How Tax Rates Affect Investment and Consumption – A Look at the Data
by Mike Kimel
How Tax Rates Affect Investment and Consumption – A Look at the Data
Cross posted at the Presimetrics blog
This post looks at how changes in the top marginal tax rates affect peoples’ decisions on how much to consume and invest. Ask a libertarian or conservative economist and the answer is obvious – raising tax rates on high income individuals dissuades them from doing productive things – that is to say, it causes them to cut back on working and investing. In the interest of avoiding strawmen at all costs, many libertarians and conservatives might assume that a hike in the tax rates on such individuals can also cause them to cut back on consumption. After all, if tax rates are raised high enough, perhaps people won’t have enough left over to consume as much as they otherwise would. However, the reduction in voluntary activities that take effort (i.e., work, investment) should easily swamp the reduction in consumption, some amount of which is needed for simple survival. Put another way, as tax rates rise the ratio of investment to consumption should fall.
That right there is what’s known as a testable implication, and there’s data aplenty for that purpose. But before we move on to testing this, let me note that the first paragraph actually provides a second, far more familiar testable implication, namely that higher tax rates will generally lead to slower economic growth. While that particular narrative seems to be widely believed even by non-economists, it certainly isn’t borne out by US data from the last eight decades or so:
Figure 1
(Figure 1 first appeared in this post.)
The graph shows that, at least until top marginal tax rates get somewhere above 50% (a bit more precision available here), increasing those rates does not correlate with slower economic growth, but rather with faster increases in real GDP. In fact, raising top marginal tax rates doesn’t have many of the effects many people seem to expect (And incidentally, its worth noting that state level data also produces results the Chicago school and most libertarians don’t expect.)
Now, the reason I mention the data’s irresponsible failure to abide by conservative and/or libertarian philosophies when it comes to tax rates and growth is because I think the relationship between tax rates and economic growth can be at least partly explained by the relationship between tax rates and investment. As I stated here, in my opinion, higher tax rates can lead to more investment. After all, one way a person who owns a business (large or small) can reduce the taxes they pay on profits is to reinvest the profits, which in turn leads to faster economic expansion. Furthermore, the incentive to avoid taxes and reinvest increases as tax rates increase. Of course, at some point, tax rates get high enough to encourage individuals to reinvest even though the “benefits” from more reinvestment, at the margin, are negative. Where that happens, I don’t know, but based on Figure 1, my guess is that it takes a top marginal tax rate above 50%.
So… here’s what libertarians and conservatives should expect to see: as the top marginal tax rises, the ratio of investment to consumption falls.
Here’s what I expect to see: the relationship between the top marginal tax rate and the ratio of investment to consumption is somewhat curved. For top marginal tax rates between 0 and some point X (where X > 50%), an increase in the top marginal rate leads to an increase in investment/consumption. After that, as the top marginal rate rises, we should investment/consumption level off, and for even higher marginal rates, investment/consumption should fall.
So… using top marginal rates from the IRS’ Statistics of Income historical table 23, and national investment and consumption figures from the Commerce Department’s Bureau of Economic Analysis’ National Income and Product Accounts table 1.1.5, we can construct this little graph:
Figure 2
It’s not a perfect quadratic curve, but it sure looks a lot more like what I had in mind than what any conservative or libertarian would expect. FYI, the correlation between the top marginal tax rate the ratio of investment to consumption for top marginal tax rates below 50% is 55%. That is to say, an increase in tax rates increases the ratio of investment to consumption when tax rates are below 50%. On the other hand, the correlation is a negative 11% when tax rates are above 50%. That is to say, increasing tax rates when they are above 50% has a (not particularly strong) negative effect on people’s “invest v. consume” decision.
Put another way – conservatives and libertarians have a very, very flawed theory of the world. At the very least it does not conform at all with historical US data. At all. Which of course has serious consequences; because that theory is somewhat dominant in the political sphere, and has been since the late 60s. The end result – slower economic growth for all of us since the late 60s. That has real consequences for real people – 310 million of us. That should have repercussions for the consciences of economists who peddle this garbage, though apparently it doesn’t.
But that’s for another post. Today, I want to remain clinical. So… what does Figure 2 mean, with respect to Figure 1? It means that, yes, at least until a certain point (somewhere above 50%), raising the top marginal rate both increases the ratio of investment to consumption and the real economic growth rate. Its not outlandish to assume that increasing investment is one of the factors that can increase real economic growth. (Worth exploring more in a post sometime in the future.) Other things matter, of course, but I think investment is up there among factors that matter.
