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Canadian economic growth is about two percentage points higher under Liberal governments

by Mike Kimel

Canadian economic growth is about two percentage points higher under Liberal governments
Cross posted at the Presimetrics blog.

Frances Woolley has a piece in Worthwhile Canadian Initiatives that begins like this:

Canadian economic growth is about two percentage points higher under Liberal governments. At least, that’s what my colleagues Stephen Ferris and Marcel Voia found in their recent article in the Canadian Journal of Economics (earlier ungated version here).

This is a large impact. For example, if the economy was growing at 1 percent under a Conservative government, switching to a Liberal government would increase the predicted GDP growth rate to around 3 percent.

If you’ve been reading my blog posts, or Presimetrics, the book I co-authored with Michael Kanell, you’ll recognize this is about the same conclusion that can be drawn about the United States.

Because of the similarity in outcomes for Canada and the US, its worth considering whether the drivers are the same. Woolley suggests two explanations for the Canadian results. The first:

One hypothesis begins with the observation that the Liberals are Canada’s natural governing party – they have been in office more often, and for longer, than any other political party. Temporary interruptions to their rule, for example, the election of R.B. Bennett, occur when something goes seriously wrong.

This explanation doesn’t work for the US. Democrats have outperformed Republicans from 1929 (the first year for which data is available from the BEA) to the present. That’s 81 years, and Republicans have had the Oval Office for 39 of them – just slightly less than half. In the period from 1953 to the 2008 the period we focus on in our book, Democrats still easily outperform Republicans, there are a total of 56 years, and Republicans have been President for 36 of them.

The second explanation:

A second hypothesis is that Liberals pursue pro-poor policies and Conservatives don’t. This means that Liberals will tend to be elected when people are feeling poor, that is, at the bottom of the business cycle, whereas Conservatives will tend to be elected at the top.

This one also doesn’t work in the US. Yes, FDR and Obama were elected when economic disasters were underway, but malaise was the word of the day when Reagan was elected. (And leaving out FDR and Obama doesn’t change results.) On the other hand, JFK was elected and both Truman and LBJ became President when the country’s mood was exceptionally strong. (Growth under LBJ was second only to FDR, and Truman turned in the worst performance among Democrats thus far.)

Frankly, I think the first sentence of the second hypothesis may have some juice to it, but you have to divorce it from the sentence that follows it:

A second hypothesis is that Liberals pursue pro-poor policies and Conservatives don’t.

The difference in “pro-poor” versus not “pro-poor” explains tax policy, and tax policy correlates with growth in the US. The difference in “pro-poor” versus not “pro-poor” explains tax policy, and tax policy correlates with growth in the US. I suspect, but I haven’t checked yet, that there are two other differences between Democrats and Republicans in the US, and Liberals and Conservatives that matter:

1. Where the money gets spent. (i.e., “pro-poor” spending v. not “pro-poor” spending)
2. Regulation of externalities

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Rules to Write By

by Mike Kimel

Rules to Write By
Cross posted at the Presimetrics blog.

Things to keep in mind, especially when posting here or writing me letters:

1. I don’t cite authority as proof, and I ask that you have the courtesy to not do the same to me. Its bad enough when you cite Paul Krugman. After all, you could be quoting him incorrectly, or out of context. Additionally, Krugman, like the rest of us, could simply be wrong. Its even worse when you cite someone who is paid to have a specific opinion. Cut out the middle man and make the argument yourself.

2. Get your data from a reputable source. In general, that means whatever government agency generates the data though there are exceptions. A think tank which pushes a specific point of view is not one of those exceptions. When it comes to international data, either get it from the government agencies in countries you are looking at, or the World Bank, IMF, UN, CIA, Statistical Abstract of the US or Penn World Tables.

3. If you want to compare economic growth across time periods, adjust for inflation or the size of the economy or both.

4. If you want to compare economic growth across countries, adjust for inflation as well currency differences.

5. If you want to compare growth rates of anything, be consistent with your starting and ending points.

6. If you want to compare any two samples, be consistent in how you assign points between the samples.

7. Do not argue by assertion.

8. Economics is not complicated. If you require assumptions you cannot explain or which do not pass the giggle test when stated in plain English to the average person in order to show a given effect, that effect does not exist.
9. Do not try to impress me with big words. Especially when they are statistical terms.

10. If you haven’t tried applying data to your model, your model is probably worthless.

11. If most or all of the observations in your sample are a special case to your model, your model is worthless.

12. One anecdote does not make a rule.

13. Use as much data as is available, or follow a consistent rule for how much data to use and how to deal with it. Do not cherry pick.

