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The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940

by Mike Kimel

The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940

This post is the second in a series that looks at the relationship between real economic growth and the top individual marginal tax rate.

Last week I had a post looking at the relationship between the state of the economy and the top individual marginal tax rate from 1913, the first year for which there were individual income taxes, to 1928. Because there is no official data on GDP for that period, I used recessions as a proxy for how well (or poorly) the economy was doing. I note that there was no sign whatsoever that the economy did better during periods when income taxes were non-existent (the post also looked back to 1901), or were low, or were falling, than when tax rates were high or were rising between 1901 and 1928.

This post extends the analysis to the period from 1929 to 1940, 1929 being the first year for which official real GDP data is available from the Bureau of Economic Analysis. 1940 is the end of FDR’s first eight years in office, and serves as a decent bookend to the New Deal era given America’s entry into WW2 in 1941. Top individual marginal tax rate figures used in this post come from the IRS.

The following graph shows the growth rate in real GDP from one year to the next (black line) and the top marginal tax rate (gray bars). In case you’re wondering, 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.

Notice that tax rates fell from 77% in 1920 and 1921 to 24% in 1929, the year the Great Depression began. (As noted in the last post, the so called Roaring 20s was a period when the economy was often in recession.)

Figure 1

In 1932, tax rates rose to 63%, and by 1933, the economy was growing quickly. That doesn’t match with what people believe, I know. It seems these days its commonly accepted that FDR, who took office in 1933, created the Great Depression or at least made it worse, and that only WW2 saved us. In part to address that issue, the graph below shows growth only during the New Deal era, 1933 – 1940 (no WW2!!!). To put the growth in perspective, I’ve added two lines. One represents the fastest single year growth during the Reagan administration, and the other shows the average of the single year growth rates during the Reagan administration. I figured it would be a good comparison, the Reagan administration being today’s gold standard for all that is good and pure.

Figure 2.

As the graph shows, in all but two years from 1933 to 1940, the t to t+1 growth rate was faster than in every single year of the Reagan administration. In fact, the average of the yearly growth rates during this period was about a percent and a half faster than Reagan’s best year.

And yes, there was a sharp downturn shortly after the tax hike in 1935, but its hard to credit that tax hike with the downturn when immediately after the economy continued on a rocket trajectory.

Now, whenever I point something like this out, I get told the same thing (at least by folks who are smart enough not to argue with the data): the rapid growth in the New Deal era occurred simply because the economy was slingshotting back from the Great Depression, and if anything the New Deal policies slowed the recovery. The problem with that argument, of course, is that because the unfortunate events of 2007-2009 witnessed the biggest economic decline since the end of WW2, the economy should be primed for the fastest spurt of growth in the past 60 years. After all, the policies we’ve been following before, during and since that decline have not been very New Dealish at all: top marginal tax rates are 35%, not 63% or 79%, there are no work relief programs, and Glass Steagal Act, passed as part of the New Deal, borders on irrelevant. Yet I think its safe to say just about everyone is in agreement that sort of growth isn’t going to happen anytime soon.

It is also safe to say that for the first two periods covered in this series (i.e., 1901 – 1928 and 1929 – 1940), we once again haven’t seen any sign of the purported relationship between higher lower marginal tax rates and faster economic growth. No doubt that relationship shows up later on. Next post in the series: WW2 and the immediate post-War era.

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 at gmail period com.

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A Post: Tax Burdens, Presidents, and Subsequent Economic Growth – A Few Pictures, Part

by Mike Kimel

A Post: Tax Burdens, Presidents, and Subsequent Economic Growth – A Few Pictures, Part 1

Last week I had a post looking at the relationship between the change in the tax burden in the first two years of a Presidential administration and the growth of real GDP during the remaining years of the administration. I’ve done variations of this exercise before. It turns out that the more an administration reduced the tax burden in its first two years, the slower the growth the in real GDP over the remainder of its term in office administration. Assuming the result is more than an artifact of the data (and it does seem to correspond with other results I’ve reported here over the years), it requires an explanation. While (I am not happy to report) an increased tax burden might in and of itself stimulate faster economic growth, I suspect a bigger effect is that a) the easiest way to move the tax burden is by increasing or decreasing tax regulation and b) there is a correlation between an administration’s views on tax regulations and its views on other regulations that are intended to prevent externalities. This theory is supported by the fact that the relationship between lower tax burdens and slower growth is strengthened by not including the administrations that served only four rather than eight years makes the relationship stronger.

