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Do Tax Cuts Pay for Themselves? Sorry, No.

June 21st, 2011 . by economistmom

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Here’s a really nice video interview of Bruce Bartlett on the issue. Don’t let the fact that it’s MSNBC lead you to automatically dismiss the story as hyper-partisan hogwash. It actually quotes a lot of Republican experts. The basic point is that certain tax cuts can do a decent job stimulating demand for goods and services in a recessionary economy, and certain tax cuts (usually other kinds) can do a decent job encouraging the supply of productive resources (labor supply and saving) in a full(er)-employment economy. But neither type of tax cut is likely to generate so much demand or so much supply that they pay for themselves (a la Laffer), even over the longer run. And once you get long enough into the longer run, chances are any credit you are giving to the tax cut itself is misplaced.

More of my way of explaining this to come in future Tax Notes columns.

50 Responses to “Do Tax Cuts Pay for Themselves? Sorry, No.”

  1. comment number 1 by: Brooks

    FYI all,

    In 2007 I compiled this list of quotes of (mostly) conservative economists explicitly rejecting that persistent talking point that “tax cuts increase revenues” http://swordscrossed.org/node/1671

    That said, the heart of Bartlett’s analysis (at least per his argument in the video and on his blog) seems fundamentally flawed. Bartlett claims that, as a general rule, the key metric (”what really matters”) for measuring the net effect a tax cut has on revenues is revenue as a % of GDP. That is an invalid claim, and one that, to a large extent, rigs the game to produce the result he then points to as the be-all, end-all determinant of the key answer to the key question. Leaving aside bracket creep and other factors generating incremental revenue as income per capita and profits grow with GDP growth, Bruce’s metric is akin to static analysis. If you cut tax rates (and don’t also reduce tax credits, deductions, exclusions, etc.), you are, by definition, reducing tax liability as a percentage of individual income, and thus in aggregate you are reducing the percentage of tax revenue as a percentage of national income. It doesn’t matter how much GDP grows, and in turn how much the tax base grows, the lower ratio of tax revenues-to-income stays largely fixed, even if incremental growth caused by the tax cut were so great as to yield a net increase in revenues (even in real terms or real per capita terms). If we change from y=x to y = 0.9x, no matter how large x gets, y is still going to be no more than 0.9x (i.e., less than x) and thus less than it was before the change as a percentage of x.

    Imagine if a cut in tax rates of 10% (not points, but rather, for example, a 30% rate were reduced to 27%), generated 15% incremental growth in the tax base* with roughly the same composition (i.e., leaving aside bracket creep, etc.). That would mean revenues would be 3.5% higher (0.9 X 1.15 = 1.035). We’d have people able to keep a larger portion of their income and more cash going to the Treasury — the best of both worlds in the view of most people. Yet Bartlett would say the revenue effects were negative in both the mathematical sense and in terms of undesirability simply because revenue as a % of GDP had declined by 10% (again, a rigged result akin to static analysis).

    * Obviously a simplified example that ignores the dimension of time re: the incremental growth and resulting revenue effects, and thus ignores the “time value of money”.

  2. comment number 2 by: Brooks

    Also, Bartlett says that refundable tax credits (which, unfortunately, he offers as an example of “tax cuts”), “just lose [revenue] dollar for dollar and have no feedback effects whatsoever!”

    Really? Since when does it make sense to presume that something that puts or leaves money in millions of people’s pockets have zero revenue feedback effect?

    It is particularly odd to see such an implication in an era (the last couple of years and presently) in which many (mostly on the left) have seemed to offer up the left’s equivalent of the strong supply-sider argument of tax cuts paying for themselves, by implying that stimulus spending would pay for itself. Although I think it’s safe to assume some revenue feedback effects (particularly in this economy), and I think probably such stimulus is good policy amid deep recession if monetary policy seems insufficient, I question that assumption of such a great degree of feedback effects.

    Although I don’t consider Bartlett to be on the left, he is so passionately critical* of today’s conservative leaders and voices (largely, I think, driven by his legitimate grievance over the lame way they dumped and trashed him after Imposter) that I wonder if he’d say that explicit spending (which is what refundable tax credits are) has “no feedback effects whatsoever”, and thus put himself in conflict with the left (and with common sense, just as with his claim here that refundable tax credits have zero feedback effects).

    * As a note, I consider his criticism of those leaders and voices on the right to be usually valid, although he is obviously very partial to criticizing conservatives, while giving the left a pass on similar levels of nonsense.

  3. comment number 3 by: Vivian Darkbloom

    MSNBC hyper-partisan? Naw. Despite his best attempts to steer Bartlett in the direction he wanted, Bartlett told the truth. Do tax cuts pay for themselves? I don’t think anyone knows for sure, but the best evidence is that they partially do, but only partially. One hardly ever hears that version of the story, because most often it is either “they pay for themselves” (without adding the proper adverb “partially”) versus “they don’t pay for themselves” (without adding the proper adverb “fully”). The sophistry is symmetrical.

    Some Republican politicians play fast and loose with their description of the economic effects of tax cuts. Technically, when they say “tax revenues increased as a result of the tax cut” they are perhaps referring to the dynamic effect only and not the net effect, or they might be referring to the nominal change in revenues over time, without considering what would have been without those cuts. That’s on par with saying “I didn’t inhale”, or “I didn’t have sex with that woman”; it’s hair-splitting sophistry ( I think the idea is “plausible deniability”) which shouldn’t be part of this debate.

    Speaking of hair splitting, one factual point. In the video clip of Pawlenty at the very start of the show, Pawlenty claims tax revenues nearly doubled “in the 1980’s”. A minute or so later in the program, O’Donnell doesn’t refer to what Pawlenty said in the clip, but to a quote supplied by Dave Weigel of Slate where the period in question was allegedly the 8 years of the Reagan administration and not the 1980’s. Those two are different measurements—one involves a 10 year period and the other only an 8 year period. In fact, during the 1980’s (that is, FY 1980 through FY 1989), tax revenues increased from $517 billion to $991.2 billion. That is nearly double. That doesn’t mean the doubling was in real dollar terms, or that it was attributable to those cuts, or that Pawlenty should be implying such a conclusion; but, on its face, the claim wouldn’t be patently wrong and I suspect that this is where the Pawlenty number came from. Both sides a being a bit too cute here.

    I think I could feel O’Donnell’s pain when this interview nearly went off track. Bartlett laid out, quite fairly I think, the probable effects of tax cuts. He opined that some tax cuts, like the capital gain tax cut, could very nearly pay for themselves. He also stated that an across the board cut could cost, say, 70 cents on the dollar in line with studies posted recently on CG1G).

    Strangely, Bartlett referred to the “refundable child credit” as a tax decrease with nearly no stimulative effect (much to the chagrin of the anchor, I think) rather than as a spending item (can’t anyone keep their story straight on tax expenditures)?

    Now, how do we fairly sum all this up? Per O’Donnell, tax cuts have a tiny dynamic effect and in many cases zero (the latter undoubtedly referring to a progressive spending program, the refundable child credit).

    As a follow-up to this spot, perhaps we could run a column on how many times proponents of tax increases mention the dynamic costs, i.e., that they don’t fully raise the revenue they claim they do? I cannot recall one single instance in which this has been admitted in connection with proponents of tax increases. Indeed, it is all symmetrical.

  4. comment number 4 by: Patrick R. Sullivan

    Brooks and Vivian both make good points. In fact, framing the issue as, ‘Do Tax Cuts Pay for Themselves?’, is hardly rigorous logic in the first place.

