Taxes and Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

William Gale and Andy Samwick have a new Brookings paper out on the relationship of tax rates and economic growth in the U.S. [Apologies to whichever blog/site led me to the paper, I can’t remember.] Short answer, there is no relationship. They do not identify any change in the trend growth rate of real GDP per capita with changes in marginal income tax rates, capital gains tax rates, or any changes in federal tax rules.

Gale Samwick Fig 1

One of the first pieces of evidence they show is from a paper by Stokey and Rebelo (1995). This plots taxes as a percent of GDP in the top panel, and the growth rate of GDP per capita in the lower one. You can see that the introduction of very high tax rates during WWII, which effectively became permanent features of the economy after that, did not change the trend growth rate of GDP per capita in the slightest. The only difference after 1940 in the lower panel is that the fluctuations in the economy are less severe that in the prior period. Taxes as a percent of GDP don’t appear to have any relevant relationship to growth rates.

Gale Samwick Fig 2

The next piece of evidence is from a paper by Hungerford (2012), who basically looks only at the post-war period, and looks at whether the fluctuations in top marginal tax rates (on either income or capital gains) are related to growth rates. You can see in the figure that they are not. If anything, higher capital gains rates are associated with faster growth.

The upshot is that there is no evidence that you can change the growth rate of the economy – up or down – by changing tax rates – up or down. Their conclusion is more coherent than anything I could gin up, so here goes:

The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

The effects of tax cuts on growth are completely uncertain.

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16 thoughts on “Taxes and Growth

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  3. But how do we know that growth rates wouldn’t have been even higher than they were if income taxes weren’t increased?

    I.e. Suppose the growth rates was +2%. Then you increase taxes 10% and the growth rate next year is still +2%. How do we know the growth rate wouldn’t have been +3% if it wasn’t for the tax hike?

    Is it really safe to say that taxes had “no effect” in this case?

    This is the age-old problem in economics I guess- we don’t have an exact replica of the US economy running at the Pre-WW 2 tax rates alongside the actual US economy in order to do a comparative study and see what the real effect of tax rates is.

    But perhaps the authors addressed this issue. Thoughts?

    • Woodrow – you’re right on. We don’t know the counter-factual here (what growth rates would have looked like in the absence of the tax increase). So we can’t say for sure that there is any relationship between taxes and growth. I was trying to make just that point – we just don’t know – but I don’t think that came across clearly enough.

  4. Pingback: “The effects of tax cuts on growth are completely uncertain.” | Avoiding Citation

  5. It’s good to see some empirical work being done in economics. Really. There is no evidence whatever that cutting taxes improves economic growth. Anyone looking at data for US since the start of the 20th century, for example, can’t help but notice the exact opposite. Tax increases boost growth. Tax cuts lead to recessions or even depressions. Keep up the good work. Yes, water does flow downhill, despite the prevailing dogma.

    • Empirical work has been done in economics since the field has existed and has become the largest piece of published economic research over the last 20 years.

      But this empirical work in most cases is thankfully more rigorous than just looking at the data for the US since the start of the 20th century because understanding economic forces requires more than just eyeballing correlations.

      • It definitely is. Gale and Samwick don’t go through this literature on taxes/growth empirics in detail – but that lit. doesn’t offer any different results than their eyeballed correlations in this paper. The upshot is that we don’t have any compelling evidence that tax cuts or tax increases have any statistically significant effect on long-run growth rates.

    • I’m with you that the more we can look at actual empirical evidence, the better. But be careful here – Gale and Samwick say there is no relationship at all. So tax cuts or tax increases don’t really seem to have a noticeable affect. (Assuming of course that there weren’t offsetting factors involved, etc.. etc.. )

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    • No, they are not. I think the defense of this for Gale and Samwick is that this is more of a policy briefing than an academic paper. They aren’t trying to introduce any brand new results.

  7. In the later data one would have to very carefully pick out the part of GDP that is associated with only private actions. Higher taxes usually mean higher government spending and borrowing which has been a v high proportion of GDP since the war.

    That last point is basically why GDP gets less volatile, a big part of it (40% or more) is not affected by the market, if anything it is counter cyclically managed. GDP can be a very misleading statistic.

    There is certainly some empirical evidence to suggest that low taxes (and the right regulatory framework) do lead to higher growth e.g. Singapore, China, Hong Kong, Botswana, The USA itself, Great Britain, Chile.

    Nonetheless it is good to remind ourselves that this stuff is all lot less certain than we tend to think it is.

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  9. Pingback: Andrew Samwick's Blog: Income Tax Changes and Economic Growth - Taxes-Info.com

  10. Reblogged this on DAMIJAN blog and commented:
    O tem sem pisal februarja letos v “Ti nesrečni davki”. Nova študija “Effects of Income Tax Changes on Economic Growth” (Gale & Samwick, 2014) potrjuje, da znižanje davkov nima vpliva na gospodarsko rast.

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