As I keep noting, one doesn’t have to like the results. I personally would much prefer a world in which lower tax burdens do lead to faster economic growth. But the data doesn’t seem to show that. Still, every time I put up a post like this, I get a lot of flack. One thing people keep telling me is that the results are, at best, a coincidence. In their honor, in today’s post I’m going to describe a few more coincidences that the data shows in my next few posts. Some of these coincidences I expected to see, and some, to be frank, I did not. Today I’m going to stick with a few coincidences I expected.

So… let’s go with coincidence number one. The graph below shows the change in the tax burden from Year 0 (i.e., the last full year of the prior administration) to Year 2 on one axis, and the growth rate in the last full year of each administration. (Only eight year administrations are included.) As an example, for Ronald Reagan, we see the change in the tax burden from 1980 to 1982 along one axis and the percentage change from the 1987 real GDP to the 1988 real GDP.

Figure 1

Notice that the relationship between the tax burden in the first two years of each administration and the growth rate in its last year is extremely strong. That’s consistent with what I wrote in my last post (and so many times before): most administrations do not change their tax policy very much, but tax policy (and other policies that correlate with tax policy) can take a while to have an effect on the economy.

Before I go on, a few ground rules for those who want to comment or send me e-mail:
1. If you really believe that the growth rate in the last year of an administration is “causing” the change in the tax burden in the beginning of the administration, I encourage you to seek psychiatric help. I can’t do anything for you.
2. US’ participation in World War 2 prior to 1940 is best described as peripheral. Growth in 1940, or 1939, or 1934 for that matter, is not due to World War 2.

(If you find my constant repetition of these ground rules funny, hazard a guess as to what creeps into my inbox.)

Now, another coincidence… the next figure shows the the change in the tax burden from Year 0 (i.e., the last full year of the prior administration) to Year 2 on one axis, and the growth rate in the fourth year of each administration.

Figure 2

Again… the picture looks an awful like Figure 1. The fit isn’t as good (consistent with the idea that it takes a while for policy to have a a very strong effect. Kind of odd for a coincidence.

Now… you may be wondering… what about other years. I’ll tell you flat out, the fits in years 1 and 2 are awful… consistent with the idea that it takes a while for policy to have a very strong effect. As to the rest, that will wait for the next post.

To close, nominal and real GDP come from the Bureau of Economic Analysis. GDP was first computed in 1929, so the first complete administration for which we have data is FDR I. Data on the Federal government’s tax receipts comes from the Bureau of Economic Analysis’ NIPA Table 3.2.

As always, if you want my spreadsheets, drop me a line at my first name (mike) period my last name (kimel – with one m only) at gmail period com. I should also point out, you can find a lot more of this sort of analysis in Presimetrics, the book I wrote with Michael Kanell.

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Optimal Tax Rates for Generating Economic Growth According to Barro-Sahasakul Tax Data

By Mike Kimel

Optimal Tax Rates for Generating Economic Growth According to Barro-Sahasakul Tax Data

This piece is a bit more wonky than what I normally post.

I recently re-read “Macroeconomic Effects from Government Purchases and Taxes” by Barro & Redlick. I was struck by how different the conclusions they make about taxes are from what you get if you simply make a bar chart of the top marginal rate at any given time versus the growth rate over the next year.