It also means that since we’re keeping tax rates at the level they’ve been for the past decade or so, we shouldn’t expect sustained rapid investment or economic growth any time soon. Don’t expect the 60s or even the 70s again any time soon – we’re in end of the 80s and 00s level taxation, and over the long haul, we’re in for that sort of growth too.
A few closing remarks:
1. 1. This post was partly inspired by an interview I had with George Kenney of Electric Politics. It was a really useful and interesting conversation for me, in part because he pressed me a bit past my comfort level. I understand he’ll have that interview up in a few weeks.
2. 2. I’ve noticed that a number of the graphs I’ve been putting up are not so much quadratic as a bit bimodal. I have been thinking about that for the past few days, and I think that will be my next post on this “kimel curve” approach to world I’ve been following lately.
3. 3. Please, please, please, please, if you object to something in this post and are planning to bring up Romer and Romer, read this first to save me from being embarrassed on your behalf.
4. 4. As always, my spreadsheets are available to anyone who wants them.
5. 5. Between the time I finished my spreadsheet and the time I wrote this post, I read this blurb from Tyler Cowen’s next book. It might be uncharitable of me, but my first thought was to wonder about the odds a libertarian professor would add two and two together, and whether he could remain libertarian if he inadvertently did.
Mike:
Your premise:
in my opinion, higher tax rates can lead to more investment. After all, one way a person who owns a business (large or small) can reduce the taxes they pay on profits is to reinvest the profits
is wrong. A business can’t reduce taxes by investment. Income is taxed, then business can CAPX with what is left. The CAPX is not expensed, it gets depreciated/written off over long time periods.
sammy,
My wife and I have a small business which she runs and which we are in the process of making into an LLC. We live off of my income and don’t need the income the business generates. Right now its a very small business, but at the end of the year, we made sure every dime of revenue above the costs the business generated were reinvested into the business (i.e., we made purchases for the business generating new costs – in fact, we had to put more money in as a result) that helped expand the business. Had we not done so, the business would have generated taxable income. Having done so, we had no income from the business. However, we are helping the business to grow… which in turn is a very small positive for the economy. If we are fortunate enough that we can continue living off of my income this year, I expect we will do exactly the same thing in 2011.
Depreciation expense is deductable
sammy,
My wife and I have a small business which she runs and which we are in the process of making into an LLC. We live off of my income and don’t need the income the business generates. Right now its a very small business, but at the end of the year, we made sure every dime of revenue above the costs the business generated were reinvested into the business (i.e., we made purchases for the business generating new costs – in fact, we had to put more money in as a result) that helped expand the business. Had we not done so, the business would have generated taxable income. Having done so, we had no income from the business. However, we are helping the business to grow… which in turn is a very small positive for the economy. If we are fortunate enough that we can continue living off of my income this year, I expect we will do exactly the same thing in 2011.
Now, say we get to the point where the business generated enough income (prior to reinvestment) to pay for some extravagance or other and that we were considering taking money out to pay for that extravagance. How would our decision (take money out and pay taxes on it or reinvest and don’t pay taxes, but don’t get the extravagance either) change if the tax rate dropped to 5%? How would it change if the tax rate were raised to 95%?
but at the end of the year, we made sure every dime of revenue above the costs the business generated were reinvested into the business (i.e., we made purchases for the business generating new costs)
Mike this is just moving expenses into the current tax year, not investment. You are just moving forward the timing of expenses to get the tax deduction and this will be offset by less consumption over the first few months of the next tax year. Investment is something very different – it is buying or building assets that will increase production.
Sammy –
You are playing word games. Alas – not too effective when dealing with numbers.
No matter what you call it, money earned from the business and plowed back into the business ends up not being income, because it is reinvested or used for expenses – take your pick. Money earned from the business and kept is income, and therefore is taxable. It’s basic accounting.
Further, there is no straight line connection between the investment/expense of the current tax year, and the cash flows of the following year, such as you are assuming. The results of this year’s investments could open new opportunitues that increase investment opportunities the following year.
That kind of sounds like growth, doesn’t it?
Mike makes a cogent argument, you read nonsense from an erroneous playbook.
Plus, there’s this, which despite being an eye-opening article, makes me wonder if anybody in this coutry even knows what “socialism” actually means.
http://www.inc.com/magazine/20110201/in-norway-start-ups-say-ja-to-socialism.html
JzB
Wow, these twitter feeds really mess up the comment stream, and add no content.
Can you get rid of them?