    And, Economist Mom ought to take a lesson from the reactions to her last post, before criticizing politicians for using intellectual shortcuts during political back and forth.

  5. comment number 5 by: joe

    Vivian,
    Dynamic costs of tax hikes are often mentioned. Obama for example has admitted many times that a tax hike slows economic growth.

    So far as “tax revenue doubling in the 80s” and some alleged slight of hand by O’Donnel in talking about 8 years instead of 10, Bartlett did compare revenue in 1981 which is when Reagan cut taxes to revenue in 1989. So perhaps he could go back to 1980 where revenue was 517 billion instead of 1981 when revenue was 599 billion. In 1989 revenue was 991 billion, so there was a 91% increase from 1980 to 1989, still short of doubling as Pawlenty claimed.

    The more important point was what revenue in the base year looked like once adjusted for inflation and population growth. Inflation was 4.6% a year and population increased .92% a year. Accounting for inflation and population, that 517 becomes 838 billion So adjusted for population and inflation, tax revenue increased 18% during the 80s.

  6. comment number 6 by: Brooks

    Vivian,

    I think you are too charitable to the conservative side of this matter. I try to get a diverse diet of opinion in the media (liberal, conservative and other views in mass media and on blogs), and clearly there is a persistent, pervasive talking point that “history shows that tax cuts increase revenues” and what they clearly mean is NOT just that revenues are higher than static scoring would have it — they mean that tax cuts pay for themselves and then some. I don’t listen often to Rush Limbaugh, but on the occasions when I do, it’s not uncommon for him to repeat this baloney with emphatic, ironic arrogance. And he’s far from alone.

    It’s simple: they observe that revenues were higher in years following Kennedy, Reagan and Bush tax cuts and they infer clear causation. They obviously don’t get the first thing even about correlation, let alone causation, because they don’t ask what typically happens to revenue when there has NOT been a tax cut (when rates stayed the same or were even increased).

    I don’t think we can place an equal level of criticism on those (on the left or otherwise) who debunk that bogus conservative talking point, simply because they don’t always point out that there are some revenue feedback effects (whether 10% or 30% or somewhere in that range), given that it’s not even a close call.

  7. comment number 7 by: Vivian Darkbloom

    Joe,

    This is not an alleged “slight of hand”. It *was* a sleight of hand (correction of spelling and meaning in one go).

    Clearly, O’Donnell (and perhaps Bartlett) were aware that they needed to refer to the Slate quote (referring to “during the Reagan administration”) rather than the actual video clip shown on the MSNBC (referring to the 1980’s), to more forcefully make their case. I think that’s a little too cute. Mind you, I’m not defending Pawlenty on this point—quite the contrary. Pawlenty made no claim that his revenue estimate was inflation adjusted, but I agree that is the appropriate measure. See above. I am merely pointing out the rhetoric involved, and what I think to be a case of political “gotcha”.

    Whether or not dynamic costs of tax hikes are “often” mentioned would be a rather subjective evaluation. Perhaps someone should do a study to compare each time that effect is omitted in respect of tax hikes, versus each time the claim is made that tax cuts “pay for themselves” in respect of tax cuts. But, I suspect if we were to make a video montage of every instance in which they were *not* mentioned in connection with proposed tax increases, I think we would have a feature length film, rather than a few sound bites,.

  8. comment number 8 by: Vivian Darkbloom

    Brooks,

    Believe it or not, I do not have access to US television or radio, other than the short clips I view or listen to on internet. I can honestly tell you that I have never once viewed Limbaugh on TV or heard him in radio, but the second-hand stories I get tend to confirm your report. As far as the diverse diet, I subscribe to the NYT and the WSJ and read a lot of stuff on the internet (including this blog and many others). I also try to eat my vegetables. I think this gives me, more or less, the balance I need. From the little I’ve seen of MSNBC and Fox, they seem to be the partisan outliers, and my time is too precious to waste it on them. This clip has just confirmed that I’ve made the right decision, even though I though Bartlett’s contribution was truthful and credible, O’Donnnell very obviously had an agenda, much like a lawyer on direct or cross exam.

  9. comment number 9 by: Shadowfax

    I would think the CBO estimating that the Bush tax cuts add about $3 trillion to the debt over the next decade if extended would be sufficient evidence to put this to bed.

    But conservatives stopped listening to facts some time ago. So we are subjected to howlers such as “We have a spending problem not a revenue problem” or “Tax cuts increase revenues” or “The crisis was caused by Fannie/Freddie/CRA” or “Global warming is a myth.” The baloney just keeps coming, anything to support their ideology of low taxes and small government.

  10. comment number 10 by: Shadowfax

    Here is an old classic on the topic from CBPP.

    http://www.cbpp.org/archiveSite/3-3-03tax.pdf

    And the CBO.
    http://www.cbo.gov/ftpdocs/69xx/doc6908/12-01-10PercentTaxCut.pdf

    And CRS.
    http://fpc.state.gov/documents/organization/148790.pdf

    And Pew.
    http://www.pewtrusts.org/our_work_report_detail.aspx?id=59098

  11. comment number 11 by: Gipper

    On Bartlett’s blog I wrote a post a few months back explaining that economists who take rational expectations theory seriously in their modeling would not expect to see much correlation between tax rates and GDP.

    The reason is, what Robert Barro calls, “Ricardian Equivalence Theorem.” It suggests that consumers look at government spending as a prediction of their future tax liabilities. The timing of any tax change does not affect their change in spending.

    Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same.

    This suggests that last December’s tax deal would have little or no impact on business owners looking into the future to predict how much net income after taxes they will actually keep for themselves. They’re looking at government spending levels, and they know that someday they’re going to have to pay for it.

    In other words, “It’s the spending, not the taxes, stupid!”

  12. comment number 12 by: Brooks

    Gipper,

    I’m skeptical of the notion of full Ricardian Equivalence. I’m not saying there isn’t some effect, but wouldn’t the assumption of equivalence be dependent on the dubious premise that the population is making sophisticated calculations regarding our deficits and projected fiscal imbalance and, in effect, planning to eventually pay exactly what they are likely to end up paying to ensure some sustainable fiscal condition?

    It’s been a while since I read a bit on Ricardian Equivalence, but my recollection is that much more informed minds than mine have produced significant critiques of it.

  13. comment number 13 by: SteveinCH

    Gipper,

    I think Ricardian equivalence is interesting but it doesn’t actually make that much sense given history. History suggests that the money doesn’t actually need to be paid back in full. One might argue that from some arbitrary debt load (100% of GDP), the theory might hold but the strong version clearly doesn’t.

    Equally, the issue with the theory is timing and the timing of income. Since I don’t know my future income, the calculation that the theory holds is actually impossible to do, never mind that it is well beyond the information (accurate) possessed by the average citizen.

    Not to say it has no effect, but the strong version really doesn’t make a lot of sense.

  14. comment number 14 by: A

    And look at what happened to Bruce Bartlett for saying such things: he got hounded out of his job at AEI…
    Saying what you say (’…Sorry, no.’) might deprive you of any chance of a job in a future Republican administration, even if ‘Republican experts’ are quoted (by BB); these experts seem to have no voice whatsoever in the current Republican party.
    Commenter 2:”…something that puts or leaves money in millions of people’s pockets.” should read :”… puts millions of dollars in a few people’s pocket.”

  15. comment number 15 by: Vivian Darkbloom

    SteveinCH,

    “History suggests that the money doesn’t actually have to be paid back in full”.

    Is that true? Are you suggesting, for example, that inflation has no cost and therefore isn’t, in a sense, a form of “paying back that money”? Are you making an MMT argument?