Now, obviously, Barro & Redlick take a completely different approach… but at the bottom of everything is the data set they use (see Table 1 of the above referenced paper and this explanation of the “Barro-Sahasakul” data set). To cut to the chase, they use estimates of the average marginal tax rates paid by taxpayers rather than the top marginal rate that I used in the bar chart referenced above. Their overall marginal rate is made up of not just federal tax rates, but also social security tax rates, and even estimates of the state tax rates. It should be noted the Barro is an average rate, and since the average includes non-filers (who pay zero), the Barro rate is often well below the top marginal rate. The top Barro rate is 41.8% which occurred in 1981 (compared to top marginal rates of 90%+ from 1951 and through 1963). The Barro rate is also not correlated with the top marginal income tax rate (correlation going back to 1929 is -30%).

A lot of work clearly went into producing this overall marginal rate (I’m going to call it the “Barro tax rate” for simplicity). But does it explain economic growth rates any better than the top marginal rate?

I ran a quick and dirty regression…

Growth in real GDP from t to t+1 = f(Barro Tax Rate, Barro Tax Rate Squared, Top Marginal Income Tax Rate, Top Marginal Income Tax Rate Squared)

Data ran back to 1929, the first year for which real GDP was computed by the BEA. Top marginal rates came from the IRS Statistics of Income Table 23. And the Barro Tax Rate came from Table 1 of the Barro & Redlick paper. Since Barro rates are computed only through 2005, that’s when the analysis stops.

Results were as follows:

Figure 1

(Note… the errors got big during leading up to WW2, but I don’t think that invalidates this quick and dirty look.)

Here’s what I get out of this:

1. There is definitely a quadratic relationship between tax rates in one period and real economic growth the next.
2. If you’re going to pick either the Barro rate or the top marginal income tax rate, go with the latter. Its clearly better at explaining economic growth rates.
3. There may be something to be said about using the Barro rate and the top marginal income tax rate together. They do explain different things.

If you compute the “optimal tax rate” – the rate that maximizes economic growth implied by the regression – you get a Barro rate of 25% and a top marginal income tax rate of 64%. The optimal Barro rate was last seen in 1966, when the top marginal rate was 70% and the bottom rate was 14%. I’m guessing from this, and from looking at the Barro rate series, that this would imply that if you want to maximize growth, the top rate should be raised to about 64% and the tax burden on folks at the lower end of the income scale should be lowered. I’m not sure Barro would be pleased with these results.

I may return to this, but my next post should be the next in the series on GDP growth and the S&P 500.

As always, if you want my spreadsheet, drop me a line with the name of this post. I’m at my first name (mike), my last name (kimel – with only one m) at BTW… this spreadsheet contains a lot more wonky goodness!

Thanks to Sandi Saunders for getting me started wading through this particular pile of weeds.

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Four Graphs Looking at Real Economic Growth

by Mike Kimel

Four Graphs Looking at Real Economic Growth

This post contains four graphs looking at real economic growth, three of which also contain some tax information.

The first graph shows the five year annualized growth in real GDP for every five year period beginning the one ending in 1934. (I begin then simply because data on real GDP is only available from the BEA beginning in 1929.)

Figure 1.

I took the liberty of adding in two lines free-style. The first is my attempt to trace the high points over time, leaving out WW2. The second traces the low points, assuming the collapse from 1929 to 1932 and the post-WW2 drop are special cases. (That huge dip from 1945 to 1950, economic shrinkage and all, is what libertarian professors like David R. Henderson keep referring to inexplicably as a post-war miracle.) Those ad hoc lines seem to indicate that any “Great Moderation” in the economy – whether it began in the 1980s or earlier – is more due to a slowing down of the rapid periods of growth than to a reduction in the severity of downturns. Put another way… the Great Moderation = the Great Suckening (for readers who aren’t economists, that’s a technical term like “sterilizing monetary policy” or heteroscedasticity).

Figure 2 is similar to Figure 1, but it strips out the two ad hoc lines and adds in the five year average top marginal individual income tax rate.

Figure 2.

As Figure 2 shows, there doesn’t seem to be much of a relationship between the average top marginal tax rate in any five year period and the annualized growth in real GDP over that same period, and certainly there’s no sign from this graph that higher tax rates discourage economic growth. The fact that the correlation between the two series is positive indicates that if anything, in general real economic growth rates have tended to be higher when tax rates were higher.