JzB
sammy,
No. We had a decision to make – take some profit and use it for a few purchases we otherwise wouldn’t make, or put that money back into the business. However, the business’ needs are lumpy, and its revenues less costs last year weren’t enough to cover the costs of one more unit of input, requiring us to invest additional funds into the business.
Would we have done the same this year or next? Who knows? But… taking, say, $1000 in profits out costs us well over $1000 when taxes are taken into account. That makes it easier to decide not to take money out and instead keep ploughing it back in. And every time we make that decision, it increases the odds that the business will continue to grow and might one day be able to sustain us.
Mike,
OK. But you need to take the word “investment” out of your argument. It should read: “higher marginal tax rates creates the incentive for businesses to pull forward some expenses at the end of the tax year……”
That would be an accurate and true statement, but is very different than your “higher taxes can lead to more investment.” There is no mechanism by which higher tax rates lead to more investment (I guess I have to specify: investment in plant and equipment), not the least of the reasons why is that more money sent to the government leaves less money available for investment.
Let me pose a question is it the combined income tax rate or the federal rate that is being modeled here. It does make a difference, although one can in some cases one can relocate to reduce the rate.
Lyle,
Its Federal top marginal rates only.
sammy,
Assuming the current situation continues for two decades, will you be saying we haven’t invested any extra, we’re just eight or nine years ahead of schedule in putting money back into the business? Do you really think the amount put into one’s business over the years is predestined?
And sammy, one more thing. If we’re lucky enough that we can continue putting money back into the business every year until I reach retirement age, hopefully the business will provide our income in retirement. I.e., we’ll be taking money out at that point as that will be it for my paycheck. Is money being put back into the business when I’m a year or two or three from retirement really just money that is being moved forward? And if so, from what if we wouldn’t be putting that money in when I’m retired?
“Don’t expect the 60s or even the 70s again any time soon – we’re in end of the 80s and 00s level taxation, and over the long haul, we’re in for that sort of growth too.”
Hammers and nails, I fear. It has been evident from your writing over the years that you see past to claim that tax rates are a strong determinant of growth. However, much of your writing has focused on the relationship between taxes and growth, which could tend to lead you into statements like the one I’ve quoted. If tax rates are not a strong determinant of growth, then having tax rates similar to some earlier period does not mean we are likely to have growth similar to that period.
Before going all bimodal on us, I’d suggest eliminating the tax rates for which you have no observations from the graph. Then, you’d show a big old dip around 65%, but not in adjacent rates. That would make the thing look more like a quad, with a bit of noise around 65%, less bimodal. The lack of data at 45%, 55% and 60% probably don’t need to be represented.
“Don’t expect the 60s or even the 70s again any time soon – we’re in end of the 80s and 00s level taxation, and over the long haul, we’re in for that sort of growth too.”
Hammers and nails, I fear. It has been evident from your writing over the years that you see past claims that tax rates are a strong determinant of growth. However, much of your writing has focused on the relationship between taxes and growth, which could tend to lead you into statements like the one I’ve quoted. If tax rates are not a strong determinant of growth, then having tax rates similar to some earlier period does not mean we are likely to have growth similar to that period.
Before going all bimodal on us, I’d suggest eliminating the tax rates for which you have no observations from the graph. Then, you’d show a big old dip around 65%, but not in adjacent rates. That would make the thing look more like a quad, with a bit of noise around 65%, less bimodal. The lack of data at 45%, 55% and 60% probably don’t need to be represented.
In a growing economy, new frms enter and, given a similar set of incentives, will make similar investment decisions. Thus in an expanding economy, ownders of Kimel Co. may begin taking income out of the firm, but new firms will still be plowing all earnings back into the firm.
In an otherwise static economy, Kimel Co. arriving at the point that it distributes income to its owners represents a net decline in investment. Years of plowing everything back in can be viewed as having moved investment forward on an aggregate basis. In an economy that is not stagnant, Kimel Co. distributing income to owners need not represent a net decline in investment, and so may not represent moving investment forward in time, in aggregate.
Please, please, pretty please?
kharris –
Either you are confusing things, or I am. What I see is that Mike has devoted a lot of prior effort to exploding the myth that higher taxes deter investment, or in other ways stifle the economy. The Kimmel curve is a more recent concept that grew out of the earlier work.
If there is a relationship between taxation and economic performance, it is clearly not as described by regressive dogma. That doesn’t mean that it can’t be described by what Mike is showing us. And it does not follow that “having tax rates similar to some earlier period does not mean we are likely to have growth similar to that period.”
Mike is suggesting that it does mean that, and that idea is worth exploring. I agree.
Or am I wrong?
Cheers!
