show very clearly that supply siders treat certain incentives as egregiously as the Marxists do, but that’s for another post.

 “Back in the 1970s, Keynesian economists really didn’t believe any of that stuff and they dominated the economics profession.”

4a. This is kind of a continuation of the previous error, and it indicates Pethokoukis doesn’t understand the basic point that Keynes was trying to get across. I would assume that it isn’t controversy to say that Keynes General Theory, which is the basis for everything one can call “Keynesianism” can be summarized as follows: “When the economy slows, people buy less stuff, so manufacturers hire fewer people, pushing up unemployment and decreasing wages. This in turn slows the economy even more, leading to even more even pressure on employment and wages. But if the government were to start buying stuff, counteracting the reduction in demand from the private sector, it will decrease the pain companies feel, and thus decrease the layoffs and the downward pressure on wages, preventing the economy from getting worse and ending the recession sooner.”

If someone can tell that story in a way that doesn’t require both companies and workers to have incentives, I’d love to hear it. Alternatively, if someone can define Keynesian philosophy of any stripe in a way that doesn’t involve some variation of the story I just told, I’d love to hear that. FWIW, here’s Paul Krugman’s summary of the General Theory:

Stripped down, the conclusions of The General Theory might be expressed as four bullet points: • Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment • The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully • Government policies to increase demand, by contrast, can reduce unemployment quickly • Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach

Even if you prefer this formulation, its hard to say there aren’t incentives in the General Theory.

5. Most Keynesians do think higher tax rates slow economic growth. In fact, back to Keyenes…. the flip side of having the government step in and spend money when the economy is slow is that, according to Keynes, when the economy is running full speed, the government should cut back on spending raise taxes. One reason for raising taxes is to pay down the debt resulting from the deficit spending when the economy was in recession, but the other is to slow the economy to prevent it from overheating, thus prolonging the expansion. For what its worth, I personally don’t think slowing the economy to prevent overheating fits what data we have, but Pethokoukis wasn’ talking about me, he was talking about Keynesian economists in the 1970s.

 “Today, pretty much everybody believes incentives matter, high taxes rates hurt growth and inflation is a monetary phenomenon. ”

6. As I noted before, you could find that incentives matter in Marx and you could find it in Keynes’ General Theory, the sources of two schools of thought to which most supply-siders will agree they are in opposition, both of which predate supply-side economics. So the fact that pretty much everyone believes it today is a meaningless statement unless you can show that Marx and Keynes were exceptions – they just happened to believe something that the supply-siders would later believe, but virtually nobody else other than Marx and Keynes held that supply-sider belief prior to the supply-siders. Otherwise, we’re once again oohing and aahing over the fact that the overwhelming majority of Swedes have two arms and two legs.

7. I’m not sure what Pethokoukis is saying when he says that everyone agrees that inflation is a monetary phenomenon, or that it is a big deal that everyone believes it now, except that he is slightly misquoting Milton Friedman. That’s all very nice, but the belief that money affects inflation goes back a very long way. Lenin, for instance, talked about debauching the currency. Here’s Keynes, straight from the General Theory:

The view that any increase in the quantity of money is inflationary (unless we mean by inflationary merely that prices are rising) is bound up with the underlying assumption of the classical theory that we are always in a condition where a reduction in the real rewards of the factors of production will lead to a curtailment in their supply.

This doesn’t sound like someone who doesn’t believe that the quantity of money is unrelated to inflation. Its merely someone who believes that the quantity of money alone isn’t the only determinant of whether there is inflation – you aren’t going to have to fear inflation as much if there’s slack in the system. To provide an obvious example of what Keynes was talking about almost eighty years ago: I’m sure Pethokoukis knows how much the money supply has increased in this country since December 2007 and how little inflation we have had in that time.

 “Supply-side economics is just economics, really. We’re all supply-siders now.”