  16. comment number 16 by: SteveinCH

    Nah Vivian, I’m definitely not an MMT guy, my point is that we show no signs of paying down the debt at current levels. I think the best possible outcome is that was stabilize the debt at some modestly higher level than it’s at today. Thus, current deficits won’t be paid back by future taxpayers.

    If public debt were at say 100 percent, I think the argument might have more merit since I’m not sure we can accept debt ratios much higher than that.

  17. comment number 17 by: Vivian Darkbloom

    Brad De Long attempts a “smack down” of Diane Lim Rogers:

    http://delong.typepad.com/sdj/

    I wonder, is that why he claims she’s “in a defensive crouch”?

  18. comment number 18 by: Arne

    DeLong:
    http://delong.typepad.com/sdj/2011/06/diane-lim-rogers-confuses-republican-economists-with-ex-repubican-economists.html

    Why call it a smack down? It is an exhortation to “stand up”.

  19. comment number 19 by: Gipper

    Brooks, SteveinCH:

    Full Ricardian Equivalence doesn’t have to be true to understand the insight that rational actors aren’t as concerned about current tax rates as expected future tax rates. The extreme assumptions of Full Equivalence are for purposes of easy mathematical modelling. But the kernel of the idea is compelling.

    So looking for statistical significance between marginal tax rates and GDP growth rates year to year is not something I’d expect to find. Unless you can embed future expectations into the model, I’d expect random correlatio

    My point, and the main thrust of rational expectations views of fiscal policy is that the share of government expenditures as a percentage of GDP is more relevant than the specific tax or borrowing policies.

  20. comment number 20 by: SteveinCH

    But Gipper, history to date would suggest that only a highly irrational actor would be worried about future taxes offsetting current spending. The observational data says it hasn’t happened.

  21. comment number 21 by: Gipper

    SteveinCH,

    You are forgetting about the inflation tax as one possibility. And looking at past behavior may not necessary be a good predictor of the future.

    Regardless of the past, the mathematics of our current budget means that spending will have to be drastically cut, taxes will be increased, and there will be some inflation. The status quo cannot possibly continue.

    For me the key variable will be the percentage of GDP spend by the federal government. I’m betting on 21%. However, I believe that many businesses are spooked by Obamacare’s impact on their taxes and business costs. It’s not a data item you can measure today, but it weighs heavily on the mind’s of investors.

  22. comment number 22 by: SteveinCH

    Gipper,

    We agree on the outcome. I just don’t think you can argue that a rational actor would bet on the government acting in an accountable fashion and taking debt to zero over time when it has never done so.

    I also think that somewhere between 20 and 21 percent is a good place for the two lines to cross. That said, I cannot conceive of a scenario where that happens. Sadly, I think the best possible outcome is primary balance with tax receipts in the 20 to 21 percent range. I simply cannot see government spending coming down by 4 or 5 percent of GDP.

  23. comment number 23 by: Arne

    “So looking for statistical significance between marginal tax rates and GDP growth rates year to year is not something I’d expect to find. ”

    According to this blog there is a statistically significant correlation between marginal tax rates and GDP growth rates.
    http://www.presimetrics.com/blog/?tag=economic-growth

  24. comment number 24 by: Gipper

    Arne,

    That’s not even intro level statistical analysis. Those variables can be correlated to variables omitted from the model that provide the true influence. Of course, this guy didn’t produce a model with econometric rigor. It’s just a single variable time series with an eyeball and a graph.

    I could show better results with the timing of rooster crowing and sunrises.

  25. comment number 25 by: Vivian Darkbloom

    Howard Gleckman has an interesting piece on the latest CBO long-term debt projection at TaxVox. I left the following comment there which is relevant to this debate over “Ricardian equivalence”.

    ___

    CBO Report: “CBO’s projections in most of this report understate the severity of the long-term budget problem because they do not incorporate the negative effects that additional federal debt would have on the economy, nor do they include the impact of higher tax rates on people’s incentives to work and save.”

    The CBO has resisted, rightly I think, efforts to require them to incorporate macro economic analysis into their scoring. However, the CBO (and others) have suggested that such analysis can be useful “on the side”.

    This issue is a key factor in causing the problem we’re currently in. I don’t think the problem is the lack of “dynamic scoring” per se. The problem is demonstrated in the following:

    CBO Report: “Taking those effects into account, CBO estimates that under the extended-baseline scenario, real (inflation-adjusted) gross national product (GNP) would be reduced slightly by 2025 and by as much as 2 percent by 2035, compared with what it would be under the stable economic environment that underlies most of the projections in this report. Under the alternative fiscal scenario, real GNP would be 2 percent to 6 percent lower in 2025, and 7 percent to 18 percent lower in 2035, than under a stable economic environment.”

    Here, contrary to the standard budgeting approach of using only a 10-year budget window, the CBO is reflecting the real costs of our budget deficits over a long-term period (albeit without the same degree of false certainty). Even a dynamic scoring approach to this issue would typically fail to incorporate the long-term costs of deficits because the benefits of those tax cuts and and spending increases are deemed to fall within the 10-year window, while much of the costs beyond it. Even costs that do fall within the budget window are ignored, such as the increased costs associated with servicing the debt.

    Today, we are paying not just for those budget mistakes made last year or 10 years ago. We are now paying for budget mistakes (both taxing and spending) that go back many more years.

    While I am not an accountant, I increasingly am acquiring a much greater respect for the work that they do and the approach they generally take when measuring financial condition. Their work and the approach they take comes much closer to reflecting reality than the work of economists (which most often is designed, for political reasons, to obfuscate it). In accounting for such future liabilities of a private corporation, with few exceptions, an accountant would be required to put a liability on the balance sheet (either current or deferred). The government does not do that. I think this is largely due to the fact that our approach to government finance and budgeting has been, in recent decades, increasingly taken over by economists rather than accountants and the extent of our budget problems more or less tracks this development.

    We need more government accounting and less macro economics and we need more econometrics and less normative economics.

    —-

    The Ricardian equivalence theory posits that consumers, being rationale, react quite quickly to changes in government tax and spending policy and that demand is more or less the same whether government finances spending through tax increases or borrowing. This is an interesting academic theory, which I personally happen to believe is largely wrong. History over the past decade has, to my mind, largely disproven the theory because consumer debt went up almost as rapidly and in tandem with government debt. More importantly, as regards our budget deficit, the theory is pretty much irrelevant. The theory pretty much relates to a timing issue—do consumers anticipate the cost of government budget policies or do they wait for the actual cost of those policies actually start to have effect?

    Under the current budget static scoring policy, the Ricardian effect, if it exists, is not taken into account. I suppose if we were to stick to a 10-year budget window and incorporate some sort of dynamic scoring in which this effect were to be (accurately) counted, it would affect our budget decisions. But, if we were to simply incorporate a better accounting approach, Ricardian equivalence would not be much of an issue. A liability would be placed on the government balance sheet for the (additional) cost of deficits whether that liability would be expected to be incurred within a 1, 2 or 12-year period (see first quote cited from CBO Report, above). The work of accountants is not subject to a 10 year window, nor is it subject to the election cycle. The work of economists, on the other hand, is almost exclusively restricted to these short-term periods.

  26. comment number 26 by: Vivian Darkbloom

    Correction to the above post:

    The author of the TaxVox piece was Len Burman, not Howard Gleckman. Apologies to both.

  27. comment number 27 by: Arne

    “It’s just a single variable time series with an eyeball and a graph.”