JzB
Look at all the column space and mental effort that’s been used here because Sammy either can’t or refuses to understand simple accounting. See how meaningful dialog has been derailed.
Details and players change, but that’s been the scenario here at AB for years.
I would be worth while if the regressives would learn something from it, and come back the next time with something – anything – that actually advanced the dialog. But it’s same-old same-old misdirection play time after time.
Knowledge and truth are at a big disadvantage in dealing with ignorance and lies.
It’s why the liars are winning.
Death panels, anyone?
JzB
Interesting analysis as usual. Have you looked at the impact of increasing/dercreasing the level of progressiveness of the tax rate?
So is there any state effect, ie the difference between say CA and Tx or NY or NV? It seems to me that the state rate should have an effect all be it it might be an effect of migration, such as we see big corps migrating their headquarters out of NYC. (OF course Telecom means that there is less reason to be located there)
Jim,
Not yet. Its on the eventual to do list, but you’ll have to be patient with me. I’ve got a lot of ground I want to cover.
jazzbumpa more or less nails my philosophy, which is evolving. I started by trying to test whether there was this lower taxes = faster growth relationship I kept hearing about but which didn’t match my intuition. At that point, I simply believed that there was no relationship between tax rates and growth.
Where I am now is this – if higher tax rates (until some level X) really do lead to greater investment (and all I’ve shown here is correlation and not causality, not even granger causality), then its not unreasonable to assume that higher tax rates (below some level X) are at least indirectly helping to create faster economic growth.
I haven’t tested some of those “ifs” of course, but you know my style – unless I have to put a halt to this little hobby due to resource constraints those tests are coming. I have some beliefs – and I want to see if they’re true. If they’re not true, I want to know what is true (and why) so I can change my beliefs and avoid wallowing in error.
jazzbumpa,
Look at all the column space and mental effort that’s been used here because Sammy either can’t or refuses to understand simple accounting. See how meaningful dialog has been derailed.
You’ve got it all wrong. I like and admire Mike very much. I admire him because he is willing to think ouside the box and he has the courage to put his controversial ideas out for critique. As the former blog owner, he had the courage to publish my main posts when probably no one else would. He followed through and published his own booK! So all my comments are meant to be constructive.
I do understand accounting, no doubt better than you or cactus, as I know investment is capitalized not expensed and so does not shelter current income. I also understand depreciation. As an example of the effect of higher marginal tax rates, taking into account depreciation, I offer the following:
A business buys a machine (or other productive asset) for $100K and it expects EBITD (Earnings Before Interest Tax and Depreciation) of $20K per year for 10 years. The asset is also depreciated over 10 years on a straight line basis. The net earnings after tax are presented 1) at a 25% marginal tax rate and 2) at a 50% marginal tax rate.
25% Tax Rate: EBITD = $20K per year minus Depreciation $10K per year = pre tax earnings $10K per year. After 25% tax, net earnings are $7.5K per year.
50% Tax Rate: EBITD = $20K per year, minus Depreciation $10K per year = pre tax earnings $10K per year. After 50% tax, net earnings are $5K per year.
So you can see that the depreciation tax shelter does not offset the increase in tax rates. Unless you can find some mechanism where lowering returns increases investment, my original statement, that “there is no way that increasing marginal taxes can increase investment,” stands.
sammy,
Thanks for the kind words. But note – this isn’t accounting. This is simply a decision to take revenue that you otherwise would have moved out of the company and instead putting it into the company’s next best prospect for making money. I call that investment. Call it whatever it you want, but basically, higher taxes (up to X) lead me (and apparently, collectively, all of us as per the graph) to keep making that decision to put money back in rather than take it out.
I agree with Kharris, Can you dump the Twitter feeds?
I’m always looking for something to agree with KHarris since they are so few!!
Just to be sure I’ve been clear, my point was this: Your statement implies not only that higher corporate tax rates can lead to higher investment, but that the effect is sufficiently strong that similar tax rates between one period of time and another should lead to similar rates of investment. I am not arguing that higher rates of corporate taxation cannot lead to higher investment. I am saying that, in the past, you seemed to be of the view that tax rates were one of many factors that determine the pace of growth (mentioning governance as perhaps a bigger deal that tax rates), but that this statement imiplies tax rates are a very big factor, strong enough to determine the overall pace of investment. Is that what you mean to imply? If so, what new evidence has led you to this stronger statement?
This analysis seems familiar. Where have I seen something like this before?
Also, when thinking about the impact of constant derailment of intelligent discussion by trolls,…
Anybody know why Calculated Risk has seen fit to dump Angry Bear from its list of linked sites?