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Wednesday, June 30, 2010

Higher Income Taxes Are Benign?

In a recent issue of the online magazine Slate, former New York Governor Eliot Spitzer attempts to debunk the alleged myth that higher taxes reduce growth. Spitzer opens with the undeniable truth that the “American debate over taxes is ferocious and highly partisan.” If only he had continued to state the obvious, we would not feel compelled to write this response.

Spitzer, however, does not stop there. He begins by longing for a simpler time, a time before people took notice of obscenely high levels of taxation. After all, Spitzer reminds the reader, it was the great Franklin Delano Roosevelt who argued in 1942 that in a time of “grave national danger” no American ought to have an after-tax income in excess of $25,000 (about $325,000 in today’s dollars). “Can you conceive of a modern president suggesting that no American should earn more than $323,000 after taxes?” he wistfully notes.

Taxes and Growth

Sadly, Spitzer’s defense of high marginal tax rates did not end with normative statements in favor of higher taxes on the wealthy. After a brief and surprisingly lucid explanation of how correlation is not causation, he states, “[I]t’s obvious that there is no correlation between higher marginal tax rates and slowing economic activity. During the period 1951-63, when marginal rates were at their peak—91 percent or 92 percent—the American economy boomed, growing at an average annual rate of 3.71 percent. The fact that the marginal rates were what would today be viewed as essentially confiscatory did not cause economic cataclysm—just the opposite.”

Then he adds, “And during the past seven years, during which we reduced the top marginal rate to 35 percent, average growth was a more meager 1.71 percent.”

We could, of course, play the same game by choosing different starting and ending points (say, the late 1940s or 1990s). However, we prefer to stick to a discussion of the peer-reviewed academic literature, as Spitzer promises to do when he cites a Yale Law Review article while defending his claim that “more sophisticated efforts” to find a relationship between marginal tax rates and economic growth have produced “murky” results. According to Spitzer, this review of the literature in the Yale Law Review “concludes that there is scant, if any, legitimate academic support for the proposition that moderate, as opposed to dramatic, increases in marginal tax rates have any impact on the willingness of the wealthy to participate in the economy.”

Setting aside the question of what “moderate” increases in marginal tax rates are, it needs to be pointed out that this article is not a review of the literature at all but a book review! It is hard to fathom that a book review—even a review of a book on how the wealthy respond to changes in taxes—can overturn the basic economic conclusion that higher income tax rates inhibit growth.

Marginal taxes are the ones that matter for behavior because, as the Austrian economist Carl Menger first pointed out his 1871 book, Principles of Economics, individuals behave according to their subjective valuation of the marginal benefits and costs of an action. Higher income tax rates therefore reduce the marginal utility of working—since after-tax income goes down—and will usually reduce the number of hours worked or the amount of income realized. This is because if you are getting less reward you will be less willing to suffer the least pleasant parts of your job, giving an incentive to cut back on your hours or some similar action.

Plenty of Evidence

Thus it is no surprise that if you were to look at the economics literature you would see plenty of research showing that higher marginal income tax rates reduce growth. In a 2006 issue of Tax Notes, for example, Harvard economist Martin Feldstein estimates that a 1 percent increase in marginal income tax rates would cause taxable income to fall by $6.6 billion. When combined with the decline in payroll tax revenues, Feldstein estimates that every additional dollar of revenue raised costs taxpayers $1.76 when all the costs of raising the revenue are included. As we are unaware of any government projects or programs that yield more than $1.76 in output for every $1 spent, we feel it is pretty safe to say that higher marginal tax rates will lower growth.

These results hold at the state level as well. University of Colorado at Boulder economists Barry Poulson and Jules Gordon Caplan looked at state marginal income tax rates and economic growth from 1963 to 2004 in a 2008 article in the Cato Journal. They found clear evidence that “higher marginal tax rates had a negative impact on economic growth in the states.” The same has been found across major developed countries, as a 2002 article in the European Journal of Political Economy pointed out.

Growth and Well-Being

As you can see, had Spitzer delved a little deeper into the academic economics literature, he would have found ample evidence in favor of the conclusion that marginal tax rates affect economic behavior, including economic growth. Even if the empirical evidence showed otherwise, of course, this would not have made the case for higher marginal tax rates. Maximizing growth is not the same thing as maximizing well-being. Even if growth does not fall in response to higher marginal income tax rates because people work more to pay the higher tax bill, that doesn’t mean they are better off. Clearly they would prefer a world where they had more after-tax income and the liberty to spend it as they wanted. Whether the criterion is economics or liberty, however, the answer is the same: Higher marginal tax rates are a bad idea.

  • Joshua Hall is an associate professor of economics and Co-Director of the Center for Free Enterprise in the College of Business and Economics at West Virginia University.