Do Personal Income Tax Cuts Foster Growth? Again, No

Researchers see little effect from income tax rates on growth
Photograph by Clark Griffiths/Image Source/Corbis

Martin Feldstein and Doug Elmendorf discovered something surprising in 1989. So much so that when they presented it to a National Bureau of Economic Research conference, they titled their paper (PDF) “Budget Deficits, Tax Incentives and Inflation: A Surprising Lesson From the 1983-1984 Recovery.” Feldstein had been Ronald Reagan’s chief economic adviser during that recovery; Elmendorf now runs the Congressional Budget Office. In 1989, they were surprised to read in their own data that the recovery that began in 1983 had been caused mainly by an expansionary monetary policy. (To a lesser extent, it had come from growth in business investment after changes to corporate taxes in 1981.) Feldstein and Elmendorf pointed out that the recovery had not been caused, as was popularly thought at the time, by reductions in the personal income tax rate.

That is: As early as 1989, Reagan’s economics guy did not find any evidence that the Reagan recovery had come from the Reagan administration’s personal income tax cuts.

Two decades later, the Republican logic for maintaining the 2001 and 2003 tax cuts on the highest earners rests on an assumption about economic behavior: Small business owners return their personal tax cuts to the economy by investing in their businesses. The logic of the idea is hard to refute. It also doesn’t seem ever to have happened. The 1989 paper by Feldstein and Elmendorf sits tucked in the footnotes of a second paper (PDF), released in mid-September by the Congressional Research Service, a nonpartisan analysis group run by the Library of Congress. The CRS paper looked at 60 years of economic growth and changes to the top marginal tax rates, both for personal income and capital gains. “The reduction in the top tax rates appears to be uncorrelated with saving, investment and productivity growth,” it concludes. “The top tax rates appear to have little or no relation to the size of the pie.”

Thomas Hungerford, who wrote that paper, points out that findings in academic journals rarely make it out into public view. He had noticed, in conversations with other tax economists, that they all seemed to know that economic growth was much higher in the 1950s—when personal income tax rates were much higher—than in the 2000s. “It may be that tax professionals already know this,” he says, “and figure the rest of the world knows it.” He wrote the paper in plain, layman’s language to advise Congress as it continues to argue about the tax code. “There are plenty of citations showing that tax cuts and increases haven’t had much of an effect on the economy,” says Hungerford, “I was just trying to drive that point home graphically.”

Economics doesn’t get to undergo controlled experiments. It has models, which predict results, and it has reality, which then tests the models. “We really don’t have any evidence that [personal income tax rates have] any effect on growth,” says Alan Auerbach. “A lot of the research showing otherwise is based on theoretical calculations.” Auerbach runs the Robert D. Burch Center for Tax Policy & Public Finance at the University of California, Berkeley. He’s referring to models, which take individual components of the economy to predict growth. But when you add in other factors—such as the implosion of the tech bubble and the Euro crisis—whatever effect income taxes have on the economy becomes hard to find in retrospect. “I don’t think there’s a conclusion that there’s no relationship,” he says, “only that it’s not so big that it comes through.”

As Elmendorf and Feldstein did in 1989, Auerbach points out that business investment responds to changes in corporate tax rates. Lower corporate tax rates feature in both Mitt Romney and Paul Ryan’s economic plans, as they do in the report produced by the Simpson-Bowles commission. But the sticking point in federal budget negotiations right now is not in the realm of corporate taxes, but in that of personal income taxes, particularly for higher earners. Republicans continue to maintain that lowering high marginal personal income tax rates spurs the economy.

At some point, when observed reality keeps differing from predicted reality, it makes sense to examine your predictions. That is not what’s happening. This particular Republican argument continues to rest on a prediction—and because the test of any prediction lies somewhere out there in the awesome future, it can never be refuted. Lower income taxes and the economy will grow: It’s a unicorn of an idea, always feeding in the next meadow.

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