Figure 3 is a scatter-plot version of the data in Figure 2.

Figure 3.

Notice that it kind of looks like you can put a quadratic curve to these points – at “low” tax rates, increasing tax rates are associated with faster economic growth. Only at very “high” tax rates – somewhere north of 70% or 80% – does it appear that reducing tax rates are associated with faster economic growth. Reminiscent of this graph, dontcha think? Another thing that’s noticeable… the greater variability in growth that accompanies higher tax rates, which was also visible from Figure 2.

Finally, Figure 4 is the same as Figure 3, but rescaled to leave out 1942-1945, which only makes the lack of a lower taxes = faster economic growth relationship more obvious.

Figure 4.

As always, if you want a copy of the spreadsheet where these graphs were produced, drop me a line. I’m at mike period my last name (that is “kimel” – one m only!) at gmail period com.

Cross posted at the Presimetrics blog.

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Libertarians Looking Vaguely in the Direction of Apostasy

by Mike Kimel

Libertarians Looking Vaguely in the Direction of Apostasy

Tyler Cowen is a prominent libertarian, a professor at GMU and Director of the Mercatus Institute. He is also on very, very dangerous ground. Lately he has had a couple of posts – the latest one here – that quote a new book by Alexander Fields. I haven’t read the book yet, but it seems to describe the 1930s as a period of great innovation despite pervasive misery.

But some of the passages Tyler quotes come tantalizingly close to noting that the economy was actually growing very rapidly by 1939. But what happens if he realizes it isn’t just after 1939, that real growth under FDR was faster than under any President since data has been collected – even if you leave out 1941 through 1945. See Figure 1 at this post. (Or that FDR was followed by LBJ, and then JFK, and then Clinton.) What if he takes a look at private investment during the New Deal era. What if he looks at the relationship between tax rates and economic downturns or comparison of growth rates between the “roaring 20s” favored by libertarian myth and the New Deal era?

Could a person really remain a libertarian if they realized things like that? Cowen has a lot at stake. I wonder if he’ll take the next step.

Note… Arnold Kling is also skating on the same ground. As of this writing, his readers, usually good for at least a few comments on every post, are stunned into silence.

Cross-posted at the Presimetrics blog.

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Where Has the Spending Gone, Joe Dimaggio?

by Mike Kimel

Where Has the Spending Gone, Joe Dimaggio?

Lately there’s been a gnashing of the teeth about the deficit and the debt and what to do about it. Democrats point out that when GW took office, there was no deficit, and that a big part of the problem is that federal tax revenues have fallen from 20.6% of GDP in Fiscal Year 2000 to 14.9% in Fiscal Year 2010 (warning – Excel file), and are slated to fall to 14.4% this fiscal year. I found a nice graph here. Despite the nonsense that gets referred to as Hauser’s Law, the big fall in tax revenues is is in large part due to the tax cuts, although the poor economy also plays its share.

(Note – so I don’t have to keep typing it, all years in this post are fiscal years.)

But for there to be a deficit, tax revenues (whether high or low) have to be less than spending. And spending has also gone up (again see OMB Table 1.2 referenced above) from 18.2% of GDP in 2000 to 23.8% of GDP in 2010, and is slated to go above 25% of GDP this fiscal year. (It is worth noting – federal spending as a percentage of GDP fell in every single year during the Clinton administration… which means Newt Gingrich doesn’t get credit for it unless you believe he had one heck of a time machine.)

I thought it would be interesting to see where that spending is going, so I pulled the data from OMB Table 3.1 and graphed it below. (Dotted lines indicate future projected spending.)

Figure 1

The figure indicates that for the most part, spending in most categories has been pretty flat. Defense spending, though, rose from 3% of GDP in 2000 to 4.3% in 2008, 4.8% in 2010, and is slated to go above 5% this year. Afghanistan, Iraq, and now Libya all cost money, especially if conducted with sweetheart no-bid deals. The bigger ticket category that saw increases was “human resources” – that was 11.4% of GDP in 2000, reached 13.2% of GDP in 2008, and is expected to top 16% this year.