14. No magic lags. Be consistent in your use of lags. If your analysis says that Reagan is responsible for growth during the Clinton administration, he better be responsible for growth during the Bush 1 administration too. And if Reagan is responsible for events that happened four to twelve years after he left office, explain why he isn’t responsible for events that happened 13 years after he left office. Also, explain why some predecessor of Reagan’s isn’t responsible for growth during Reagan’s administration.

15. In economics, time moves in a single direction. For some reason a lot of people write to tell me about how growth during the Kennedy administration only picked up after the so-called Kennedy tax cuts. But those tax cuts occurred in 1964, and Kennedy was assassinated in 1963. And growth was very rapid during the Kennedy administration. (I.e., quite a bit faster than under Reagan.) I also get a lot of people informing me that growth sucked under FDR until WW2 began. But… if you consider growth during FDR’s term only through ’38 or only through ’40, it is still faster than under any other President.

16. Correlation does not imply causality. Sadly, it is impossible to prove causation in the real world when you’re talking about economics. However, if X leads to Y using a variety of different types of data, looked at a variety of different ways, it is certainly strongly suggestive.

17. Lack of correlation does imply lack of causality. If you cannot show that economic growth or tax revenues are negatively correlated with tax rates, then please don’t argue that lower tax rates lead to faster economic growth.
18. Before you insist that paying taxes cannot possibly help the economy, either explain why building roads, funding basic research and fighting epidemics harms the economy or explain why there will be a more optimal provision of such services should the government ceases providing them.

19. Regardless of what you want to believe, real economic growth during the Reagan administration was slower than real growth during the FDR, JFK, LBJ and Clinton administrations. Two of these administrations raised marginal tax rates and one cut them. What these administrations had in common was a vision for expanding the role of government.

20. In the U.S., monetary policy is conducted by the Fed, not by the President. Inflation is caused by printing too much money. Do not attribute the inflation of the 1970s to Carter (or Nixon, for that matter). Do not attribute the end of that inflation to Reagan. One can reasonably state that the Fed reacted badly to something the President did and that caused inflation. One cannot reasonably state that the President caused inflation.

21. If your example of a libertarian paradise is a city state whose government owns much of the productive capacity of that city state, drop it and come up with something that actually does look like a libertarian paradise. That is to say, a place with a very small, very non-intrusive government that does little more than setting and enforcing a very limited number of rules. I can come up with several I am sure you can come up with several too.

22. If you believe Hong Kong has a flat tax, I suggest you inform the Hong Kong Inland Revenue Department that they are in error. Bonus points if you tell them you found out about their mistake from a friend.

23. Please do not tell me I do not understand the private sector. Yes, I was an adjunct professor for five years, but that does not make me an academic by trade. When I was an adjunct, my primary profession was as a consultant, working for myself. I also have never worked directly (i.e., not as a consultant) for any government. That is to say, I have been in the private sector my entire professional career. And yes, I still have a day job with a Fortune 500 company. This is the second Fortune 500 company for which I have worked. I have also worked for a (then) Big 6 Accounting firm.

24. Please do not tell me I do not understand the entrepreneurial mentality. My wife and I own a small business we started from scratch. My wife is a serial entrepreneur. My sister is a serial entrepreneur. Two of my three closest friends are serial entrepreneurs. I also note that tax considerations have never been a big driver for myself, for my wife, for my sister, or for my buddies when starting a business.

25. Social Security is more than a retirement fund – it is also an insurance fund.

26. If someone (whether the government or the private sector) offers you a financial incentive to shoot your own foot, it is still your own #$%@ fault if you pull the trigger.

27. Birds of a feather flock together.

28. Ignore the catch-up effect at your peril.

29. Have a clue about your data sets. The BEA did not estimate GDP before to 1929. The BLS did not estimate unemployment before to 1948. Estimates for those series prior to those dates were produced decades after the fact by others, using more limited information, and sometimes an agenda. So if you use Lebergott’s unemployment statistics for the 1930s, don’t be surprised if you’re asked why we should trust figures that classified a few million people working for the WPA and the CCC as unemployed. If you tell me about economic growth in 1870, tell me where the data you are using originates and why I should consider it to be credible.

30. I used to write posts looking at the effect of the tax burden on economic growth, and people would write to tell me I should use marginal tax rates. Lately I’ve been focusing on the effect of marginal tax rates on growth, and people write to tell me I should use tax burdens. (In two cases, a person who had the first complaint also had the second complaint.) I cannot repeat every single thing I’ve ever written in every post every time I write a new post. Before you decide to berate me for ignoring your favorite hobby horse or tell me that results would be different if I used A instead of B, look through the archives at Presimetrics or Angry Bear to see if I really haven’t covered that material already.

I’ll be putting this list of rules somewhere permanent on the Presimetrics website, and expanding it as things come to me. Feel free to suggest other things people should keep in mind.

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Are Republicans or Democrats Better for the Economy?