8. Oh, really? Well, as I noted above, Keynes agreed with the three beliefs that Pethokoukis ascribes to supply siders (incentives matter, higher tax rates slow growth, and inflation is a monetary phenomenon). Yes, he had a different view of incentives than Pethokoukis, and he had some caveats on when money doesn’t affect inflation as much, but for the most part, by Pethokoukis’ definition, Keynes was a supply sider, as are most of the folks he influenced. (I note that I personally would not qualify as a supply sider by Pethokoukis’ definition, which is to say, I don’t agree with Keynes on a key piece of that definition but that’s not the subject of this post.)

 “Oh, and the Laffer Curve? Just common sense.”

9. True. But common sense is often wrong. See, the dirty little secret of modern economics as practiced in the US these days is that if you apply the Laffer curve to US data, and by that, I mean, no cherry picking. Use the entire series of US government data going back to 1929, the first year for which official data exists, estimate revenues = f(top marginal tax rate, top marginal tax rate squared) you get a quadratic function as Laffer said. The only problem is – its upside down. Results are not different from what Laffer claimed, they are absolutely and precisely the opposite. Don’t take my word for it. Do it yourself. Anyone who took an intermediate level undergraduate econometrics course and has access to a spreadsheet can do it. “

Economic historian Bruce Bartlett calls the Laffer Curve “a generally accepted analytical device … [that is] a widely discussed subject in respected academic journals.” ”

10. Show me a group of physicists discussing phlogiston and I’ll show you a group of physicists who should be extremely embarrassed. As I said above, anyone who took an intermediate level undergraduate econometrics course and has access to a spreadsheet can fit a Laffer curve. It takes a bit more effort than that to check into whether phlogiston theory has anything to it.

 “In 1980, the top U.S. marginal income tax rate was 70 percent; today it is 35 percent. Yet the share of total income taxes paid by wealthier taxpayers has risen sharply. That is powerful evidence that the United States was on the wrong side of the Laffer Curve back in 1980. ”

11. What do the first two sentences have to do with the last sentence? The Laffer curve is not about the share of taxes paid by the wealthier taxpayers. As Pethokoukis himself wrote a few paragraphs earlier:

There are two tax rates that generate zero tax revenue, 0 percent and 100 percent. And in between, there is some tax rate which generates a maximum, non-zero amount of tax revenue. As tax rates rise from 0 percent toward that level, tax revenues increase both through higher economic growth and greater tax compliance. Once beyond that inflection point, higher tax rates generate less tax revenue.

Now, powerful evidence against the Laffer curve is, in fact, is provided by Pethokoukis’ colleague Alan Viard of the AEI:

For decades, lower tax rates have led to lower government revenues, says Alan Viard, an economist at the American Enterprise Institute, a conservative policy group. “The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”

Well, for me this is just a hobby – I don’t get paid for this. I’ve already spent too much time at this and I have to get to work.

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A Modest Forecast: The Average Real Growth in Ireland will Exceed 10% a Year From 2012 to 2014

by Mike Kimel

A Modest Forecast: The Average Real Growth in Ireland will Exceed 10% a Year From 2012 to 2014

 You read the title correctly: the Irish economy will grow by more than 10% next year. Now, hearing that, you might be asking yourself: “Is this guy for real? He must be nuts.”

 Because I’ve looked around and nobody is predicting that sort of growth for Ireland for the next few years. So let me lay out ten facts that should make it obvious to just about everyone:

1. According to the Central Statistics Office of Ireland, real GDP (measured in 2009 Euros) peaked at 45,583 million Euros in the fourth quarter of 2007. It bottomed out in the fourth quarter of 2010 at 39,403 million Euros. That is, real GDP fell by 13.5%. Since then, GDP has barely budged. So its safe to call 2011, four years after the peak, as a year when the bottom out process was ongoing.