So what are these human resources? I don’t have the definition in front of me, but I think that includes things like unemployment compensation, food stamps, and the like. Put another way, some of the spending (it’s 3:36 AM right now – I think the “how much” part of “some” has to wait for another post) is happening because the tax cuts didn’t work as advertised. But then, its not like that should have been a surprise.

Cross-posted at the Presimetrics blog.

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Robert Reich’s After Shock and Corey Robin’s Freedom Arguments

by Linda Beale

In earlier posts on ataxingmatter (here and here), I reviewed Robert Reich’s 2010 book, After Shock, and wrote about his suggested cures for the problems made most visible in the 2007 crash and the Great Depression that followed.

The gist of the book is summed up in the following quote:

“[L]eft to its own devices, the market concentrates wealth and income–which is
disastrous to an economy as well as to a society.” at 59

Corey Robin writes in the Nation about the same problem, Reclaiming the Politics of Freedom, The Nation, Apr. 26, 2011. But he notes that harping on the distributional inequality doesn’t resonate with voters. If the left wants to influence policies and capture the hearts of voters, he suggests, it needs to demonstrate that this distributional mayhem, which leaves everybody but the rich vulnerable, has even broader consequences that reach to the very fundamental creation myths of our society–the desire to be our own masters, to free ourselves from a tyrannical monarchy and colonial overlords who seemed to want to dictate how we could work, what we could drink, and where we could live. That is, to make what we are saying comprehensible at the “yeah, that’s what counts for me” level, we need to connect to America’s own Founding Moment. We need to “reclaim[] the politics of freedom.”

And I think he is correct. Because the problem we are facing today, with corporate lobbying and campaign contributions reinforcing the elite class’s wining and dining of politicians, is more than the dysfunction of the economy. Yes, there is too much money at the top where there is not enough ability to spend it. Yes, there is too little money at the bottom where there is no way to provide for basic needs. Yes, there is barely enough in the middle, resulting in stagnation in local businesses who don’t have enough customers to sell to and can’t afford to give credit to those who want to buy.

It is not just that banks, connected to power through their managers and shareholders, are able to speculate with other people’s money (our money!) in the international derivatives casino and then push their losses off on us. It is not just that corporate bosses rake in as much in a day as many of their workers make in an entire year of hard labor. It is not just that we can no longer talk to anybody local when there is a problem with our phone or our order from a company. It is not just that ordinary people are ignored, disregarded, almost shunned, because the elite really are only comfortable in the company of other elites. It is not just that we can’t get an appointment with a doctor unless we have (expensive) health insurance, or can’t get that crown we need on the broken tooth because it costs as much as some of us make in half a year.

No. These things are real, they affect us every day, they make us angry every day because we recognize our powerlessness to deal with the highly impersonal Big Business world that has been fostered by the four decades of reaganomics’ deregulation, privatization, tax cuts and militarization. But still, the problem goes much deeper than these things.

Our very freedom is threatened. When we are economically powerless, we are also powerless in our lives because we lose our freedom to make choices that are right for us.

  • we lose our rights to bargain with our employers (look at how Wisconsin and Ohio have treated their public employees or how WalMart treats its workers and anyone who talks unions),
  • we lose the power to improve ourselves by pulling ourselves up by the bootstraps through publicly funded education from grade school through university,
  • we are dominated in the marketplace by powerful businesses that use automated systems to turn us off, ignore our calls and letters seeking redress for a mischarge or a poorly done job,
  • we lose our jobs, are forced to accept paycuts or furloughs, when the company claims times are tought, yet we watch the same public companies to pay their CEOs millions more

Our freedom to improve ourselves, freedom to choose the kind of work we want to do, freedom to prepare for our retirement and then retire with some security about our future, freedom from worry about whether or not a catastrophic medical emergency will eat up all our savings and leave family without an adequate living–all these freedoms are being threatened today by the concentration of wealth in the hands of an elite few who thereby become emplowered to set the market terms as they choose.

