It has been something of an article of faith among conservatives that the solution to America's problems is in smaller government and lower tax rates. The argument on taxes goes something like: 'We need to unleash the wealth creators, who stimulated by the prospect of more income (due to lower tax rates), will create wealth for all of us.' And, that any tax increase -- for even the wealthiest taxpayers -- would have catastrophic consequences.
Actually the post World War II American economy provides a nice empirical test of this hypothesis -- the maximum marginal income tax rate gradually declined from about 90% to about 35%. Shouldn't this decline have lead to an explosion of economic growth as our wealth creators were unleashed? Sorry, Sarah Palin... it didn't.
During the ultra high tax 1950s (top marginal income tax rate of 90%), the United States had some of its best real economic growth (over 4%/year). And, for the decade where we had our lowest marginal income tax rates -- we had our worst real economic growth (about 1.5%/year). (See Table 1 below.)
So what happened? Well, first of all (Spoiler Alert! The following will upset ideologues!), the real world is complicated. Taxes are one part of the American economy, but by no means the only driver of our decision making process. People are motivated by lots of things -- not just money. In all the recent discussions about Steve Jobs, I can't recall a single quote, anecdote or story that suggested income tax rates had any influence on Steve Jobs' behavior. Does anyone really believe that if US income tax rates had been slightly higher Bill Gates would have founded Microsoft in Singapore (or some other low tax center)? As another example -- Warren Buffet, who has been an active investor from the 1950s to today, certainly could have moved offshore when tax rates were higher. He didn't.
Also, keep in mind that economic growth is not driven just by entrepreneurs and their hard work (okay, I've now simultaneously infuriated both the left and the right). In the 1950s, the global economy was emerging from World War II and the United States was the only industrial economy relatively unscathed. With better policies (arguably, the then current 90% tax rate was too high), we might have had even higher economic growth rates in the 1950s. But, our strong economic growth throughout the 1950s was helped by a strong tail wind (from outside the US).
In the early 21st century, we suffered relatively anemic economic growth (despite much lower tax rates), but we also faced a far more competitive world and a disastrous real estate bubble. It is not clear that lower income tax rates would have had much impact. But higher income tax rates and other policy adjustments might have avoided the real estate bubble from which we are now recovering.
Finally and most importantly, it is not just how the money is raised, but how it is spent. Tax revenues that improve infrastructure, and pay for basic research and education are investments in our future, and will foster economic growth. Tax cuts that primarily favor high end consumers might stimulate the purchase of luxury goods (McMansion anyone?), but may not contribute much to overall economic growth.
My point, and I do have one -- is that ideology is a poor substitute for pragmatic approaches to complicated problems. In fact the evidence that tax rates influence economic growth in any way is equivocal at best. A myriad of other factors are involved. Simply reducing tax rates, and primarily for the wealthy, may hinder -- rather than enhance our economic recovery.
Table 1: Comparison of mean marginal tax rates and mean real GDP growth rate
Steven Strauss was the founding Managing Director of the Center for Economic Transformation at the New York City Economic Development Corporation. He will be an Advanced Leadership Fellow at Harvard University for 2011-2012. He has also worked as a management consultant for McKinsey and has a Ph.D. in Management from Yale University. You can follow him on Twitter @steven_strauss.
Sources: The real GDP growth rates are from www.wolframalpha.com; the income tax rates are from the National Taxpayers Union.