Barry Ritholz’s The Big Picture carries a link to Presimetrics in the Reads to start your week section of his blog and Mike has been asked by Barry to post a chapter in the book section.

Dan says:

Mike’s book is one that people need to study and not skim to reinforce a dearly held slogan.

One of the complexities is that the data cuts across favored soundbites for political and political/economic announcements. The ‘conservative’ economic announcements of the day are so grossly inaccurate that they mask what liberals get wrong as well in the debate of the day.

Snark alert…hat tip Ken H….The Atlantic carries an article along a similar vein and poor Megan McArdle has to contend with the growing numbers thinking along the lines of ‘Mike’s band of merry madmen’. )

Are Republicans or Democrats Better for the Economy?

Feb 6 2011, 12:35 PM ET By James Fallows

By Chuck Spinney

This is my last post and I want to thank Jim and Justin [Miller, of the Atlantic web team] for the wonderful opportunity to be a guest blogger. It has been a fun gig, but quite frankly I am running out of steam. But life is an interplay of chance and necessity, and serendipity has just offered up a chance for a final blast.
For several years now, I have been in a analytical battle with an official in the Department of Defense over the question of whether Republicans or Democrats are better for the economy.
Newk A. Mineshaftgap is the pseudonym of a senior career official in the Pentagon, with a civilian rank comparable to that of a general in the military. He must remain anonymous for policy reasons — to borrow from the insightful reasoning used by President Merkin Muffley in Dr. Strangelove, Minesthaftgap cannot get into a policy fight, because he works in the “the war room.”
I can tell you this: Newk has a PhD in physics, but he is not a geek. In fact, he is a bit of polymath, with wide ranging interests, including nuclear weapons, ballistic missile defense, battleship and tank design, global warming and carbon default swaps, economics, and the development of metrics for measuring the quality of medical doctors. I have known Newk for about 20 years and consider him to be a good and most interesting friend with solid if somewhat eccentric instincts. Politically, I would categorize Newk as an independent with libertarian biases.
So, as my last blast, let me offer the following link [PDF] to Newk’s latest report on whether Republicans or Democrats are better for the economy. For a knuckle dragger from the Pentagon, his conclusions might surprise you.

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A Few Graphs Describing the Reagan Presidency

by Mike Kimel

A Few Graphs Describing the Reagan Presidency
Cross posted at the Presimetrics blog.

On February 6, 2011, Ronald Reagan would have been turned 100 years had he been alive. In this post I’d like to share a few graphs from Presimetrics (the book I wrote with Michael Kanell, with graphs and illustrations by Nigel Holmes) which hopefully will give you an idea of how Reagan did as President.

Figure 1 below shows growth rates in real GDP per capita for every administration beginning in 1929, the first year for which the BEA provides data:

Figure 1.

(Note – FDR I was through 1940, FDR II was most of the War years. We broke up the sample that way because there are a lot of people who either out of ignorance or some odd desire to spread BS insist that under FDR, the Great Depression got worse or that growth only picked up with the start of WW2. Either way, I’ve found it is safe to use a person’s pronouncements about FDR as a signal about the accuracy of other things they choose to share. Also note – the remaining graphs in this post focus on the period from 1952 – 2008, as that was the main focus of the book from whence they come.)

As the graph shows, when it comes to real economic growth, Reagan did better than other Republicans. But growth under Reagan was also slower than it was under most of the Democrats since 1929. While the growth rate under Reagan is far less impressive when that last detail is mentioned, it is less impressive still if you remember the definition of GDP:

GDP = Private Consumption + Private Investment + Gov’t Consumption & Investment + Net Exports.

Put another way – if the government borrows a lot and spends what it borrows, it will boost GDP, and that in turn causes real GDP per capita growth to increase. And that is precisely what happened under Reagan:

Figure 2

As we note on page 50 of Presimetrics, early in his term Reagan noted:

Our national debt is approaching $1 trillion. A few weeks ago I called such a figure, a trillion dollars, incomprehensible, and I’ve been trying ever since to think of a way to illustrate how big a trillion really is. And the best I could come up with is that if you had a stack of thousand-dollar bills in your hand only four inches high, you’d be a millionaire. A trillion dollars would be a stack of thousand-dollar bills sixty-seven miles high. The interest on the public debt this year we know will be over $90 billion, and unless we change the proposed spending for the fiscal year beginning October 1st, we’ll add another almost $80 billion to the debt.

We also noted this:

By the time he left office, the national debt, which had been “approaching $1 trillion” had more than doubled to $2.7 trillion, and the stack of thousand-dollar bills that had been 67 miles high was now 193 miles high and rising fast. Interest payments on the debt—“over $90 billion” in 1981—were just shy of $200 billion in Reagan’s last year in office.