The idea of the “free market” is a bill of goods sold to replace the real concepts of freedom we should be considering. Markets, of course, can only function well for the people where government constraints prevent the owners and managers from setting all the terms to suit themselves, leaving externalities of their profitmaking to be borne by the people. literally ripping them off. The sloganeers have persuaded ordinary Americans to think that the American Dream of freedom is encapsulated in that little bitty notion of a “free market” so that they will unknowingly throw away the big idea of freedom–the freedom to set one’s own course in life, in a cooperative society that works to provide those tools.

The reason we need a progressive tax policy–including at the least progressive tax rates with brackets that reach much higher into the stratosphers of the ultra rich (55% for those making $1 million or more annually) ; elimination of the capital gains preference (so that all income is taxed under the same rate structure); and an estate tax with bite (meaning a graduated rate that protects a reasonable nest egg for the next generation while serving as one method of limiting the concentration of wealth)– is to ensure the freedom of each and every one of us, from rich to poor, from newly arrived immigrant to elderly Native American.

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GW Broke with Clinton. Did Obama Break with GW?

by Mike Kimel

Update: McClatchy tackles the question here.

GW Broke with Clinton. Did Obama Break with GW?
Cross-posted at the Presimetrics blog

The following major initiatives had occurred toward the end of April 2003, about two years and three months into the GW Bush administration:

1. Marginal income tax rate cuts in 2001, 2002 and 2003.
2. Passage of No Child Left Behind Act
3. Outlays as a percentage of GDP rose.
were 18.2% in fiscal 2000, 18.2% in fiscal 2001 and 19.1% in fiscal 2002.
4. The inherited surplus became a deficit.
5. Passage of the Patriot Act.
6. Invasion of Afghanistan in response to the Sept 11 attacks. Note that by April 2003, the Taliban insurgency was already gaining strength again.
7. Abortion restrictions. Reinstatement of the Mexico City Policy. Withdrawing funding for the United Nations Population Fund. Began the push for the Partial Birth Abortion Ban (introduced in Feb. 2003 by Rick Santorum, passed in November of 2003).
8. Sarbanes Oxley.
9. Homeland Security Act.
10. Invasion of Iraq.

Whether you agree with these policies or not, its a not insubstantial list. Several, if not most of these initiatives represent big breaks with the previous administration. For instance, Clinton raised marginal tax rates, whereas GW lowered them. Federal spending / GDP fell during every single year of the Clinton administration, but would rise in most years of the Bush administration. Clinton managed to turn a deficit into a surplus, whereas GW went the other way. The Mexico City Policy which GW reinstated had been rescinded by Clinton. The Patriot Act and the Homeland Security Act don’t seem to be Clinton’s style. And while one might argue Clinton might have acted against Afghanistan following 9/11/2001, it is very, very hard to envision the subsequent invasion of Iraq had Clinton been President in 2003.

We are now about two years and three months into the Obama administration – about the same amount of time it took GW to engage in the initiatives mentioned above. So…. what are the major initiatives of the Obama administration so far, and which of them represent clear breaks with the Bush administration? (Please stick to things that actually happened or at least in which Obama invested some political capital. Something Obama might have said during his campaign, something you heard from one of your hallucinations, or something reported by Fox News may not fit into that category.)

Note – this post is a follow-up to the post entitled Why I Will Not be Voting for Obama in 2012 which appeared in the Presimetrics blog and at Angry Bear.

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Why I will not be Voting for Obama in 2012

by Mike Kimel

Why I will not be Voting for Obama in 2012

Cross posted at the Presimetrics blog.

The presidential elections are a year and a half away, but I am pretty certain of one thing: I will not be voting to re-elect Barack Obama. That does not mean that I will be voting for the Republican nominee, or for any of the third party candidates, but rather that I do not see any likely circumstances under which Barack Obama will do anything I think is necessary to earn my vote. That may seem unusual because I voted for Obama, and my economic views are probably best described as slightly left center.