2. According to the OECD, Ireland’s all in top marginal tax rates are about 52.1%.

3. According to the BEA, real GDP (measured in 2005 dollars) was 976.1 billion in 1929. It reached a nadir of 715.8 billion in 1933, amounting to a drop of 26.6%. Note that while growth was negative in 1933 (four years after the peak), it was just a small drop. The bulk of the decrease occurred from 1929 to 1932. 

4. According to the IRS, the top Federal marginal tax rate was 63% in 1934, and it rose to 79% in 1936. Note that this wasn’t an “all in” rate.

5. According to the BEA, real economic growth in the US in 1934, 1935 and 1936 was 10.9%, 8.9% and 13.1%. The annualized rate of growth from 1933 to 1938, years which I’m cherry-picking to show some relatively poor growth, was 6.7% a year.
6. FDR instituted a number of large scale programs. For instance, [b]y March, 1936, the WPA rolls had reached a total of more than 3,400,000 persons. For comparison, according to the BEA’s NIPA Table 7.1, the entire population of the US in 1936 was 128.181 million. Thus, 2.7% of the US population was employed in the WPA alone. Throw in the CCC, the Rural Electrification Administration, the TVA, and I think we can all agree that the Federal government was playing a big role in the economy.

7. Many eminent worthies, too many to name, in fact tell us that the rapid growth in the economy from 1933 to 1940 was due to the bounce-back in the economy. They also tell us that the economy would have recovered much more quickly if FDR had not followed socialist policies.

8. Ireland doesn’t have as far to bounce back from as the US did in 1934, implying slower growth in Ireland today than in the US in 1934.

 9. On the other hand, taxes are much lower in Ireland today than in the US in 1934, and nobody is accusing the Irish today of following socialist policies, implying faster economic growth in Ireland today than in the US in 1934.

10. Facts 8 and 9 probably cancel each other out, leaving us to expect, on average, about the same growth rate in Ireland over the next few years as we saw in the US during the New Deal years when FDR ruined the economy.

As the eggheads say, QED. 

What’s nice about this is that we will see rapid growth in other countries too. Taxes are much lower in the US now then they were during the New Deal years, and for all the cries of socialism and whatnot, there is WPA or CCC or Rural Electrification Program. Heck, even the Fed doesn’t seem to want to do anything about jobs and that’s part of its mandate. Back to the eggheads for a moment.

There’s a bunch of them who think the New Deal helped the economy, that lower taxes don’t generate faster economic growth or that its a good idea for the government go out and buy stuff to boost demand at times of economic weakness. Boy are those folks about to be surprised by the magic of the free market and low taxes. — Disclosure:

I profess, in the sincerity of my heart, that I have not the least personal interest in endeavoring to promote this necessary work, having no other motive than the public good of my country, by advancing our trade, providing for infants, relieving the poor, and giving some pleasure to the rich.

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Peter Diamond, Emmanuel Saez, Paul Krugman and Me!! Looking at Optimal Tax Rates

by Mike Kimel

Peter Diamond, Emmanuel Saez, Paul Krugman and Me!! Looking at Optimal Tax Rates

Via Paul Krugman, I learned of this paper by Peter Diamond and Emmanuel Saez. Diamond, of course, is a Nobel Laureate. I will be shocked if Saez isn’t one too in ten or fifteen years.

Long story made very short, Diamond and Saez jump through a lot of hoops and find that the optimal top marginal income tax rate (all in, that is, including federal, state and local), which they define as maximizing social welfare, is about 73%.

Now, long time readers may recall I’ve been doing this sort of analysis for years, though of course I’ve been looking at tax rates that maximize real GDP growth. Simply put, you cannot maximize long run social welfare if you aren’t maximizing economic growth.

My approach is much simpler than that followed by Diamond and Saez. I like to think its much more intuitive and easier to explain. I note that US data shows a simple quadratic relationship between real GDP growth from one year to the next and tax rates:

growth in real GDP, t to t+1 = f(top marginal tax rate, top marginal tax rate squared, other variables)

One recent post on the topic is here. (Unlike the Laffer curve, the coefficients come out statistically significant and with the right signs.)