Using more relevant measures, real debt per capita (in 2008 dollars) grew from about $10,620 in 1980 to $19,860 in 1988, and from 32 percent of GDP to 51 percent of GDP over the same period. However you slice it, Reagan’s profligacy bore no resemblance to his promises.

All that increased debt creates an obligation to taxpayers, who will, after all, have to repay that debt eventually. One measure we used in the book looks at the impact of that debt obligation – that is, the real net disposable income (i.e., income after current taxes less the increase in the debt per capita):

Figure 3

When you take into account future obligations to pay back debt, Reagan no even longer looks as good as Jimmy Carter. A rising tide, fueled by debt, wasn’t so great at lifting at most people’s boats… unless compared to the tide generated during other Republican presidencies.

But concluding that Reagan was someone to emulate means more than just ignoring the fact that he underperformed most Democrats on economic issues. It also requires means ignoring the fact that Reagan also didn’t particularly care about Republican ideals either, not even the ones he parroted frequently and loudly. For instance, a big source of state and local funding is the federal government. Presidents who truly want to move power away from Washington generally try to increase the transfers from the Federal government to state and local governments. But that is most definitely not what Reagan did:

Figure 4

So what did Reagan excel at, other than outperforming other Republicans on economic issues? Well, it turns out that he was very, very good for the public mood:

Put another way, some Presidents are better with reality, some are better with perception. Reagan was better at the latter.

And if I may, a quote from the book (page 178) about another way Reagan’s administration stood out:

And it’s not just the quantity of crime in Washington that is noteworthy. Some of the plots these folks engage in are—let’s call it like it is—cartoonish. Consider, for instance, the Iran-Contra affair, a convoluted scheme by which American weapons were sold to Iran in exchange for Iran’s exerting influence on Hezbollah, Iran’s terrorist buddies in Lebanon, to release American hostages. (Hezbollah, not incidentally, is thought to be the group responsible for the 1983 U.S. barracks bombings in Lebanon, in which 220 U.S. Marines and 79 international peacekeepers were killed.) To bring the complication of the scheme to the level worthy of a comic-strip villain, much of the loot resulting from the sale of American weaponry to an extremely hostile country would go toward funding the Contras, a rebel group in Nicaragua, thus providing the Contras with a much-needed source of funding that did not involve drug trafficking. A number of administration officials were convicted for their role in the affair. This included the secretary of defense (that would be our friend Weinberger, previously featured in Nixon’s White House), as well as two successive national security advisors (Robert McFarlane and John Poindexter).

The folks who believe, who truly believe, won’t let facts stand in the way of their faith. And the cult of Reagan will continue to live on. Anyone who says Sarah Palin is no Ronald Reagan don’t have the facts on Ronald Reagan.

At this point, I’d normally give you my sources. Since everything here comes from Presimetrics, you’ll find the source for all the data and all the quotes there.

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Tax Rates v. Real GDP Growth Rates, a Scatter Plot

by Mike Kimel

Tax Rates v. Real GDP Growth Rates, a Scatter PlotCross posted at the Presimetrics blog.

This post was submitted by Kaleberg.

In this post, I will look at the relationship between top marginal income tax rates and real GDP growth using a scatter plot.

I am inordinately fond of scatter plots. The nice thing about a scatter plot is that you can present a lot of data in a fairly small space, so rather than just comparing tax rates at time period t against real GDP growth rates from period t to t+1, I can also show real GDP growth rates from period t to t+2, from t to t+3, and from t to t+4. (I.e., the scatter plot shows tax rates at any given time, and the growth rates over one year, two years, three years, and four years.)

The vertical axis is the GDP growth rate, the geometric average for multiple years. The horizontal average is the top marginal tax rate. The one year comparison is shown in dark blue, and each subsequent year is shown with a paler color and a smaller marker.

Figure 1

Data is for the period from 1929 to 2009 (i.e., all the years available from the BEA.)

Lower top marginal tax rates seem to limit economic growth with a rate of about 60% seeming to divide the restricted growth phase from the unrestricted growth phase. There might be a little falloff when the tax rate passes 90%, or there might not. There are lackluster growth rates associated with higher and lower top marginal tax rates. Mediocre growth is not all that hard to achieve. Finally, if high top marginal tax rates had a multi-year effect, we’d see a distinctive pattern in paler blue in this chart, but we don’t. The paler blue, longer term comparisons seem bounded by the single year effect.

The data used in this scatterplot is the same data used to build the bar chart in this this post.

Note from Mike Kimel – as always, if you want the spreadsheet (I have a copy of Kaleberg’s work), send me an e-mail. I’m at my first name dot my last name at, and my first name is “mike.” My last name has only one “m.”

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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.

