Explaining Why Low Tax Rates are Correlated with Slower Economic Growth, Once Again

by Mike Kimel

Explaining Why Low Tax Rates are Correlated with Slower Economic Growth, Once Again

One of the regular mysteries facing economists is why the US economy fails to display evidence of a relationship that everyone seems to accept implicitly, namely that lower taxes lead to (or even are correlated with) faster economic growth. Sure, the argument is sometimes made by academics using rather heroic assumptions. The paper everyone seems to cite these days uses the assumptions made by politicians before a change in the tax rate as the “effect” that actually occurred after the change in the tax rate. Non-academics rely on other heroic assumptions. My favorite is attributing the rapid growth during the three years of the Kennedy administration to a cut in tax rates that occurred the year after he died. (Actually, even Alan Greenspan made this one well before he made the transition from Maestro to goat.)

I’ve taken a crack at explaining that puzzle, most recently here:

people will want to minimize their tax burden at any given time subject provided it doesn’t decrease their lifetime consumption of stuff plus holdings of wealth. Put another way – all else being equal, peoples’ incentive to avoid/evade taxes is higher when tax rates are higher, and that incentive decreases when tax rates go down. Additionally, most people’s behavior, frankly, is not affected by “normal” changes to tax rates; raise or lower the tax rates of someone getting a W-2 and they can’t exactly change the amount of work they do as a result. However, there are some people, most of whom have high actual or potential incomes and/or a relatively large amount of wealth, for whom things are different. For these people, some not insignificant amount of their income in any year comes from “investments” or from the sort of activities for which paychecks can be dialed up or down relatively easily. (I assume none of this is controversial.)
Now, consider the plight of a person who makes a not insignificant amount of their income in any year comes from “investments” or from the sort of activities for which paychecks can be dialed up or down relatively easily, and who wants to reduce their tax burden this year in a way that won’t reduce their total more or less smoothed lifetime consumption of stuff and holdings of wealth. How do they do that? Well, a good accountant can come up with a myriad of ways, but in the end, there’s really one method that reigns supreme, and that is reinvesting the proceeds of one’s income-generating activities back into those income-generating activities. (i.e., reinvest in the business.) But ceteris paribus, reinvesting in the business… generates more income in the future, which is to say, it leads to faster economic growth. To restate, higher tax rates increase in the incentives to reduce one’s taxable income by investing more in future growth.

Restating again: when the tax rate is 75%, a business owner has a strong incentive to reinvest all his/her profits in the business rather than take those profits out and consume them. This is because reinvesting in the business means the profits aren’t pulled out and thus aren’t recognized as income by the IRS. Reinvesting in the business also increases the business’ chances to do well in future years, which generates growth for the economy. On the other hand, when the tax rate is 15%, there is more of an incentive to take out profits and engage in consumption of the type that does not generate much growth.

David Glasner has another (albeit complementary) suggestion:

The connection it seems to me is that doing the kind of research necessary to come up with information that traders can put to profitable use requires very high cognitive and analytical skills, skills associated with success in mathematics, engineering, applied and pure scientific research. In addition, I am also positing that, at equal levels of remuneration, most students would choose a career in one of the latter fields over a career in finance. Indeed, I would suggest that most students about to embark on a career would choose a career in the sciences, technology, or engineering over a career in finance even if it meant a sacrifice in income.  

If for someone with the mental abilities necessary to pursue a successful career in science or technology, requires what are called compensating differences in remuneration, then the higher the marginal tax rate, the greater the compensating difference in pre-tax income necessary to induce prospective job candidates to choose a career in finance. So reductions in marginal tax rates in the 1980s enabled the financial sector to bid away talented young people from other occupations and sectors who would otherwise have pursued careers in science and technology. The infusion of brain power helped the financial sector improve the profitability of its trading operations, profits that came at the expense of less sophisticated financial firms and unprofessional traders, encouraging a further proliferation of products to trade and of strategies for trading them.