Presidents, Taxes and Economic Growth
by Mike Kimel
One of the never-ending debates in economics is the extent to which taxes affect the economy. Most people are fairly certain that higher taxes slow growth. They’ve learned this from economists.
To get my own look at the issue, about six years ago, I wrote a post looking at the relationship between the federal tax burden and growth in real GDP, and I did so in the context of Presidential administrations.
To avoid questions about which leads which (i.e., did the tax burden affect the economy, or were tax burdens changed by the political class in response to changing economic conditions), I looked at the change in the federal tax burden over the first two years of a presidential administration and compared that to the % change in the real GDP over years two through eight of that same administration. (I left out administrations that served less than 2 terms.)
That way, if there was a relationship between the two series there would be no question that taxes were leading the economy rather than the other way around. Also, two years is enough time for an administration to impose its policies, but not enough time for reality to set in and for it to start flailing about. Conversely, six years is long enough to see outcomes, and won’t be susceptible to huge movements due to extraordinary positive or negative performance in one outlying year.
Thus, for example, for Reagan, I looked at the annual change in the Federal Tax Burden (i.e., Federal Current Receipts / GDP) between 1980 (before Reagan took office, and therefore the baseline year for Reagan) and 1982, Reagan’s second full year in office. I then compared that to the annualized % change in real GDP from 1982 to 1988.
Going back to 1932, the first year for which there is National Income and Product Accounts data on a full presidential administration generated a graph that looks like this:
The lesson here is…. contrary to what most economists will tell you, during administrations which started off by lowering tax burdens, the rest of us suffered through lower economic growth. When administrations started out by raising the tax burden, the rest of us enjoyed greater economic growth. And before you object with something along the lines of “well, maybe the President cut taxes to deal with a recession” bear in mind that no President in our sample, perhaps no President in American history, had to deal with worse starting conditions than FDR.
Also note that leaving out one or another administration changes the slope of the line, but doesn’t make it negative. The biggest outlier seems to be the FDR (pre-war) administration. Removing that data point results in this:
So that mostly rehashes a post from six years ago. But today we are knee deep into the political season, and seven years and change into the Obama administration. How does the Obama administration look so far? The graph below is identical to the first, but it superimposes the Obama administration (data through 2015)
So Obama cut the tax burden in his first two years in office, and subsequently generated mediocre growth. Sure, he took office during the worst economic headwinds since FDR, but his reaction was more GW than FDR. So we’re his results. GIGO remains immune to wishful thinking.
Comments and conclusions:
1. Does this mean that lower taxes lead to slower economic growth rates? It would seem that way. At a minimum, it is safe to say these graphs most definitely fail to support the free lunch scheme that the economics profession has instilled in the American public, namely that paying less in taxes leads to faster economic growth.
2. Why look at tax burdens and not tax rates? Well, simply put, the tax burden is the amount people (and companies) actually pay, and those affect after tax income available for consumption or investment, behavior, and to some extent, the amount the government has to spend and interest rates. Tax rates, tax exemptions, tax deductions, etc., are simply a component of how much people pay. For example, George HW Bush famously reneged on his pledge not to raise tax rates, but the tax burden, the share of income that went to taxes, was lower when he left office than when he left the White House than when took the oath of office. In practical terms, people paid less taxes after 4 years of Poppy Bush’s presidency.
3. How does a a President affect the tax burden? Tax laws are relatively short when compared to what really matters: rules, regulations, what gets challenged by the administration in Court, decisions by the tax Courts, and general behavior by the administration. The administration decides how much effort and the level of resources devoted to enforcement. It’s executive appointees write the rules and regulations. It’s judicial appointees decide the outcome of cases. It is also reasonable to assume that how much a President cares to enforce tax issues is a proxy for how much that President cares to enforce other financial rules and regulations.
4. So what’s the transmission mechanism by which tax burdens can affect growth? As small business owners, my wife and I have a simple strategy to reduce our tax bill: we plow as much of our profits right back into the business. Put another way, the reduction in our taxes is a function of how much we invest. That in turn makes the business grow faster. But as the tax burden falls, our incentive to avoid (or rather postpone) taxes in this way goes down. Lower taxes mean we invest less and increase our consumption. And while they may talk their book, anyone with a profitable business makes the same calculation.
5. Data used in this analysis is stored in this google doc: https://docs.google.com/spreadsheets/d/1kOFjkaCCoqVm_KoiwmHvTHJYi5JsuSJrOa6irpO1XOM/pubhtml
The formulas didn’t copy from Excel, nor did the graphs, but the file contains everything you need to replicate what I did.
Thanks for reading and have a great day!