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The Data Shows that State "Beggar Thy Neighbor" Policies Don’t Work.

by Mike Kimel

The Data Shows that State “Beggar Thy Neighbor” Policies Don’t Work.
Cross posted at the Presimetrics blog.

Many states seem to believe a “beggar thy neighbor” approach to taxes works best. That is, the state with the lowest taxes will “steal” business from other states and produce the fastest economic growth. A lot of people seem to believe it works. The data stands in opposition to them.

States raise revenues through a variety of means – state income taxes, property taxes, fines on overdue books, etc. The Tax Foundation , which bills itself as “a nonpartisan tax research group based in Washington, D.C” and which I believe can be fairly described as generally advocating lower taxes in general, provides a file showing the the overall state tax burden and per capita income for every state for each year from 1977 to 2008.

So here’s what I did after the fold.

I took the per capita income, adjusted by the CPI-U, and got the real per capita income, which I then used to compute the percentage growth (or shrinkage) in real per capita from one year to the next for every state and every year from 1977 to 2007. I did the same thing for the US, getting the US average growth in real per capita income from t to t+1 for every year from 1977 to 2007, and subtracted that amount from the state growth rates. This provided the amount by which each state grew (or shrunk) faster (or not) than average, each and every year from 1977 to 2007.

The next step was to take the state tax burden for each state for each year, and subtract from that the average state tax burden for that year. Result: 1,550 combinations of (tax burden for a state in a year less average tax burden for all states for the same year) on one hand, and (growth in real per capita income from one year to the next for a state in a year less the average growth in real per capita income over the same period). In other words, a comparison between being above or below average on tax burdens and being above or below average on real per capita income growth.

Here’s a histogram:

Figure 1

The graph is a bit busy, but let me interpret it. The first bar is for observations for which the tax burden was between 4.25% and 3.75% below (i.e., more 4.25% below, or less than or equal to 3.75% below) the average state tax burden for that year.(sentence updated….dan)
There are 7 observations (figure in purple at the bottom), and the median growth rate for those 7observations was 1.65% slower than the average for that year.

What the graph tells us is that there seem to be two maxima; going the beggar thy neighbor route can lead to faster than average growth, and there is a sweet spot: keeping tax burdens at about 2.5% below average has, historically tended to be associated with growth rates in real per capita income 0.47% above average. However, get too far away from that sweet spot and the doo-doo really hits the fan. The states that keep the tax burdens the lowest also produce the slowest growth, on average.

For states that don’t take the beggar thy neighbor route (i.e., they take a tax and spend approach), things generally go a little better. The sweet spot there – keeping tax burdens about 2% above average – produces growth rates about 0.67% above average. And getting too far away from that sweet spot doesn’t seem to lead to catastrophic outcomes either.

This post continues the “Kimel curve” theme I’ve been following for the past few weeks, namely that there is a top that maximizes the growth of real GDP. This post has an analogous histogram showing the relationship between top marginal tax rates and growth in real GDP for the US from 1929 to the present. This one – the first of several to do so – computes the growth maximizing tax rate for the US economy. I plan to go back to work on the national data analysis in the coming posts, but everyone needs a break now and then.

As always, my spreadsheets are available to anyone who wants them. Drop me a line at my first name, period my last name, at gmail period com. And note my first name in the e-mail address is mike. An “m” gets you someone else whose patience is starting wear thin. Also, on the subject of “m”s – my last name has only one. Because a lot of people have been asking for my spreadsheets as of late, to make things easier please tell me the the name of this post, the date it appeared, and where it appeared.


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The Tax Rate that Maximizes Economic Growth, Part 3

by Mike Kimel

The Tax Rate that Maximizes Economic Growth, Part 3… With Gov’t Spending, Money Supply and Demographics
Cross posted at the Presimetrics blog.

Today I will build a model that explains over three quarters of the annual movement in real GDP between 1929 and the present. The model depends on marginal tax rates, government spending, the Fed, and demographic trends. This post isn’t light reading and will demand a bit of attention, but I’m going to try to make it worth your while. Let’s just say there’s a lot here that contradicts what you’ll read in your standard economics textbook.

This post continues the “Kimel curve” theme I’ve been following for the past few weeks, namely that there is a top that maximizes the growth of real GDP. That is relatively easy to find: run a regression with growth in real GDP as the dependent variable, and the top marginal income tax rate and the top marginal income tax rate squared as explanatory variables. (If you haven’t seen any posts in this series, or aren’t familiar with regression analysis, you might want to take a look the first post in the series .) Official and relatively reliable data for GDP is available going back to 1929. The growth maximizing top marginal tax rate according to that simple model is in the neighborhood of 65%.

This week I’d like to add a few other variables that I think might affect growth. The first is government spending; for a long time there has been a debate in this country about whether government spending can boost the economy.

