This post looks at the relationship between the tax burden and economic growth. Sadly, this one has no pretty graphs and pictures… so its relatively boring. Sorry. I’m just not inspired this afternoon.
Anyway, call this post a follow up to yesterday’s post on tax cutting by administration, in which we saw that Republicans are (no surprise) the party of cutting taxes, where taxes were measured as the total taxes other than social security collected plus changes in the national debt held by the public, all as a percentage of GDP. This measure of taxes takes into account the fact that a run-up on debt has to be paid off at some point.
In terms of Economic growth, the story is different. Beginning with Ike, Democratic administrations have tended to outperform their Republican counterparts when it comes to real GDP per capita growth – only the best performing Republican administration, Reagan’s, performed better than Carter, the worst performer among Democratic Presidents. Regular readers know I’ve since then looked at real GDP per capita many different ways, the the relationship doesn’t seem to disappear.
Because the government can boost real GDP per capita simply by borrowing and spending, a better measure of economic growth is real (GDP less change in the national debt burden) per person. On that series, JFK/LBJ, Clinton, and Carter all outperformed their Republican counterparts.
The fact that Reps cut taxes more than Dems, and Dems have done better on economic growth, would suggest that tax rates and economic growth are positively correlated. In other words, higher tax rates, not lower, are associated with faster growth.
And a first pass at the data seems to indicate that’s true. The correlation between the % change from the previous year in our measure of taxes and % change from the previous year in real GDP per capita is 0.06699. The correlation between the % change from the previous year in our measure of taxes and % change from the previous year in real GDP less change in debt per capita is .34157, using data from 1951 to 2006. (I probably should have gone with 1952… sorry… I don’t feel like redoing it for one year.)
So a first pass would indicate that the correlation between percentage changes in tax rates and percentage changes in real GDP per capita was positive, albeit weak. In other words, tax rates and real GDP per capita tended to rise and fall in (weak) tandem. The relationship between taxes and real GDP less changes in debt per capita is somewhat stronger.
Note… I’m completely skating over the whole issue of what sort or mix of taxes makes the most sense, which is definitely not a topic for today.
But… anyone except a fanatic will readily admit when tax rates are too high, they discourage economic activity, and tax cuts will benefit the economy. Conversely, when tax rates are too low, they lead to more debt or too little government, and therefore a tax hike will be helpful. But what’s too high or too low? Who knows? What I do know is that taxes (not counting SS) plus the change in the national debt as a share of GDP ranged from just under 10% to just over 17% of GDP in our sample.
So let’s look at how the % change in this tax rate is correlated with the % change in growth for tax rates that are low or medium or high for the observed sample… Here’s a summary of the results…
How do you read this? There are seven observations for which (Tax + Change in Debt)/GDP is between 10.5% and 11.5%, and the correlation for those seven observations between the % change in (Tax + Change in Debt)/GDP and the % change in Real GDP per capita is 0.07. The graph seems to indicate that as long as (Tax + Change in Debt)/GDP is less than 13.5%, raising taxes is correlated with faster growth and cutting taxes is correlated with slower growth. Somewhere above that point (and its not entirely clear where), higher taxes are associated with slower growth. Correlation does not imply causality, but there must be some reason Dems have faster growth than Reps, and the idea of a Laffer curve with respect to growth must fit with almost everyone’s intuition.
If we assume that 13.75% is the fastest growth point, based on what we saw here, the following Presidents moved tax rates throughout their term in the direction most likely to lead to faster growth in real GDP per capita: Ike, JFK/LBJ, Carter and Clinton. The following Presidents favored policies that moved the country away from this faster growth point: Nixon/Ford, Reagan, GHW, GW.
Interestingly enough, the same graph for real gdp less change in debt per capita has a positive correlation at every point but one… and the correlations tend to be stronger for most points (by far) than those on the graph above. I guess what that means… much of our growth rate has been funded by debt… but we knew that.