    Blogs are seldom arranged as useful references. If you scroll down to his December post you will see that he does provide the statistics and that the result is signficance.

  28. comment number 28 by: Jim Glass

    According to this blog there is a statistically significant correlation between marginal tax rates and GDP growth rates.

    No, that blog doesn’t say that. It doesn’t even say what it thinks it says, that positive growth correlates with the one top statutory rate.

    What’s very wrong about it is that the top statutory rate is *not* the marginal rate people actual pay. Nobody paid those “91%” rates. That tax code was replete with tax preferences for the wealthy, starting with low capital gain rates and continuing through a *massive* tax shelter industry — which let the richest supposedly subject to those highest rates pay *less tax* than the less well off.

    To cut and paste in what I wrote about this here before:
    ~~~
    From IRS Statistics of Income data for 1965, the days of the good old 70% top tax bracket, effective tax rates by income level (tax actually paid/reported income, 1965 dollars)…

    Over $1 million: 30.8%
    $500k to $1,000k: 32.8%
    $100k to $500k: 36.4%
    $50k to 100k: 31.2%

    So the people who had income of $50k to $100k paid a higher effective tax rate those who had twenty times more income. The richest paid a lower effective rate than people who had only 5% of their income.
    ~~~

    The richest didn’t start paying the *highest* effective rate until the Tax Reform Act of ‘86 lowered the top rate to 28% while also killing off the tax shelter industy and eliminating the favorable rate for capital gains. If you want the rich to pay more tax than anyone else, that’s how to do it — proved by test.

    Calculating the actual marginal tax rate any group of people really pays is very complex because of all the deductions, exemptions, credits, phase-ins and phase outs, etc., which are different for every individual and change every year. But the marginal tax rates people actually pay are *not* the statutory rates, top or not.

    Barro has calculated the average marginal tax rate by year and reports[.pdf]:

    In a post-1950 sample, increases in average marginal income-tax rates (measured by a newly constructed time series) have significantly negative effects on GDP. When interpreted as a tax multiplier, the magnitude is around 1.1. When we hold constant marginal tax rates, we find no statistically significant effects on GDP from changes in federal tax revenue (using the Romer-Romer exogenous federal tax-revenue change as an instrument). In contrast, with revenue held constant, increases in marginal tax rates still have a statistically significant negative effect on GDP.

    BTW, the author of that blog goes on about the big growth rates post-1933 and post-1947 being accompanied by expanding govt and rising taxes as if they caused that growth — somehow without mentioning either that in 1933 GDP was 30% below trend because of that Great Depression thing, or that in 1947 there was about a decade’s worth of deferred consumption demand due to that World War II thing *and* the Depression. I dunno about that…

    Also BTW, regarding the blog author’s snark about Romer and Romer not knowing what they said about tax cuts and growth, they really do know what they said and they meant it.

  29. comment number 29 by: Brooks

    Jim,

    Re:No, that blog doesn’t say that. It doesn’t even say what it thinks it says, that positive growth correlates with the one top statutory rate.
    What’s very wrong about it is that the top statutory rate is *not* the marginal rate people actual pay. Nobody paid those “91%” rates.

    The theory is, of course, that at lower statutory tax rates (or a lower top rate), people can keep a larger portion of the next dollar earned, and thus have more incentive to earn income, and thus will earn more income, and thus (in aggregate) GDP will be greater, ceteris paribus.

    So, if the question is of the degree of correlation (and possible causation) between GDP and either marginal statutory income tax rates or the top statutory rate (excluding investment income or any income taxed at different statutory rates), isn’t that a legitimate question to ask, given that raising/lowering statutory rate(s) raises/lowers the incentive level for particular form(s) of income, and aren’t you forcing in extraneous variables when you shift to effective tax rates (net of tax deductions, credits, etc.)?

    For example, if Scenario A were a top 60% income tax rate with no tax deductions, credits, etc., and Scenario B were a top 60% rate with tax deductions for purchases of luxury cars, boats, etc. such that the effective tax rate were lower, those tax deductions don’t change the incentive level for any form of income taxed per that tax structure — someone in that bracket (as long as they were still in that bracket after the deductions) would still get to keep 40 cents per marginal dollar earned, no more and no less, in either Scenario.

    So why (if I’m understanding you correctly) do you assert/imply that a correlation analysis of GDP and the top marginal rate would necessarily be invalid or misleading or moot in some way if effective tax rates have been much lower than the top statutory rate?

    Perhaps that’s not what you’re asserting, but if not that, then what is your point re: what is “very wrong” about a correlation analysis of GDP growth and the top statutory rate?

  30. comment number 30 by: Jim Glass

    So why (if I’m understanding you correctly) do you assert/imply that a correlation analysis of GDP and the top marginal rate would necessarily be invalid

    If you want to draw a legitimate correlation between marginal tax rates and their effect on GDP, you have to have data on marginal tax rates *paid* — not a line on a graph that refers to … ??? … what?

    In the post linked to there is no data, none whatsoever, on marginal tax rates actually paid. In year #1, how many taxpayers paid the 91% rate: 1? 10,000? None? How much tax did they pay? A lot? None? How about in year #2 …#4 … #20…??

    For all we know from the data presented nobody ever paid the 91% rate. So how can we say from that data that increasing the tax rate to 91% had a causal effect on increasing GDP?

    Now if you want to ask if we can correlate a line on a chart with GDP growth, even if we have no data indicating any causal connection between the two, sure we can.

    We can do it with that line on top statutory tax rates, even though it tells us zero about whether anyone ever paid the rate. Still …it correlates!

    We can also draw a line of historical annual average baseball major league batting averages. By far the highest batting averages were in the 1930s-early 40s. By far the highest average GDP growth was in the 1930s-early 40s. It correlates!

    The blog post has zero data, none, on marginal tax rates actually paid, and draws a conclusion about how they affect GDP growth.

    The Barro paper has fully worked up data on marginal tax rates actually paid, and draws a conclusion about how they affect GDP growth.

    Which one would you give greater weight?

    The point of the SOI 1965 data is simply that increasing tax rates on the rich doesn’t mean they will pay higher tax rates. And I think it is a fair guess that the “tax the rich” crowd is working on the assumption that putting the highest tax rates on the rich will result in them paying higher tax rates than anyone else — though this is contradicted by all historical data.

    The reason is simple. Put a 91% tax on income of the rich and they can afford to pay huge amounts to lawyers, and more importantly Congress, to buy a tax preference for it, and still come out ahead. Once they get it they have it forever.

    Who slashed their taxes paid the most with tax preferences in 1965? The very richest.

  31. comment number 31 by: Vivian Darkbloom

    Jim Glass makes a pretty good point. As he says, though, calculating the effective marginal income tax is very, very difficult. But, the simple fact that the average effective rate for high income taxpayers is much lower than the statutory effective rate suggests that the effective marginal tax rate must also be significantly below the statutory marginal rate for most taxpayers. (In recent years, this is due mostly to the preferential rates on CG and dividends which I don’t consider “tax preferences”).

    Mr. Glass might be compressing two likely thought processes into one. A taxpayer is fully aware of his marginal statutory rate and what effect that rate would have on an additional dollar earned. But, that taxpayer is also likely aware of the tax expenditures available to him on that additional dollar of income, too. If one were to put this on a chart (that is, the use of expenditures to reduce marginal rates), I think it would look something like a Bell curve due to the fact that most tax expenditures for individual taxpayers are phased out at upper income limits due to AMT, Pease limitations, PAL rules, etc, but these limits generally were introduced after 1986. Thus, I think, historical comparisons pre- and post-1986 would be the most distorted.