Another variable I want to add is the Fed’s behavior. If you’ve read Presimetrics, the book I wrote with Michael Kanell, you know this is a variable I think has a huge effect on the economy, and not quite in the way textbooks tell you. So I’m going to add two variables, both of which are dummies. As I’ve noted in a couple posts, a dummy variable takes a value of one or zero, which also amounts to a “yes” or a “no.” The first of these Fed behavior dummy variables tells us whether the real money supply increased a lot. I’m defining that as a situation when the median 3 month change in real M1 throughout the year exceeded 1%. (Real M1, obviously, being just M1 adjusted for inflation.) The second Fed behavior dummy variable looks at whether there’s a big drop in the real money supply; that is, the variable is true when the median 3 month change in real M1 was a decrease of greater than 0.5%. Why the asymmetry between big increases (over 1%) and big decreases (over 0.5%)? Simple –the money supply should grow over time if only to keep up with population increases.

Moving on… the model contains two demographic variables. One is the percentage of the population between 35 and 54 years of age. That is to say, the proportion of people in more or less their prime earning years. (I imagine prime earning years was closer to 35 in 1929, and has moved closer to 54 today as manual labor has become a less important piece of the economy.) I’m also including the percentage of the population that is above 70 years of age; on average, most people in that demographic are not active in the work force.

Finally, I’ve included one more dummy variable for the 1929 to 1932 period. I’m not ready to explain that collapse yet, so I’ve included this variable if only to indicate that there is something different about those years than other years for which we have data.

So here’s what we get when we run a regression in Excel.

Figure 1

To interpret… the adjusted R2 (light blue) tells us that the model explains about 76% of the variation in the growth in real GDP. (If you’re interested – I did some residual analysis and the usual batch of things to be worried about come up with nothing. E.g., the correlation between et and et+1 = 0.04.)

Tax rates and tax rates squared are significant (green cells). We get the same curve that has showed up in previous posts on this topic, but in this instance, the fastest real GDP growth occurs when the top marginal tax rate is 59%. A bit lower than the 65% figure from earlier models, but close enough… and pretty far away from what most economists and politicians and talk show hosts will tell you. Like it’s a surprise such folks are wrong.

And on the topic of those folks being wrong… government spending is significant, contributes to growth, and does so at an increasingly faster rate as government spending increases. (Burnt orange.) On the other hand, it doesn’t necessarily pay for itself. In future posts I’d like to split out government spending, as I have a feeling different forms of government spending have different effects.

What about the Fed? Well, it turns out the economy grows faster when the Fed increases the money supply quickly, and grows more slowly when the Fed decreases the money supply. Not a surprise if you read my book, but… you may recall your econ courses that taught you the Fed is supposed to try to boost the economy when it is in the doldrums, and slow the economy when its growing too quickly. If the Fed really behaved that way, big increases in real M1 would be accompanied by slow economic growth, and big decreases in real M1 would be accompanied by fast economic growth. This is yet another indication of something I’ve pointed out many times before – historically, either the folks on the Fed’s board don’t know what they’re doing, or they’re doing something different than most economists believe they’re doing. Since they’re political appointees, I’d bet on both.

1929 – 1932 is negative and significant. No surprise.

Demographics – the prime earning demographic is positive and significant. The more people in that demographic, the faster the economy grows. No surprise, but a big negative – that demographic hit a peak in 2001. It drifted down very slowly since, but its not going up any more. The elderly contingent, on the other hand, is not significant.

OK. So… the idea that if we want to maximize economic growth, the top marginal rate is somewhere well north of what most people believe seems to survive over a number of different posts. Here’s one reason why. Here’s another. I’ll have a few more posts on the topic – this little exercise keeps raising more and more questions in my mind.

But a question – are these posts getting too complicated for a blog? More graphs? Comments?

Data sources:

Real GDP and real gov’t spending from NIPA Table 1.1.6

Top individual marginal income tax rates from the IRS’ Statistics of Income historical table 23

M1 comes from a number of different sources. M1 from prior to 1947 is available biannually (June and December) from documents in the FRASER collection of the Federal Reserve Bank of St. Louis. Specifically, data from prior to 1946 came from here, and data from 1941 to 1947 came from here. The data was “monthleycized” using a simple linear transformation. FRASER also contains monthly data from 1947 to 1958 in this document . Finally, another St. Louis Fed database, FRED, contains monthly M1 from 1959 to the present.

Inflation adjustments were computed using monthly and yearly CPI-U figures from the BLS.

