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How do higher taxes affect economic growth? To most economists, the answer is obvious. At the margin, increased taxation reduces the incentive to work and invest, and less work and less investment mean less growth. But as William McBride writes in an analysis for the Tax Foundation, “the economy is sufficiently complex that virtually any theory can find some support in the data.” One argument made recently is that high taxes have little or no effect on economic growth. The evidence allegedly supporting this theory is found in post-World War II American history. Last fall, the Congressional Research Service issued a report (updated in December) that noted:
The top marginal tax rate in the 1950s was over 90%, and the real GDP growth rate averaged 4.2% and real per capita GDP increased annually by 2.4% in the 1950s. In the 2000s, the top marginal tax rate was 35% while the average real GDP growth rate was 1.7% and real per capita GDP increased annually by less than 1%.
But McBride points out that this study exemplifies
the most basic problems with this sort of statistical analysis, including: the variation in the tax base to which the individual income tax applies; the variation in other taxes, particularly the corporate tax; the short-term versus long-term effects of tax policy; and reverse causality, whereby economic growth affects tax rates.
These problems are all well known in the academic literature and have been dealt with in various ways, making the CRS study unpublishable in any peer-reviewed academic journal.
By contrast, McBride reviewed 26 empirical studies of taxes and economic growth published in scholarly journals. “All but three of those studies, and every study in the last fifteen years, find a negative effect of taxes on growth.” “While there are a variety of methods and data sources,” McBride notes, the academic literature consistently indicates
significant negative effects of taxes on economic growth even after controlling for various other factors such as government spending, business cycle conditions, and monetary policy.
Of particular interest, McBride summarizes research on OECD countries determining “a ranking of the most harmful taxes for economic growth”:
corporate taxes are the most harmful, followed by personal income taxes, consumption taxes, and finally, property taxes, particularly property taxes levied on households rather than corporations.
Another study summarized by McBride suggests that “a cut in the corporate rate of 10 points would raise annual GDP growth per capita by about 0.6 to 1.8 points,” while still another projects that “cutting the corporate rate by 10 points raises the annual per capita growth rate by 1 to 2 points.” McBride asserts that this scholarly consensus “establishes some standards by which a tax system may be judged”:
If we apply these standards to our national tax system, the U.S. has probably the most inefficient tax mix in the developed world. We have the highest corporate tax rate in the industrialized world. If it came down 10 points — still higher than most of our trading partners — it would add 1 to 2 points to GDP growth and likely not lose tax revenue, because the tax base would expand from in-flows of foreign capital as well increased domestic investment, hiring, and work effort. The preponderance of evidence is such that virtually everyone agrees that the corporate rate should come down, although many continue to claim, opposite the evidence, that such a move would lose revenue.
As for income taxes, McBride notes, “We already have the most progressive tax system in the industrialized world, according to the OECD,” and raising taxes would make it more so. “The OECD finds such steeply progressive taxation reduces productivity and economic growth.” “In sum,” McBride concludes, “the U.S. tax system is a drag on the economy”:
Pro-growth tax reform that reduces the burden of corporate and personal income taxes would generate a more robust economic recovery and put the U.S. on a higher growth trajectory, with more investment, more employment, higher wages, and a higher standard of living.
Robert Asahina has been a newspaper and magazine editor and writer, a book publishing executive and editor, and a data management consultant. He was editor in chief and deputy publisher of Broadway Books, president and publisher of the adult publishing group of Golden Books, and vice president and senior editor of Simon and Schuster; deputy managing editor of The New York Sun and an editor at The New York Times Book Review, Harper's, George, and The Public Interest; and a consultant at Freddie Mac. He is the author of "Just Americans" and of numerous articles and reviews for The Wall Street Journal, Harper's, The New York Times Book Review, and elsewhere.