  32. comment number 32 by: Brooks

    Jim,

    Yes, I agree that the marginal tax rates actually paid are more important to use than the statutory rates (although the latter are still worth correlating, since, at least in theory, many of the tax deductions/credits/etc. are intended to foster economic growth — e.g., taxpayer’s tax liability is lowered if he buys a home [with mortgage], in theory b/c, in aggregate, that ends up supporting the economy).

    And that’s why I said in my hypothetical illustration:
    “someone in that bracket (as long as they were still in that bracket after the deductions) would still get to keep 40 cents per marginal dollar earned, no more and no less, in either Scenario.”

    BUT the marginal tax rates actually paid is NOT the same as the effective tax rate. To apply my earlier illustration:

    First, let’s assume just two tax brackets to keep this simple. 25% on the first $100,000, and 60% on income above $100,000.
    Joe makes $1 million in salary.

    Scenario A: Joe pays, $565,000 in income taxes. For every dollar of salary he earned over $100,000, he was taxed at the 60% marginal rate, so his incentive was the opportunity to keep 40 cents of each dollar.

    Scenario B: Let’s assume Joe takes advantage of $300,000 of tax deductions, credits, etc. so his taxable income becomes only $700,000. Now he pays only $385,000 in taxes on his salary. But he still faced a marginal tax rate of 60% on every marginal dollar he earned above $100,000, so his incentive was still that same 40 cents of each marginal dollar of salary earned.

    Yet his effective tax rate has just gone down from 56.5% in Scenario A to only 38.5%. Does that change the fact that the level of his incentive to earn more in salary was still the opportunity to keep 40 cents of each dollar? No, unless I’m missing something here.

    So I’m asking you why you (seem to) focus on the discrepancy between the statutory top marginal rate and the effective tax rate as what’s “very wrong” with someone focusing on the correlation b/w top marginal rate and GDP.

    I agree that the marginal rates actually paid is probably more useful to use for such a correlation, and surely some people initially in the top bracket will have enough tax deductions (etc.) to bring them down to a lower bracket, but that’s very far from assuming that just because effective tax rates were much lower, there weren’t any/many people actually taxed at that top marginal rate.

  33. comment number 33 by: Arne

    Other measures of tax rates paid (or factors that drive growth and taxes) may well produce better correlations and may even lead to actually understanding some underlying causation, but the original question was just whether there was a correlation.

    I think you are taking the warning against confusing correlation with causation a little too far. The reality that there are other factors does not justify ignoring that you have found a correlation.

  34. comment number 34 by: Vivian Darkbloom

    Brooks,

    “Yet his effective tax rate has just gone down from 56.5% in Scenario A to only 38.5%. Does that change the fact that the level of his incentive to earn more in salary was still the opportunity to keep 40 cents of each dollar? No, unless I’m missing something here.”

    I think you are confusing *marginal effective tax rate” with “*average effective tax rate”. As I said in my earlier post, Joe faces two questions: 1) what is the marginal statutory tax rate on that additional dollar; and 2) what opportunities do I have with respect to that additional dollar to offset it by an additional deduction. You are assuming that the additional dollar is not associated with any additional deductions. But, in reality, Joe might well be thinking I’ll just create an additional deduction (or take advantage of some sort of tax subsidy tied directly to that additional dollar).

    That is why I wrote that Jim Glass is really compressing two decision factors into one.

  35. comment number 35 by: Brooks

    Vivian,

    Remember, ultimately we want to see what, if anything, we can infer re: the causal relationship between levels of incentive to earn more (i.e., portion of each additional dollar earned that the people can keep after taxes) and GDP, so we’re looking for useful variables for related correlation analysis.

    Now, let’s look at the matter you raise re: the possibility of additional deductions accompanying additional earning.

    Generating more deductions means spending more on deductible products and/or investing more time and/or money to find and process more deductions based on current or currently planned spending on such products.

    Let’s look at Scenario B: Joe plans to earn $1 million in salary and claim $300,000 in deductions. His tax benefit for every dollar of those deductions is 60 cents.

    Now suppose Joe has an opportunity to earn another $200,000 of salary income. Let’s look at Joe’s incentive to generate more deductions, and his incentive to earn that additional $200,000.

    Does Joe have any more incentive to generate more deductions if he earns that additional $200,000 than if he does not earn that additional $200,000?

    No, he doesn’t. At $1 million of salary income he can get a tax benefit of 60 cents for each additional $1 of deductions, and the same is true at $1.2 million of salary income. So there is no reason to presume he will generate more deductions at $1.2 million than at $1 million. If he generated only $300,000 in deductions at $1 million of salary income, there’s no reason to think he’d generate more deductions at $1.2 million, because there’s no additional incentive to generate more deductions.

    (The only exception would be if his goal in either case were to generate sufficient deductions to move him in to a lower tax bracket. In that case, at higher income he’d have to generate more deductions to bring his taxable income down that much farther to get into the lower tax bracket, but as I’ve explained, I’m not talking about such cases).

    And as I’ve explained, his incentive to earn that additional $200,000 is the additional 40 cents per dollar, which would be $80,000. And he’d have the same incentive level with or without his tax deductions.

  36. comment number 36 by: Vivian Darkbloom

    Brooks,

    I see your point, but the type of deduction you are talking about would not be the type I am thinking of when I wrote about opportunities associated with the additional dollar of income (not the prior one).

    If that additional deduction is actually tied to that additional dollar, your example does not hold. For example, Joe might say, I’ll earn that additional dollar through an investment that entitles me to accelerated depreciation, an investment tax credit, an additional pension contribution, energy credit or some other type of targeted subsidy that is only available to that additional dollar and not the one I’ve already earned. There is also, of course, the example of the tax bracket that you mentioned.

  37. comment number 37 by: Brooks

    Vivian,

    That’s why I was speaking only of income subject to a given tax rate structure, in particular the individual income tax (not including capital gains or dividends, not business income unless it’s passed through as individual income, nor any other types of income for which there is a different rate structure from the one being used for a given correlation analysis).

    To some extent there may be tax deductions, etc. that are linked to the generation of the form of income in question (the income applied to the tax rate structure in question), but yes, that would be different from what I’m discussing, and although I don’t know, I would guess that most (in dollar terms) of the deductions related to individual income tax rate structure that I’m discussing (as is the chart on that blog) are unrelated to the form of income, as opposed to, say, a tax credit or deduction (or exclusion) that Joe would get on that additional $200,000 of salary income if he earned it working as a teacher — such a case would reflect the nature of the kinds of things you are referring to that would be applicable here, because Joe’s marginal tax rate for earning that additional $200,000 would be net of the tax credit or deduction, not the statutory tax rate. In fact, if it were all deductible or excludable, his marginal tax rate on that income would be zero, by definition.

  38. comment number 38 by: Jim Glass

    Mankiw on dynamic tax scoring, money quote:

    “In the long run, about 17 percent of a cut in labor taxes is recouped through higher economic growth. The comparable figure for a cut in capital taxes is about 50 percent.”