I mention all this to note that no matter what I throw into the equation, I find that the top marginal tax rate that maximizes economic growth is somewhere around 65%. Of course, I’ve focused only on federal tax rates… add in state and local it comes pretty close to what Diamond and Saez have found.

As I noted above, my approach is somewhat simpler, and easier to follow than that of Diamond and Saez. Part of the reason is that they come at it from a point of view of elasticities. But with all due respect to my betters (Diamond and Saez, and Krugman as well considering the explanation in his post) I think this is the wrong way to consider the problem. It requires all sorts of assumptions and generalizations about people’s behavior, some of which are both false and create resistance from folks on the right.

For example, there is a notion that raising tax rates will reduce people’s willingness to work… which is only true above certain thresholds. (That threshold, of course, varies per individual.) As anyone who has ever had a business will tell you (when they’re not busy demanding tax reductions), you don’t pay taxes on income from the business if you turn around and reinvest that income. (An accountant would talk to you about decreasing your tax liability by increasing expenses which amounts to the same thing.) You only pay taxes on that income you take that income out, presumably for consumption purposes.

So to simplify, consider an example…. is a successful businessperson more likely to take money out of the business if his/her tax rate is 70% or if its 25%? In general, a person is more likely to take that money at 25%, as there’s less of a penalty. At 70% tax rates, there is more of an incentive to reinvest in the business, creating more growth in the business in subsequent years, and more economic growth thereafter. 70% tax rates are more likely to generate faster economic growth than 25% tax rates precisely because people are self-interested and the higher tax rates induce people to continue investing in things they do well.

(Of course, tax rates can get too high. At 95%, people will reinvest almost every dime… even if they have exhausted every good investment opportunity they have. Thus, to avoid taxes they’ll be making lousy investments which in turn slow economic growth.)

Still, its gratifying to see others who are more, er, credentialed doing similar work. If I might end on a digression, though, I can think of a number of examples of work being done on blogs by people who are essentially hobbyists which is somewhat ahead of the academic literature. However, to a large extent, if something wasn’t published in the academic literature, for all practical purposes it didn’t happen. Which is a shame, because most of us who aren’t academics don’t have time or the resources required for such publication (such as access to econlit). That inevitably slows economic development three ways:

1. the lack of recognition discourages hobbyists who have the potential and otherwise would have the willingness to improve on the existing literature
2. should such hobbyists persist and do the research, that research will not be widely disseminated even if it is an improvement over the academic literature
3. it maintains an insular attitude among those who are not hobbyists. As smart as Diamond, Saez, and Krugman all are, none of them are thinking the way someone running a business thinks of they’d have realized immediately how people who are running a business react to higher and lower tax rates. I have read a lot of academic papers on taxation and have yet to stumble on one that gets it right.

Thanks to Steve Roth of Asymptosis and Jazzbumpa of Retirement Blues for notifying me of Krugman’s post.

And since I always offer… if anyone wants any spreadsheets showing the quadratic relationship between tax rates and economic growth or anything else I’ve done, drop me a line. I’m at my first name (mike) then a period then my last name (kimel – with one m only!!!) at gmail.com.

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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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Top Marginal Income Tax Rates & Real Economic Growth, a Bar Chart

by Mike Kimel

Top Marginal Income Tax Rates & Real Economic Growth, a Bar Chart
Cross posted at the Presimetrics blog.

The chart below shows tax rates on one axis and the growth rates in real GDP that accompanied those tax rates on the other:

I broke the tax ranges into 5 percentage point increments centered around intuitive numbers (30%, 35%, etc.). Growth rates are the median observed for each range. For ranges which did not occur in the real world, growth rates are left blank.

Top marginal tax rates come from the IRS’ Statistics of Income Historical Table 23, and are available going back to 1913. Real GDP can be obtained from the BEA’s National Income and Product Accounts Table 1.1.6, and dates back to 1929. Thus, the graph uses data starting in 1929.