Now, I’m nobody special, and my endorsement or lack of it isn’t going to make a whit of difference, but I suspect there are other people who are also somewhere close to slightly left of center (i.e., who are either what Obama considers to be his “natural constituency” or close enough that they can be convinced to vote for him rather than his likely eventual opponent) who are starting to think the same thing I am. So perhaps its worth trying to explain why I feel the way I do. I think its easiest to do that by discussing the issues I think I important and what Obama has done (or not) about them.

1. Economic growth/unemployment/taxes. These three topics, as Senator Ryan and all economists know, are closely inter-related. Sadly, the relationship between these three topics is very, very different than Senator Ryan and most economists believe. Getting the economy moving is vital after eight years of mediocre growth under GW Bush, culminating in the Great Recession. But when you go back as far as the data allows, you find a quadratic relationship between the top marginal tax rate in one year and growth in the subsequent year , and that we are at a point on the curve where it is an increase, not a decrease in tax rates, that is likely to lead to faster economic growth. Even sticking to the period of relatively low taxes we’ve been in since Reagan started his tax cuts, growth rates should go up and unemployment rates should go down if tax rates go up.

There are two reasons this is true. One is that taxes pay for the existence of the government. The government provides services the government provides that are conducive to growth and which the private sector simply has not historically provided at non-negligible levels. These services include national defense, monitoring and controlling epidemics, and building infrastructure.

The government also provides some leadership that can make it possible for the private sector to adopt new technologies. As an example – in this day and age, having a vehicle that could run on any mix of gasoline, ethanol or natural gas (depending on which is cheapest per mile) would be a nice thing to have. You can buy one of those vehicles today… in Brazil. Never heard of such a thing? Well, there are millions of bi-flex and tri-flex vehicles on the road in Brazil today, made by such exotic companies as GM, Ford, Volkswagen, and Mercedes. Why are there so many flex-fuel cars and motorcycles on the road in Brazil? Because the Brazilian government realized you can’t get from 1970s fuel shortages to where they are now without someone forcing both auto makers and fuel stations to make changes simultaneously. Without government action, auto makers wouldn’t have been willing to mass produce flex-fuel vehicles out of fear there would be no filling stations for those vehicles, and fueling stations would have been reluctant to make investments out of fear that there would be no vehicles to take advantage of them. In other words, the situation we see in the U.S.

But there is another, perhaps more important reason, why higher tax rates often lead to faster economic growth and lower unemployment. As I keep pointing out, any good business owner (and any lousy one, for that matter) will tell you, if you tax something more, you get less of it. And income taxes can be seen as penalties on withdrawing money from one’s business for the purpose of consumption, which means they discourage business owners from taking profits out of their business. The alternative to taking profits and consuming is re-investing in the business. Thus, higher tax rates on income lead to more investment on business. And this result is borne out empirically; when the top marginal rate is below 50%, a tax increase is correlated with more private investment and less private consumption.

2. Deficits and the national debt. This is another tax related issue. Historically, during and following tax hikes tax collections /GDP rise. During and following tax cuts, tax collections fall. (How a fact so basic that even a child could observe it in the data became a surprise to many people is a testament to, ahem, economists like Art Laffer and Thomas Sowell.
But there are many ways to cut taxes people pay, and changing the marginal rate is only one such way. Enforcement of tax law is another. Since 1929 (that’s as far back as data is available) – every single Republican President decreased the tax burden, the percentage of people’s income paid in taxes, and thus far, all Democrats but Truman and Obama have increased that percentage. Click on the link and you’ll also see that growth rates were much faster for Presidents who increased the tax burden than for Presidents who decreased it. Though there are many ways of being fiscally responsible or irresponsible, it is, of course, easier to balance the budget if tax revenues are higher. The last four Republican Presidents – Ford, Reagan, and the two Bushes all increased the national debt. Conversely, before Obama you had to go back to 1944, when the nation was fighting World War 2, to find a Democrat in the Oval Office who increased the national debt.