  39. comment number 39 by: Brooks

    Jim,

    If you’re interested in some more like that, below is from the compilation I linked to in my first comment upthread:

    BusinessWeek, FEBRUARY 17, 2003:
    R. Glenn Hubbard, chairman of the White House Council of Economic Advisers, estimates that as much as 40% of the cost of the Administration’s proposal would be offset by higher economic growth.
    http://www.businessweek.com/magazine/content/03_07/b3820001_mz001.htm?chan=search

    The Washington Post, October 17, 2006:
    An analysis of Treasury data prepared last month by the Congressional Research Service estimates that economic growth fueled by the cuts is likely to generate revenue worth about 7 percent of the total cost of the cuts, a broad package of rate reductions and tax credits that has returned an estimated $1.1 trillion to taxpayers since 2001.http://www.washingtonpost.com/wp-dyn/content/article/2006/10/16/AR2006101601121_pf.html (I don’t have link to the referred to CBO analysis, but apparently it was a September 2006 report)

    Here’s a different CBO report, Congressional Budget Office, Economic and Budget Issue Brief, “Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates”
    December 1, 2005:
    Summary
    This brief by the Congressional Budget Office (CBO) analyzes the macroeconomic effects of a simple tax policy: a 10 percent reduction in all federal tax rates on individual income. Because there is little consensus on exactly how tax cuts affect the economy, CBO based its analysis on a number of different sets of assumptions about how people respond to changes in tax policy, how open the economy is to flows of foreign capital, and how the revenue loss from the tax cut might eventually be offset. Under those various assumptions, CBO estimated effects on output ranging from increases of 0.5 percent to 0.8 percent over the first five years on average, and from a decrease of 0.1 percent to an increase of 1.1 percent over the second five years. The budgetary impact of the economic changes was estimated to offset between 1 percent and 22 percent of the revenue loss from the tax cut over the first five years and add as much as 5 percent to that loss or offset as much as 32 percent of it over the second five years.
    —Douglas Holtz-Eakin, Director
    http://www.cbo.gov/ftpdocs/69xx/doc6908/12-01-10PercentTaxCut.pdf

    Heritage Foundation — by Tracy Foertsch, Ph.D. and Ralph A. Rector, Ph.D , February 15, 2007 (EGTRRA and JGTRRA refer to the 2001 and 2003 tax cuts, respectively)
    Extending EGTRRA’s and JGTRRA’s expiring provisions has a positive effect on U.S. GDP, incomes, and employment over the 10-year budget period. It also generates substantial revenue feedbacks ($295.5 billion). Ignoring the macroeconomic effects of the extension plan on individual, non-corporate business, and corporate incomes puts federal tax revenues $991.9 billion below the CBO’s projected baseline levels over 10 years. Taking the dynamic effects of the extensions into account reduces the estimated revenue loss to the Treasury to $696.4 billion over 10 years.(Footnote:These estimated changes in federal individual income tax revenues exclude net refundable credits.) http://www.heritage.org/Research/Taxes/wm1361.cfm

    Martin Feldstein (who was, at or about that time, an adviser to the Bush 2000 campaign)
    Originally published in the WALL STREET JOURNAL
    Monday, December 6, 1999:
    Bush’s Tax Plan Makes Sense
    …The revenue effect of specific tax changes is of course important if we are to avoid a return to budget deficits. Any sensible estimate of the effect of tax rate reductions on government revenue would take into account their favorable impact on work effort, skill development, risk-taking and other factors that increase taxable income… I estimate that such favorable feedback effects would offset about one-third of the traditionally estimated revenue loss from cutting the top tax rate to 33% from 39.6%.
    http://www.nber.org/feldstein/wj120699.html

    Martin Feldstein, Testimony before Senate Budget Committee regarding President Bush’s 2001 Tax Cut Proposal, February 13, 2001:
    The true cost of reducing the tax rates is likely to be substantially smaller than the costs projected in the official estimates. Studies of past tax rate reductions show that taxpayers respond to lower marginal tax rates in ways that increase their taxable income. They work more and harder and take more of their compensation in taxable form and less in fringe benefits. At the National Bureau of Economic Research we have used a large publicly available sample of anonymous tax returns to estimate how the actual revenue loss would compare to the official estimates that ignore this behavioral response. Our analysis shows that when the proposed Bush tax cuts are fully phased in the net revenue loss would be only about 65 percent of the officially estimated costs.

    Martin Feldstein, interview, The Region (publication of the Federal Reserve Bank of Minneapolis), September, 2006:
    Think about an across-the-board tax cut. Let’s say you cut all tax rates by 10 percent, so that the 25 percent rate goes to 22 1/2 percent, 15 percent rate goes to 13 1/2 percent, and so on. That raises taxable incomes. The revenue cost of that tax cut is only about two-thirds of the so- called static result that you’d get if you didn’t take behavior into account. http://www.minneapolisfed.org/pubs/region/06-09/Feldstein.cfm

  40. comment number 40 by: Vivian Darkbloom

    Brooks,

    Jim Glass makes here a good point about *which* marginal rate and the effect of this is not captured in most mainstream analyses, but let’s leave that aside and concentrate on the marginal rate of tax for “ordinary income”.

    I will grant you that there are instances in which that additional deduction does not necessarily come into play in the decision-making process of whether to earn an additional dollar. However, I think those instances are much less frequent than you think (and less frequent than I suggested in my earlier post).

    From a strictly psychological viewpoint, you seem to be assuming that the decision process for earning an additional dollar is always forward-looking, but the decision-process for incurring deductions or other tax preferences is always backwards looking (your way of thinking and allocating deductions does not even seem to allow that it could be both). After all, when we speak of incentives, we are by definition talking about what motivates people to do things in the future, not what has already motivated them to do something in the past.

    As regards deductions, in addition to the actual limitations I mentioned (some deductions are limited to specific items of income), we have some very practical limitations. Faced with the issue of whether to take the effort to earn an additional dollar, Joe may (or may not) go to a tax planner (the whole idea of “tax planning” suggests forward-thinking). Having already earned $500,000, Joe could go to this planner and say, I’d like to earn an additional $100,000, but too much of that will go to tax at my high (statutory) marginal rate. The planner, could, as they normally do, come up with a number of creative ideas to shelter that income. For example, the planner might say that he could help set up a deferred compensation plan, using a Rabbi trust or something, but that can only be done going forward, it can’t be done for income already earned. Under your way of thinking, any benefit from this type of planning would be allocated to the past and not to the future.

    And let’s step back a bit in time, before Joe earned that $500,000. Don’t you think Joe was already thinking about how to shelter taxes on *that* income through use of tax deductions, etc? In Joe’s mind (if not his bank account) the deductions used to offset that first $500,000 have already been committed.

    There are, of course, likely some exceptions to what I am saying. For example, let’s assume Joe goes to that tax planner and the planner says, well, you have yet to exhaust the maximum contributions allowed for your IRA, 401(k), defined benefit plan or defined contribution plan or whatever. You can put part of that additional $100,000 into that. Joe might say, wait, I don’t have to do that, I’ve got $100,000 in cash from my first $500,000 of income sitting around doing nothing. I don’t have to earn another $100,000 to get that tax benefit. In that situation, you might be right. On the other hand, Joe could likely (more likely, I think) say “that’s a good idea”. If I hadn’t already committed my first $500,000 to other things, I could use part of that.

  41. comment number 41 by: Jim Glass

    I think you are taking the warning against confusing correlation with causation a little too far.

    OK, some thoughts:

    1) When claiming to have found a correlation between marginal tax rates paid and GDP growth, one should have at least *some* data on marginal tax rates paid. As Barro does. But I won’t belabor this.

    2) Reverse causation is an even worse problem than no causation. Look at the chart on that blog post. The *dominating* strongest part of his correlation is 1938-1944. The top tax rate rocketed up from 25% to 63% … 79% … 88% … 94!! And GDP exploded going upward by 9% … 17% … 16% … 18% … !!!

