As Congress moves to consider tax reform, critics are asserting that lower tax rates may not significantly boost the economy. For instance, earlier this month New York Times columnist Neil Irwin argued that the economic record on tax cuts is mixed and unproven.
Basic economics tells us that if you tax something, you’ll get less of it. True, not all tax cuts are created equal. Successful tax reductions are immediate, permanent, broad-based, and (unlike tax rebates) rely on tax rate reductions to encourage working, saving, and investing. Such well-designed tax policies have a clear record of success.
Nobel Laureate Edward Prescott has shown that much of America’s widening economic advantage over other major economies between the 1970s and 1990s can be traced to America’s decision to lower tax rates while other countries raised them.
Harvard economist Martin Feldstein estimates that a dollar increase in taxes costs the economy 76 cents of growth.
Even liberal University of California-Berkeley economist Christina Romer – formerly President Obama’s chief economic advisor – calculated that, in most circumstances, a “tax increase of 1 percent of GDP reduces output over the next three years by nearly three percent.”
If academic studies do not convince you, note that the reduction of the top income tax rate from 70 percent to 28 percent during the 1980s was followed by a historic economic boom.
While Irwin concedes that some well-designed tax cuts have succeeded, his main counter-example is that “George W. Bush’s 2001 and 2003 tax cuts were followed by years of disappointing growth. Bill Clinton’s tax increases in 1993 were followed by a boom that surpassed the Reagan-era expansion.”
It is a myth that the booming (high-tax) 1990s and sluggish (low-tax) 2000s showed that tax rates may not matter much for growth.
Granted, the 2001 tax cuts failed to bring strong growth. This poorly-designed law slowly phased-in the tax cuts (which just delays productive behavior until the full tax reward comes), and its most immediate component – tax rebates – merely redistributed existing purchasing power from the government to families. Rebates did not encourage more productive behavior moving forward.
However, the 2003 tax cuts were not disappointing. Correcting the 2001 problems, they made all the remaining tax cuts immediate, and encouraged investment by cutting tax rates on capital gains, dividends, and business investment. The weak economy responded instantly.
Consider the record:
The 2003 tax cuts were designed to encourage businesses to invest in the economy. After declining in the previous 11 quarters by an average of 1.8 percent annually, business investment grew at a rapid 7 percent annual clip for the next 11 quarters.
Economic growth – averaging 1.25 percent annual growth in the previous 11 quarters – quickly surged, and tripled to 3.75 percent in the next 11 quarters.
After losing 1.1 million jobs in the preceding 18 months before the tax cuts, America gained 2.3 million jobs in the subsequent 18 months.
In the previous three years from the May 28th enactment, the S&P 500 had declined by 7.3 percent. 15.9 percent, and then 11.3 percent. In the next three years, it leaped by 17.6 percent. 7.0 percent, and then 6.8 percent.
This was not a coincidence. No comparably-large economic events occurred in the Spring of 2003. These stagnant or declining economic indicators suddenly reversed right after the law was signed (with the exception of a normal hiring lag that pushed the job growth to late summer).
The economic surge following the 2003 tax cuts produced enough tax revenue to pay for most of their cost, according to Congressional Budget Office data. It was nearly a free lunch. How is that “disappointing?”
Unfortunately, the 2003-2006 economic turnaround is largely forgotten because it was followed in late 2007 by an unrelated housing collapse and recession brought on by failed Federal Reserve, financial, and housing policies. The tax cuts had nothing to do with the crash. And yet many of them were not extended when they ended in January 2013.
The second part of Irwin’s assertion is that the 1993 tax increases did not hold back the 1990s economy. He is correct that raising the top tax rate from 31 percent to 39.6 percent did not plunge the economy into recession. At the same time, the 1990s economy was blessed with a historic trade deal and a technological boom that revolutionized the American economy. So while the respectable 3.3 percent annual growth from 1993 through 1996 roughly matched the 2003-2006 period described above, it is likely that tax policy held back what should have been even faster growth. In fact, the underperforming economy became a major campaign issue in the 1994 and 1996 elections.
The real “roaring 1990s” consisted of the 4.5 percent annual growth between 1997 and 2000 – right after a large 1997 capital gains tax cut.
The overall lesson is that an economy can survive high tax rates only if it has other major advantages. The post-World War II economy thrived despite higher tax rates (that few taxpayers actually paid) because of a technological boom, a rapidly-expanding workforce, and America’s dominant position in the world economy as Asia and Europe rebuilt. The late-1990s economy was aided by its own technology boom. Conversely, the struggling 1970s and 2010s economies lacked the structural advantages to overcome bad tax policy.
Tax rates are one powerful factor that government can control. Let’s cut them and unleash economic growth.
Brian Riedl is a senior fellow at the Manhattan Institute. Follow him on twitter @Brian_Riedl.
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