Population figures were obtained (and organized painstakingly) from various Census sources: pre-1980s, 1980s, 1990s, and 2000s. (I’m certain there was an easier way…)

As always, my spreadsheets are available to anyone who wants them. Drop me a line at my first name, period my last name, at gmail period com. And note my first name in the e-mail address is mike. An “m” gets you someone else whose patience is starting wear thin. Also, on the subject of “m”s – my last name has only one. Because a lot of people have been asking for my spreadsheets as of late, to make things easier please tell me the the name of this post, the date it appeared, and where it appeared.


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The Tax Rate that Maximizes Economic Growth, Part 2… With Tax Burdens Too

by Mike Kimel

The Tax Rate that Maximizes Economic Growth, Part 2… With Tax Burdens Too!Cross posted at the Presimetrics blog.

This post continues my look at the relationship between taxes and growth (what I modestly called the “Kimel curve”), which I will continue expanding on over a series of posts. Today I want to look at marginal rates, effective tax burdens, and how each or both affect growth rates. As an added bonus for non-economists and folks who don’t deal with statistics on a daily basis, I will also expand a bit on regression analysis and the process of building a rigorous “econometric model.” (Some basic material appeared at the Presimetrics and Angry Bear blogs).

To begin… its no secret that marginal tax rates don’t always have all that much to do with the amount that taxpayers actually pay. This is especially true for folks with extremely high incomes, particularly if a big chunk of their income doesn’t come with a W-2 attached. (Don’t take my word for it – I’ll give you a number later in the post.)

So, while the Kimel curve equation I provided last week dealt with the effect of the top individual federal marginal tax rate on economic growth, this week I want to throw the federal “tax burden” into the mix. The tax burden is simply the percentage of income that actually gets paid in taxes, which we can calculate as the personal current federal taxes divided by personal income. The former comes from line 2 of NIPA Table 3.2. The latter came from line 1 of NIPA Table 2.1.

(If you’re new to my posts, the NIPA tables, or National Income and Product Accounts tables, are computed by the the Bureau of Economic Analysis of the Commerce Department, the agency responsible for computing GDP. They also keep track of a lot of other interesting data about the US economy.)

Real GDP comes from any number of tables on the BEA website – let’s just pull ‘em from here this time around. And of course, we need top individual marginal tax rates IRS’ Statistics of Income Historical Table 23.

Before we go on, let’s just note that the correlation between the tax burden and the top marginal rate from 1929 to 2008 is 4.5%, which is to say, pretty close to zero.

Now, I’m setting up a simple model of growth as follows:

Growth in Real GDP, t to t+1 = B0 + B1*Top Marginal Tax Rate, t

+ B2*Top Marginal Tax Rate Squared, t

+ B3*Tax Burden, t

+ B4*Tax Burden Squared, t

As I mentioned in the previous post, I’m throwing in the X and X squared terms to account for the fact that the effect of variable X on growth rates can change as X rises or falls. For example, maybe when tax rates are low, increasing taxes has only a small effect on growth, but as tax rates rise, further increases in those tax rates can have a very big effect on growth. I’m also fitting the model using a regression. If none of this makes sense, or you don’t remember how to interpret a regression, please take a look here again.

OK. So we let it rip, and get this ouput:

Figure 1, Regression 1 Output

So now we can just go ahead and compute the optimal tax rate and optimal tax burden, right? Well, not so fast. Just because we ran a regression doesn’t mean its any good. Last week we discussed some of the diagnostics you can find in the output above, but what I didn’t mention is that you really should look at the error terms of the regression as well. The errors, or residuals, in a “good” regression look like they came out of a shotgun – they don’t have any obvious patterns. Patterns in the residuals from a regression mean something is systematically wrong with the way the model being estimated fits the data, and if something is systematically wrong, it can (and should be) fixed. Worse still, one of the mathematical assumptions of regression analysis is that you didn’t specify a model that has something systematically wrong with it, which means that the output of a regression is misleading in various ways if you there is something systematically wrong with the model. (In practice, you will never see a perfect shotgun pattern, but you want to shoot for something close.)

But, errors in this regression do show a pattern:

Figure 2, Residuals Diagram 1

As the graph above shows, the errors tend to be pretty big in the beginning, and they tend to shrink over time. Since OLS regressions maximize the sum of squared errors, big errors early on mean the model is putting an overemphasis on the early years. Additionally, the correlation between the errors in one period and the errors in the next are about 50%; big errors tend to be followed by big errors, small errors by small errors, positive errors by positive errors, and negative errors by negative errors. Now, if you’re in a Ph.D. program where showing you have chops is a big deal, you’ll deal with this using any number of cool sounding techniques, each of which is built on a number of assumptions that are truly horrifying if you stop and think about it. But if you’re long gone from academia, and spent a decade post grad school working with these cool sounding techniques, you might have gotten smart and comfortable enough to have rediscovered the KISS rule. If that’s the case, you’ll take a look a second look at the residual graph, and conclude a few things:

1. The 1929 – 1932 recession was a major outlier early on

2. The early part of the US’ involvement in WW2 (starting in 1940- think lend lease, and other gov’t expenditure) is a major outlier

So you might, as a first pass, create a couple of dummies – one for the 1929 – 1932 recession, and another for “major US involvement in WW2” aka 1940 – 1944. A dummy variable takes a value of 1 or 0, which amounts to “yes the condition is met” or “no the condition is not met.”