    Wow! If *that* doesn’t prove that really high rates bring on booming economic growth, what ever will?

    Oh, wait. During 1938-45 was something else going on that drove a huge increase in govt spending, which created those big GDP numbers, and forced those big tax hikes to pay for it all?

    3) No correlation ever proves causation by itself. That’s why one has to ask about it, “Is there a coherent explanation for this? Does it fit with the known world?” Then one also has to ask, “Are there other known explanations for the correlation?”

    If a correlation suggests the earth is square it may be mathematically entirely correct but you *know* it is wrong because you’ve seen a thousand pictures of the earth from space. If I show that baseball batting averages correlate with GDP growth, you can be 99% sure it is random chance, because what connection is there? — and be 100% sure that if there is causation it doesn’t run from baseball to GDP, because how could it?

    Here is a paper by three economists showing “a significantly positive, non-spurious, and robust correlation between the Washington Redskins’ winning percentage and the amount of federal government bureaucratic activity as measured by the number of pages in the Federal Register” — *and* giving a serious explanation for it too! Do you buy it?

    As far as taxes and GDP goes, that guy on his blog claims his correlations show that higher taxes increase growth — and that the best top tax rate for faster growth is 65%.

    But do you know *any* economic theory that says increasing taxes *increases* growth? Does any school of thought say that? Even Krugman says taxes reduce growth — except not by much, and in the US they are so low that its not worth considering.

    Does any economic school of thought say: “Tax something, get more of it!”?

    OTOH, consider 1934-1945 — the core of the correlation on that entire chart. Obama’s former top economist, Chrisitina Romer, has shown that from 1934-39 fisal policy had negligble effect on GDP growth, which was driven by devaluation of the dollar and 10% annual money growth. Then from 1939-45 … that other thing drove massive govt spending which upped GDP and forced huge tax increases.

    So what happened in all those years is known — and it *ain’t* what that guy said! Take all that away, what has be got left?

    4) The reality that there are other factors does not justify ignoring that you have found a correlation.

    Do you want to see a really *impressive* correlation involving taxes? I mean a *really strong* one?

    First consider how much the tax landscape has changed since 1967:

    The top income tax rate went down from 77% to 28%, and up 39.6%, and down to 35%.

    The payroll tax rate has gone up from 7.8% on $43,089 (2010 dollars) to 15.3% — 12.4% on $106,800, plus 2.9% on unlimited.

    Now look at the first graph here. (R^2 = .9957!)

  42. comment number 42 by: Brooks

    Vivian,

    Re: Jim Glass makes here a good point about *which* marginal rate and the effect of this is not captured in most mainstream analyses

    It seems Jim was saying that a correlation of the top statutory rate with GDP as a step toward inferring causation is “very wrong” because effective tax rates were much lower than the top statutory rate. I’ve been challenging that argument.

    Re: I will grant you that there are instances in which that additional deduction does not necessarily come into play in the decision-making process of whether to earn an additional dollar. However, I think those instances are much less frequent than you think (and less frequent than I suggested in my earlier post).

    If we were talking about earning another dollar of any sort, including income in forms that are taxed per a different tax rate structure (e.g., cap gains, corporate income, etc.), I think you’d have a stronger point. But other than that, it seems the largest of the tax deductions, credits, etc. are related to purchases of goods that have nothing to do with the pursuit of the ordinary income from which they are deducted to reduce tax liability.

    Re: From a strictly psychological viewpoint, you seem to be assuming that the decision process for earning an additional dollar is always forward-looking, but the decision-process for incurring deductions or other tax preferences is always backwards looking (your way of thinking and allocating deductions does not even seem to allow that it could be both). After all, when we speak of incentives, we are by definition talking about what motivates people to do things in the future, not what has already motivated them to do something in the past.

    What are you talking about? First, of course we are talking about incentives and decisions for future actions (to earn more ordinary income). That’s why we’re thinking about possible correlation and possible causation between tax rate levels and GDP. And as for deductions, I explicitly included generating more deductions either by deciding to spend more on deductible products or investing more time/money to find and processing more deductions among current or currently planned purchases of those products (or any other form of deductions). So again, what are you talking about?

    Re: let’s step back a bit in time, before Joe earned that $500,000. Don’t you think Joe was already thinking about how to shelter taxes on *that* income through use of tax deductions, etc? In Joe’s mind (if not his bank account) the deductions used to offset that first $500,000 have already been committed.

    First, we’re talking about the top marginal rate with Joe, so we’re not talking about his first dollar. He’s well into the top tax bracket, and will be even after his deductions. We’re talking about marginal income from that base. And again, the key is the question of whether or not the deductions were tied to the generation of that marginal income or enabled by that income. Let’s say Joe could earn additional income working out of his home, and this would enable him to expense part of his home (which he could not otherwise do). That would fit the kind of deduction you’re talking about, because, in effect, Joe’s marginal tax rate on that set of income would have to take into account the tax savings from expensing part of his home. By contrast, if you’re talking about Joe thinking that if he earns this money, he’ll pay an accountant more to find more deductions for purchases he’s made or plans to make (or could make) of deductible products that are unrelated to whether or not he earns that money (e.g., deducting some unrelated expense for his boat), we’re back to my point that he has no greater incentive to generate such additional deductions with that additional income than without it, so we wouldn’t presume he would pay his accountant more to generate more deductions.

  43. comment number 43 by: Brooks

    Obviously the paragraph starting “What are you talking about?” should not have been italicized. That was my reply.

  44. comment number 44 by: Brooks

    I should note that, although I referred to the “largest of the tax deductions, credits, etc.”, I realize that the largest for U.S. taxpayers overall are not necessarily the largest among those at the top statutory rate.

  45. comment number 45 by: Jim Glass

    Jim Glass makes here a good point about *which* marginal rate and the effect of this is not captured in most mainstream analyses, but let’s leave that aside and concentrate on the marginal rate of tax for “ordinary income”.

    Aw, let’s not. :-) Because it really misses my point.

    I will grant you that there are instances in which that additional deduction does not necessarily come into play…

    When I talk about how the richest paying *less* tax than others back in ye olden “really high tax bracket days” — during the last of I worked professionally as a young puppy tax lawyer — I’m not talking about them using deductions as we know them today.

    Those *very top* tax brackets the left longs for aim at the uber-rich, “the top 1% … richest 400″, etc. But income at that level is dominated by capital gains — and they were never taxed at anything like those top rates. Moreover, changes in the “top tax braket” do *not* show the changes in the capital gains rates that the uber-rich *really* paid.

    E.g., before TRA ‘86 the top tax bracket was 50%, then it dropped it to only 28%, then Clinton pushed it back up to 39.6%. So the tax rate paid by the uber-rich was high, then fell, then rose … right? Wrong.

    Before TRA ‘86, long-term capital gains were only 40% taxable, so the top rate paid on them was only 20%. The ‘86 Reform Act *increased* it to 28% under egalitarian Reagan, then the famous Clinton “tax increase” *lowered* the rate for the uber-rich to 20% (by 29%) again.

    Now let’s say back in ye olden days one was one of the few fortunate enough to have earned income reaching into top-rate levels. No problem! E.g., Widely popular options, very briefly…

    [] Converting salary into capital gain income by taking compensation via stock, stock options, etc.

    [] Deferring income so it is spread over years when one will be in a lower tax bracket (such as after retirement).

    [] Using income-averaging — in ye olden days one could have one’s income taxed as if received over 10 years, which dropped the tax rate to as if one’s income was only 10% of what it was. That took care of that! (When tax rates are so high, Congress *can’t resist* creating options like this.)