Consider this post a quick follow up to my previous post on optimal tax rates that appeared at the Presimetrics blog and Angry Bear blogs. There will be a lot more follow-ups, but it occurs to me that a look a the data might be useful before going on.

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The top marginal income tax rate should be about 65%…

by Mike Kimel

Cross posted at the Presimetrics blog.

To maximize real economic growth in the United States, the top marginal income tax rate should be about 65%, give or take about ten percent. Preposterous, right? Well, it turns out that’s what the data tells us, or would, if we had the ears to listen.

This post will be a bit more complicated than my usual “let’s graph some data” approach, but not by much, and I think the added complexity will be worth it. So here’s what I’m going to do – I’m going to use a statistical tool called “regression analysis” to find the relationship between the growth in real GDP and the top marginal tax rate. If you’re familiar with regressions you can skip ahead a few paragraphs.

Regression analysis (or “running regressions”) is a fairly straightforward and simple technique that is used on a daily basis by economists who work with data, not to mention people in many other professions from financiers to biologists. Because it is so simple and straightforward, a popular form of regression analysis (“ordinary least squares” or “OLS”) regression is even built into popular spreadsheets like Excel.

I think the easiest way to explain OLS is with an example. Say that I have yearly data going back to 1952 for a very small town in Nebraska. That data includes number of votes received by each candidate in elections for the city council, number of people with jobs, and number of city employees convicted of graft. If I believed that the votes incumbents received rose with the number of people jobs and fell with political scandals, I could have OLS return an equation that looks like:

Number of incumbent votes = B0 + B1*employed people + B2*employees convicted of graft

B0, B1, and B2 are numbers, and OLS selects them in such a way as to minimize the sum of squared errors you get when you plug the data you have into the equation. Think of it this way – say the equation returned was this:

Number of incumbent votes in any given year

= 28 + 0.7*employed people – 20*employees convicted of graft

That equation tells us that the number of incumbent votes was equal to 28, regardless of how many people were employed or convicted of graft. (Bear in mind – that first term, the constant term as it is called, sometimes gives nonsensical results by itself and really is best thought of as “making the equation add up.”) The second term (0.7*employed people) tells us that every additional employed person generally adds 0.7 votes. The more people with jobs, the happier voters are, and thus the more likely to vote for the incumbent. Of course, not everyone with a job will be pleased enough to vote for the incumbent. Finally, the last term (- 20*employees convicted of graft) indicates that every time someone in the city government is convicted of graft, incumbents lose 20 votes in upcoming elections due to an increased perception that the city government is lawless.

Now, these numbers: 28, 0.7, and -20 are made up in this example, but they wouldn’t have been arrived at randomly. Instead, remember that together they form an equation. The equation has a very special characteristic, but before I describe that characteristic, remember – this is statistics, and statistics is an attempt to find relationships based on data available. The data available for number of people employed and number convicted of graft – say for the year 1974 – can be plugged into the equation to produce an estimate of the number of votes. That estimate can then be compared to the actual number of votes, and the difference between the two is the model’s error. In fact, there’s an error associated with every single observation (in our example, there’s one observation per year) used to estimate the model. Errors can be positive or negative (the estimate can be higher than the actual or lower), or even zero in some cases.

OLS regression picks values (the 28, 0.7, and -20 in our example) that minimize the sum of all the squared errors. That is, take the error produced each year, square it, and add it to the squared errors for all the other years. The errors are squared so that positive errors and negative errors don’t simply cancel each other out. (Remember, the LS in OLS are for “least squares” – the least squared errors.) You can think of OLS as adjusting each value up or down until it spots the combination that produces the lowest total sum of squared errors. That adjustment up and down is not what is happening, but it is a convenient intuition to have unless and until you are someone who works with statistical tools on a daily basis.

