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.