Why the Correlation Between Top Marginal Rates and Real Economic Growth is Positive

by Mike Kimel

Discouraging Greg Mankiw From Working Would be Good for the Economy, Part 2: Why the Correlation Between Top Marginal Rates and Real Economic Growth is PositiveCross posted at the Presimetrics blog.

I had a post the other day noting that the correlation between top marginal rates and real GDP per capita is positive. Depending on how you look at it (i.e., growth over several years, growth over one year, going back to 1929, focusing only on the period since Reagan took office, etc) that correlation might be small or it might go above 50%, but it is positive. That is to say, higher top marginal income tax rates have not caused with slower real economic growth in this country. Not the message you’ll get from most economists, but the data says what the data says, and where economists disagree with the data, its a sign that something is seriously wrong with the profession, not the data. (Note – the post appeared at the Presimetrics blog and at Angry Bear, and was in response to an op ed piece by Greg Mankiw noting that higher marginal income tax rates would dissuade him from working.)

Now, in that post I didn’t explain why higher top marginal income tax rates haven’t reduced growth, and may have, at times, dare I say it, actually been a force for faster real economic growth. So I’m going to cover that here.

To start with, there is no question that if you tax someone’s efforts enough, they will reduce their efforts. Any answer that is true will have to be consistent with both that statement and the facts (i.e., the positive correlation between top marginal income tax rates and real GDP per capita growth). I can think of several such answers, and I believe all are true to some extent. Now, before I lay out these answers, there is something I should note. I’ve listed these answers in order, from more believable and less important to less believable and more important. The reason I think most people will find the most relevant explanations most believable is that they don’t quite believe that pesky fact, that the correlation between top marginal income tax rates and real GDP per capita is positive. With that warning, here goes:

1. Top marginal tax rates are simply not high enough to induce people who pay it to reduce their efforts. That’s an answer a number of bloggers (Mark Thoma is a good example) gave in response to Mankiw; raising the top marginal tax rate from 35% to 39.6% shouldn’t change Mankiw’s behavior much at all as the difference probably amounts to peanuts for Mankiw. That may be true, but it does nothing to explain why growth rates were highest during periods when marginal tax rates were in the 70% range and up.

2. Dissuading people from putting in certain efforts doesn’t prevent others from putting in the same efforts. Linda Beale is one of several bloggers to note that others might happily step in to do Mankiw’s job should he choose. I’m sure this is not what Linda Beale had in mind when she wrote it, but finding people willing to give policy advice that contradicts the known facts and results in sub-part growth shouldn’t be all that difficult, frankly.

3. Rising top marginal tax rates may dissuade some people from working, but generally won’t dissuade those doing productive work. This is related to explanation 2, but it is subtly and importantly different. Simply put, most people are easily replaceable. Charles De Gaulle famously said “The cemeteries of the world are full of indispensable men.” By that, I imagine he meant that in general, most people are easily replaceable. That holds even for folks who are deemed irreplaceable; I suspect if you replaced almost everyone working for the Fortune 100 or the Ivy League tomorrow, the change would be un-noticeable pretty quickly. (An exception appears below.) Now, there are some people that genuinely are irreplaceable, that genuinely do change things, but there aren’t many of these people, and beyond a certain point, they aren’t motivated by money. Heck, most of them don’t end up all that wealthy despite being irreplaceable, and those few unique innovators that do accumulate vast fortunes (Steve Jobs would probably be an example) would happily do what they as long as they were making enough to meet some relatively basic needs. The few people who can’t be replaced if they upped and quit because the big bad gubmint raised their taxes aren’t the sort of people to go Galt in the first place.

4. A substantial percentage (and no, I don’t know what percentage that is) of people who are motivated enough by money that they might reduce their output in the face of even small changes to the top marginal rates are engaged in activities that are not good for society. For example, they might be Harvard professors who peddle theories that are 180 degrees opposed to reality. Or perhaps they develop or implement financial instruments that help bring down the world economy. There is a bit of a self-selection bias at play; people who care enough about money to become homo universitus of chicagus are also the kind of people willing to generate massive negative externalities with nary a thought to the victims (except perhaps to call them “losers”). Loss of their services is to be encouraged, not decried.

5. At the margin, the gov’t can be more efficient with resources than many people whose needs are sated. The primary motivation for such folks may be not risking what they accumulated and paying as little in taxes as possible. The result, in many cases, is paying vast sums to accountants and keeping the money parked or hidden rather than in productive use.

Anyhow, that’s what I came up. Your thoughts?

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