    [] Use the huge tax shelter industry of those days. E.g., a investing in a real estate partnership let one deduct “non cash expenses” such as depreciation against earned income, wiping out the tax on it. Then when the business real estate was sold after keeping or increasing in value, the depreciation was “recaptured” and taxed as capital gain — converting the salary to capital gain.

    I could go on for 100 pages. Some of you may remember Art Linkletter, who was a hugely sharp and successful businessman/investor (he brought the Hula Hoop to America) in addition to being the top “family show TV host” of his generation. He died just last year at age 98. Shortly before he died I saw him in an interview in which he was sharper than I am now.

    One of his stories was: when he first became a big success on TV his salary put him one of those absurd tax brackets, and he wasn’t going to pay that, so he started investing in oil wells, which let him deduct their expenses against his income while taking the ultimate returns from the wells tax-favored (much like real estate). At the age of maybe 95 he started rattling off the IRS oil depletion allowance rules of the 1960s like he wrote them.

    That was the world of the 70% top tax bracket — and why in those days the very richest paid lower effective rates than those with only 5% of their income.

    Uber-rentiers never faced those top rates *at all*, and uber-earners designed their own compensation packages so they never had to pay them (while creating a whole class of rich tax shelter lawyers like I wouild have been, but for TRA ‘86). They didn’t use “deductions”, everything was planned out from the day they signed their contracts.

    The top 28% rate of the ‘86 Reform ended all that. Why pay a lot of money to a tax lawyer like me if it doesn’t save you much? Why defer receiving pay? Etc.

    Because the tax shelters no longer saved much money, lobbying for them died and Congress was able to kill most of them outright. (Tax shelter lawyers had to move on to doing traffic cases.)

    And the uber-rich started paying the *highest* effective tax rate.

    Here’s that impressive tax correlation again. Does anyone see the effect of “top marginal tax rates” in it?

  46. comment number 46 by: SteveinCH

    Recently, I’ve been looking at the Piketty and Saez data in a different way. I’ve started to look at it this way in part because I disagree with their treatment of estate taxes and in part because our discussions tend to focus on elements that drive effective tax rates.

    If you look solely at income and payroll tax rates, it basically says that since 1970, there have been pretty massive changes in the distribution of taxes in favor of the least well off.

    For example, the total effective Federal payroll and income tax rate increased from 1970 to 2004 (last year of their data set) from 18.3% to 20.8%, meaning that taxes in 2004 were higher than they were in 1970, deeply contrary to current argumentation. At the same time, taxes on the bottom 90 percent of the population were basically unchanged, going from 17.1% to 16.9% effective rates. In addition, taxes on the top .01% declined by more than 500 basis points.

    The conclusion…all of the increase in Federal income and payroll taxes came from the 90th to the 99.99th percentile, hardly the stuff of modern fantasy. But by all means, we have a revenue problem which should be solved by increasing tax rates or decreasing tax expenditures.

    People seriously need a sense of history.

  47. comment number 47 by: Arne

    “Here’s that impressive tax correlation again. Does anyone see the effect of “top marginal tax rates” in it?”

    I did not realize at first you were serious. I assumed it was an example of how to have a meaningless high correlation. After all, your example does show the same issue that I see in Kimel’s correlation - namely, that both variables have a correlation with time, so they must have a correlation with each other.

    “do you know *any* economic theory that says increasing taxes *increases* growth?”

    No, but since most theories would suggest you should be able to find a positive correlation, I do find it more than mildly interesting that the actual correlation is negative. Even if the published rates are not the best factor to employ, doing do should not reverse the results.

  48. comment number 48 by: Jim Glass

    The Kimel correlation has these problems –

    1) He *overtly* claims causation from higher tax rate –> higher GDP growth, e.g. saying the best tax rate for growth in 65%. This in spite of the fact that…

    2) His claimed correlation is very weak — he finds the tax rate explains only 17% of growth. And…

    3) His strongest numbers contributing to this weak result are from:

    * 1934-1940 — for which his claim is *known wrong*, as per Romer et al again.

    * the WWII years — in which the claimed causation is backwards. The 91% tax rated did not produce the 18% annual GDP gwowth. World War II created massive war production to be blown up/sunk into the sea, etc, which was counted in GDP, and mandated the 91% tax rate to pay for it as a consequence.

    … and, yet again

    4) He never measures at all what he pretends to measure — marginal tax rates people pay. The “top nominal tax rate” provides *zero* information, *none*, about the marginal tax rates anyone actually pays. So the correlation is entirely bogus in principle. You might as well correlated GDP to something else that provides zero information, none, about marginal tax rates that people pay — like maybe MLB batting averages.

    I mean, if Congress enacted a 127% marginal tax rate on annual income over $17 billion, that would be the data used for the correlation, right?

    The whole thing is bogus from the start — and from there he adds *reverse* causation, etc. Sheesh. :-)

    most theories would suggest you should be able to find a positive correlation

    Studies of how marginal tax rates *paid* affect the economy conclude they do just as one would expect, Romer and Romer, Barro, etc.

    I do find it more than mildly interesting that the actual correlation is negative.

    When he starts by not measuring what he is talking about and then adds on reverse causation and the rest, all kinds of “interseting” results will hardly be surprising.

    BTW, here are some more correlations from his data set:

    ~~
    32 years highest government expeditures, average: 21.6% of GDP
    average GDP growth rate: 2.76%

    32 years lowest goverment expenditures, average: 17.5%
    average GDP growth rate: 3.65%

    So … 23% more spending 24% less growth
    ~~~

    Top marginal tax rate…

    70% or above, 34 years, average tax rate 80.5%
    .. average government expenditure 17.8%
    .. average personal tax paid (excluding payroll tax) 7.8%

    69.1% or less, 30 years, average tax rate 38.3%
    .. average government expenditure 21.5%
    .. average personal tax paid (excluding payroll tax) 8.1%

    So … lower tax rates larger government

    and .. 52% lower personal tax rate more personal tax collected.
    ~~~~

    I did not realize at first you were serious. I assumed it was an example of how to have a meaningless high correlation.

    That tax correlation at Political Calculations is a world apart from Kimel’s.

    1) No direction of causation is claimed.

    2) It is extremely strong — the R^2 of .9957 is about as close to 1.0 that you’ll ever get. This in spite of all the huge changes in the Tax Code over 45 years. That’s startling.

    3) It fits the known pattern of power laws, with implications as the post describes.

    What it may mean for policy purposes is unclear, but that .9957 is enough to get one musing.

  49. comment number 49 by: Brooks

    Jim,

    Re: 4) He never measures at all what he pretends to measure — marginal tax rates people pay. The “top nominal tax rate” provides *zero* information, *none*, about the marginal tax rates anyone actually pays. So the correlation is entirely bogus in principle.

    Not bogus for the (main) reasons you give: (1) different tax rate structure on capital gains, and (2) lower effective tax rates after tax deductions and credits (my words).

    Some other tax avoidance measures you mention do seem to be valid points, such as getting more income as stock options rather than salary on income more typically received as salary, and the resulting reduction in tax liability. So simply correlating the top statutory rate to GDP can be misleading (to your point) insofar as the availability and/or usage of such measures results in lower de facto top marginal tax rates (vs. the statutory top rate) on income normally subjected to that (ordinary) income tax structure (and insofar as the size of the gap [proportionately] varies over time.

  50. comment number 50 by: Arne

    “that .9957 is enough to get one musing.”

    Not really. It takes but a moments thought to see that the number one reason they are so well correlated is because they are both driven by inflation.