Note that there are forms of regression that are different from OLS, but for the most part, they tend to produce very similar results. Additionally, there are all sorts of other statistical tools, and for the most part, for the sort of problem I described above, they also tend to produce similar outcomes.

I gotta say, after I wrote the paragraphs above, I went looking for a nice, easy representation of the above. The best one I found is this this download of a power point presentation from a textbook by Studenmund. It’s a bit technical for someone whose only exposure to regressions is this post, but slides eight and thirteen might help clarify some of what I wrote above if it isn’t clear. (And having taught statistics for a few years, I can safely say if you’ve never seen this before, it isn’t clear.)

OK. That was a lot of introduction, and I hope some of you are still with me, because now it is going to get really, really cool, plus it is guaranteed to piss off a lot of people. I’m going to use a regression to explain the growth in real GDP from one year to the next using the top marginal tax rate and the top marginal squared. (In other words, explaining the growth in real GDP from 1994 to 1995 using the top marginal rate in 1994 and the top marginal rate in 1994 squared, explaining the growth in real GDP from 1995 to 1996 using the marginal rate in 1995 and the top marginal rate in 1995 squared, etc.) If you aren’t all that familiar with regressions, you might be asking yourself: what’s with the “top marginal rate squared” term? The squared term allows us to capture acceleration or deceleration in the effect that marginal rates have on growth as marginal rates change. Without it, we are implicitly forcing an assumption that the effect of marginal rates on growth are constant, whether marginal rates are five percent or ninety-five percent, and nobody believes that.

Using notation that is just a wee bit different than economists generally use but which guarantees no ambiguity and is easy to put up on a blog, we can write that as:

% change in real GDP, t to t+1 = B0 + B1*tax rate, t + B2*tax rate squared, t

Top marginal tax rates come from the IRS’ Statistics of Income Historical Table 23, and are available going back to 1913. Real GDP can be obtained from the BEA’s National Income and Product Accounts Table 1.1.6, and dates back to 1929. Thus, we have enough data to start our analysis in 1929.

Plugging that into Excel and running a regression gives us the following output:

Figure 1

For the purposes of this post, I’m going to focus only on those pieces of output which I’ve color coded. The blue cells tell us that the equation returned by OLS is this:

% Change in Real GDP, t to t+1 = -0.15 + 0.63*tax rate, t – 0.48* tax rate squared, t

From an intuition point of view, the model tells us that at low tax rates, economic growth increases as tax rates increase. Presumably, in part because taxes allow the government to pay for services that enhance economic growth, and in part because raising tax rates, at least at some levels, actually generates more effort from the private sector. However, the benefits of increasing tax rates slow as tax rates rise, and eventually peak and decrease; tax rates that are too high might be accompanies by government waste and decreased private sector incentives.

The green highlights tell us that each of the pieces of the equation are significant. That is to say, the probability that any of these variables does not have the stated effect on the growth in real GDP is very (very, very) close to zero.

And to the inevitable comment that marginal tax rates aren’t the only thing affecting growth: that is correct. The adjusted R Square, highlighted in orange, provides us with an estimate of the amount of variation in the dependent variable (i.e., the growth rate in Real GDP) that can be explained by the model, here 17.6%. That is – the tax rate and tax rate squared, together (and leaving out everything else) explain about 17.6% of growth. Additional variables can explain a lot more, but we’ll discuss that later.

Meanwhile, if we graph the relationship OLS gives us, it looks like this:

Figure 2

So… what this, er, (if I may be so immodest) “Kimel curve” shows is a peak – a point an optimal tax rate at which economic growth is maximized. And that optimal tax rate is about 67%.

Does it pass the smell test? Well, clearly not if you watch Fox News, read the National Review, or otherwise stick to a story line come what may. But say you pay attention to data?