Rerun the regression with those dummies and you get a regression with these residuals:

Figure 3, Residuals Diagram 2

I’ve kept the scale in this graph the same as on the other. Notice… most of the big errors have dropped away, much of the “heavy early on” pattern is gone, and the correlation between errors in one period and errors the next has dropped quite a bit. A simple fix, and we’re good enough to move on for now. Here’s the output:

Figure 4, Regression 2 Output

Notice… the new model (using tax data and a couple dummies alone) explains about 57% of the variation in the growth in real GDP. Also… the tax burden is not significant. (The P-values are too far above a “significant” value such as 0.01, 0.05, or 0.1 depending on how strict you want to be, or how many asterisks you want to put in your paper.) The two dummies, not surprisingly, are significant; growth was slower than the model would otherwise predict during the 1929-1932 recession/depression, and faster than the model would otherwise predict during the 1940-1944 period when the US gov’t ramped up its involvement in the War. (BTW… anyone thinking that war is a way to promote economic growth should consider we’ve had a number of other wars during this period. What was unique about 1940-1944 was the degree to which the government decided to run the economy.)

The top marginal tax rate and top marginal rate squared are both significant, and we can use them to compute a top marginal rate that maximizes growth (at least in this model). That figure is (drumroll): 62%. Pretty close to the 67% we computed using last week’s model. And nothing like what Congressman Ryan is likely to glean from reading Atlas Shrugs…

By the way, the list of things I want to look at in future posts, in no particular order, includes:

1. Is the post-WW2 (or post 1963, or post 1981, or post 1986) era different?

2. What is the effect of different demographic groups?

3. Does this work for other forms of growth?

4. Does this type of model always provide an “optimal” result? Does this apply to states? What about other countries?

5. What about other types of taxes, such as corporate taxes? Should we focus on the tax rates paid by middle income earners rather than (or in addition to) tax rates paid by folks at the top?

6. What about the national debt? Or government spending? Or other variables?

7. Does the political party of the President or the Congress matter?

8. What is the effect of the Fed on all of this?

9. How do we know whether this is all merely correlation or is there any sign of causality going on here?

10. Given that this isn’t rocket science, why aren’t “real economists” doing stuff like this? (I would be derelict in not mentioning this paper by Pietro Peretto at Duke, which provides a model showing that “the endogenous increase in the tax on dividends necessary to balance the budget has a positive effect on growth.”)

This seems to have the potential to become the Mike Kimel full-employment act, though sadly, it isn’t my job and it doesn’t pay. Running regressions is quick and easy, and interpreting them (and spotting pitfalls) is second nature to someone who works with them on a daily basis, but pulling data, sorting it and organizing, and even just thinking about that data is very, very time consuming. So please have some patience as its going to take a while to get somewhere. Also… I will probably have occasional posts on other topics in the meanwhile as well.

All that said, one of my goals with these posts is to give non-economists a view of the way this sort thing is (or should be) done in the profession. If I’m not explaining enough, or not keeping it intuitive enough, let me know.

Finally, as always, my spreadsheets are available to anyone who wants ‘em. This one has some cool info that I didn’t get a chance to use in this post, including corporate income, corporate taxes, and some demographic information. If you want to play along at home, or even move ahead of my posts, drop me a line and I’ll send you what I have. Até à próxima, pessoal.

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Top Marginal Income Tax Rates & Real Economic Growth, a Bar Chart

by Mike Kimel

Top Marginal Income Tax Rates & Real Economic Growth, a Bar Chart
Cross posted at the Presimetrics blog.

The chart below shows tax rates on one axis and the growth rates in real GDP that accompanied those tax rates on the other:

I broke the tax ranges into 5 percentage point increments centered around intuitive numbers (30%, 35%, etc.). Growth rates are the median observed for each range. For ranges which did not occur in the real world, growth rates are left blank.

Top marginal tax rates come from the IRS’ Statistics of Income Historical Table 23, and are available going back to 1913. Real GDP can be obtained from the BEA’s National Income and Product Accounts Table 1.1.6, and dates back to 1929. Thus, the graph uses data starting in 1929.

Consider this post a quick follow up to my previous post on optimal tax rates that appeared at the Presimetrics blog and Angry Bear blogs. There will be a lot more follow-ups, but it occurs to me that a look a the data might be useful before going on.

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