And yes, I know, there was a bad recession going on when Obama took office, and the economy still sucks. And yes, I agree with Keynes – the data shows that expansions following recessions during which the government increased its spending are longer and stronger than when expansions following recessions during which the government cut spending. But that spending should have been paid for with tax hikes. Historically, when the government raises taxes during or shortly after a recession, the resulting expansion is longer and stronger than when the government cuts taxes. That’s what the data shows. The reasons are the same as given above in the discussion about economic growth, plus one: during periods of economic weakness those in the private sector tend to sit on money.

As an aside – it is worth noting that both this Great Recession and the Great Depression came about half a decade after big reductions in both marginal tax rates and regulation. Coincidence?

3. Obama’s performance might resemble that of other Democratic administrations more closely had he chosen economic advisors who paid more attention to data and were less enamored of the policies GW Bush was employing. When you pick an advisor who jumps through hoops to be like one of GW’s economic advisors, you will get GW’s outcomes. Its even worse when you’ve been warned and you do it anyway. Frankly, if I say so myself, it isn’t that difficult to find people who actually can spot business cycles at both ends.

4. The bail-outs. Of course, one of the big contributors to the Obama deficits are how Obama reacted to the poor state of the economy. (In fairness, some of the bail-out spending was pre-committed by the previous administration, but then Obama voted in favor of that spending as a Senator and didn’t try to walk it back once he became President.) But where are the prosecutions? Was there not wrongdoing? And then you have stories like Matt Taibbi’s latest. Like GW’s policies before him, Obama’s approach seems almost designed create another mess.

5. Health care. Obama care = Romney care. This is a policy that Republicans were pushing a decade ago, and would still be pushing if a Democrat hadn’t proposed it. Where is the public option?

6. The wars. I don’t have a solution, but then I didn’t spend a few hundred million bucks running for President, nor am I about to spend a billion dollars running for re-election. It is the height of immorality to seek out the presidency or re-election in a time of war and yet have no clue how to bring the war to a successful conclusion.

I always thought it was the height of insanity for anyone to vote to re-elect GW in 2004, after screwing up the economy and two wars. Yes, I know some worthies were still talking “Mount Rushmore” a year or two later, but one should be better than that. And yes, there are a handful of things Obama did that GW might not do, but let’s be realistic – this has looked from the very beginning like GW’s third term.

Which leaves just one question – if the policies of the Republicans are even worse than Obama’s – and they tend to support anti-growth tax policies (calling them pro-growth doesn’t change the data), what should a rational person do? I don’t know. But I think if I’m going to see Republican policies enacted, I’d prefer to see them run under a Republican label. See, Democratic policies may not be very good, but historically they have tended to produce better results than Republican policies. (BTW – Michael Kanell and I have an entire book called Presimetrics looking at how Presidents performed on a wide range of topics.) Another four years spent bringing the feeble Democratic brand down to the levels of the even more feeble Republican brand will cause lasting damage.

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John Taylor in Favor of Higher Marginal Income Tax Rates? If Not, Why Not?

by Mike Kimel

John Taylor in Favor of Higher Marginal Income Tax Rates? If Not, Why Not?

A couple of weeks ago, John Taylor posted a graph showing that since 1990, there has been a negative correlation between the Investment to GDP ratio and unemployment.

There’s been some back and forth between Taylor and some of the other big boys (some of it summarized at Mark Thoma’s Economists View, and even Krugman has weighed in).

Lots of fun is being had by all, but it seems everyone, especially John Taylor, is missing a key point. If, as he states in his post, “the most effective way to reduce unemployment is to raise investment as a share of GDP” and if we want to reduce unemployment, then we should be raising the top marginal tax rate.. After all, going back to 1929 (that’s as far back as the Bureau of Economic Analysis has data), there’s a quadratic relationship between the top marginal income tax rate and the ratio of private investment to private consumption.

As I note in the post in which that analysis is done (complete with a nice graph):

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%.

So… raise top marginal rate —> more investment —> lower unemployment. I imagine John Taylor’s endorsement of higher marginal tax rates should come any moment now.

Cross-posted at the Presimetrics blog.

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