Well, let’s start with the peak of the Kimel curve, which (in this version of the model) occurs at a tax rate of 67% and a growth rate of 5.85%. Is that reasonable? After all, a 5.85% increase in real GDP is fast. The last time economic growth was at least 5.85% was in the eighties (it happened twice, when the top rate was at 50%). Before that, you have to go back to the late ‘60s, when growth rates were at 70%. It isn’t unreasonable, then, to suggest that growth rates can be substantially faster than they are now at tax rates somewhere between 50% and 70%. (That isn’t to say there weren’t periods – the mid-to-late 70s, for instance, when tax rates were about 70% and growth was mediocre. But statistics is the art of extracting information from many data points, not one-offs.)

What about low tax rates – the graph actually shows growth as being negative. Well… the lowest tax rates observed since growth data has been available have been 24% and 25% from 1929 to 1932… when growth rates were negative.

What about the here and now? The top marginal tax rate now, and for the foreseeable future will be 35%; the model indicates that on average, at a 35% marginal tax rate, real GDP growth will be a mediocre 1.1% a year. Is that at all reasonable? Well, it turns out so far that we’ve observed a top marginal rate of 35% in the real worlds six times, and the average growth rate of real GDP during those years was about 1.4%. Better than the 1.1% the model would have anticipated, but pretty crummy nonetheless.

So, the model tends to do OK on a ballpark basis, but its far from perfect – as noted earlier, it only explains about 17.6% of the change in the growth rate. But what if we improve the model to account for some factors other than tax rates. Does that change the results? Does it, dare I say it, Fox Newsify them? This post is starting to get very long, so I’m going to stick to improvements that lie easily at hand. Here’s a model that fits the data a bit better:

Figure 3

From this output, we can see that this version of the Kimel curve (I do like the sound of that!!) explains 36% of the variation in growth rate we observe, making it twice as explanatory as the previous one. The optimal top marginal tax rate, according to this version, is about 64%.

As to other features of the model – it indicates that the economy will generally grow faster following increases in government spending, and will grow more slowly in the year following a tax increase. Note what this last bit implies – optimal tax rates are probably somewhat north of 60%, but in any given year you can boost them in the short term with a tax cut. However, keep the tax rates at the new “lower, tax cut level” and if that level is too far from the optimum it will really cost the economy a lot. Consider an analogy – steroids apparently help a lot of athletes perform better in the short run, but the cost in terms of the athlete’s health is tremendous. Finally, this particular version of the model indicates that on average, growth rates have been faster under Democratic administrations than under Republican administrations. (To pre-empt the usual complaint that comes up every time I point that out, insisting that Nixon was just like Clinton in your mind is not the point here. The point is that in every presidential election at least since 1920, the candidate most in favor of lower taxes, less regulation and generally more pro-business and less pro-social policy has been the Republican candidate.)

Anyway, this post is starting to get way too lengthy, so I’ll write more on this topic in the next few posts. For instance, I’d like to focus on the post-WW2 period, and I’m going to see if I can search out some international data as well. But to recap – based on the simple models provided above, it seems that the optimal top marginal tax rate is somewhere around 30 percentage points greater than the current top marginal rate. The recent agreement to keep the top marginal rate where it is will cost us all through slower economic growth.

As always, if you want my spreadsheet, drop me a line. I’m at my name, with a period between the mike and my last name, all at gmail.com.

It occurs to me that I should probably explain why I used taxes at time t to explain growth from t to t+1, rather than using taxes at time t+1. (E.g., taxes in 1974 are used to explain growth from 1974 to 1975, and not to explain growth from 1973 to 1974.) Some might argue, after all, that that taxes affect growth that year, and not in the following year. There are several reasons I made the choice I did:

1. When changes to the tax code affecting a given year are made, they are typically made well after the start of the year they affect.

2. Most people don’t settle up on taxes owed in one year until the next year. (Taxes are due in April.)

3. Causation – I wanted to make sure I did not set up a model explaining tax rates using growth rather than the other way around.

4. It works better. For giggles, before I wrote this line, I checked. The fit is actually better, and the significance of the explanatory variables is a bit higher the way I did it.

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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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