Do Tax Cuts Lead to Economic Growth?
What the historic evidence since 1960s shows.
Last week’s Data Wonk column looked at the tax proposals from Donald Trump, Paul Ryan, and Hillary Clinton. It looked at two questions: who would enjoy most of the benefits of these proposals and what effect did economic models project on the economy.
It turns out the Trump and Ryan proposals deliver most of their benefits to the wealthiest members of society, whereas Clinton’s are founded entirely by increased taxes on the wealthiest 20 percent and would result in small tax reductions on the remaining 80 percent. Two reputable models predicted that the Trump and Ryan proposals would have the effect of depressing the American economy by increasing the deficit.
Organizations supporting the Ryan, Trump, and similar plans will point out that their models predict that reducing taxes—particularly the top marginal rates as do these plans—leads to higher economic activity. What does the evidence say?
Milton Friedman, in his influential essay, The Methodology of Positive Economics, expanding on an earlier discussion by John Maynard Keynes, explained the connection between theory and evidence:
Viewed as a body of substantive hypotheses, theory is to be judged by its predictive power for the class of phenomena which it is intended to “explain.” Only factual evidence can show whether it is “right” or “wrong” or, better, tentatively “accepted” as valid or “rejected.” …the only relevant test of the validity of a hypothesis is comparison of its predictions with experience.
If the theory underlying the Trump and Ryan plan is valid, we should see increased economic activity following a reduction in the top marginal rate and decreased activity when the rate is increased. As a measure of economic activity here are the number of private sector jobs (in thousands) since 1940. The gray bars indicate recessions. Note that the general trend has been upward, but interrupted by the recessions.
To explore whether tax policy has an effect of job growth, consider the next graph. It shows the growth of jobs over each presidential term since 1960. I have combined the Kennedy and Johnson terms, as well as the Nixon and Ford presidencies. The four earliest presidencies are shown with dotted lines; the four later ones with solid lines.
Measured by the increase in the number of jobs over their terms, the two most successful job creators were Bill Clinton and, surprisingly, Carter. In the middle are three presidencies: Reagan, Kennedy/Johnson, and Obama. Once the Great Recession ended, jobs were added at a higher rate in the Obama administration than either the Kennedy/Johnson tenure or Reagan’s. These are followed by the Nixon/Ford and the first Bush administrations, which managed to include a recession or two but still ended up with a job increase. Finally, there is the Bush II administration, with a net job decrease.
How the data are analyzed can have a big effect on how they look. Using the same job numbers as before, the next chart has two changes. First, rather than starting when a president came into office and ending when he left, I associated each president with his longest growth period, starting when jobs started growing and ending when they shrank. The second change was to use the percentage increase in jobs rather than the absolute number. The second change had the effect of shrinking growth under later presidents because they were starting with a larger workforce.
I then assigned each job growth period to the president who was in office for most of that period. The first president Bush disappears from this chart; the early part of his term is treated as the end of the Reagan growth period while the later part is the early stage of the Clinton job growth.
With these changes, Reagan moves up and Obama moves down. Carter’s job record is still surprisingly strong.
The next chart (just below) shows what happened to the top marginal tax rate (shown in red) during this period. As can be seen it has dropped substantially, from around 90 percent in the early 1960s, to as low as the high twenties, before moving back up to just under 40 percent. Along with the shrinkage of the top marginal rate, the number of tax brackets (shown in blue) also shrank.
Before getting into some of the historic details, it is worth noting that if there were a strong relation between marginal tax rates and prosperity, we would expect a noticeable jump in economic activity after the precipitous drop in the top tax rate in the 1980s. Instead there have been prosperity and recession both when tax rates were high and when they were low.
The first major drop in marginal tax rates, from 90 percent to 70 percent came during the Kennedy/Johnson administration and was followed by a long period of growth. Proponents of further reductions pointed to this as proof that tax reductions worked. They didn’t mention that the strong growth started before taxes were reduced.
The next major reduction in marginal rates came during the Reagan administration, from 50 percent to 28 percent. Proponents of low top marginal rate attributed the subsequent prosperity to the tax recovery rather than, say, recovery from the recession that dominated the first two years of Reagan’s term.
Whatever their effect on economic activity, the Reagan tax reductions led to growing deficits. In reaction, taxes were raised late in the first Bush administration and again early in the Clinton administration. Marginal rates went from 28 percent to 39.4 percent, accompanied by widespread predictions of economic collapse. Instead the 1990s was a time of prosperity and one of the few times the federal government ran a surplus.
Sensing that the boom was winding down, George W. Bush proposed tax cuts, and the top marginal rate was reduced to 35 percent. Despite this, his term suffered the worst economic performance of any recent president and ended in the worst recession since the Great Depression.
During the Obama presidency, the top marginal rate was raised back to 39.4 percent. Despite this increase, the recovery has continue at a steady, if slow, pace.
What can one make of this record? First, that by being selective in the data they choose, advocates of both increasing and decreasing the top marginal tax rate can find support for their positions. Sometimes reducing marginal tax rates is followed by a strong economy and other times not. Sometimes an increase in marginal rates is followed by a strong economy. Probably the safest interpretation is that playing with marginal tax rates is likely to have a negligible effect on economic activity.
This conclusion is also supported by evidence from the states. The states which have probably received the most praise from advocates of prosperity through marginal tax rate reduction are Wisconsin and Kansas. As the next chart shows, Wisconsin’s job creation has been running behind the national rate and that of its neighbor Minnesota. Kansas has lost jobs since its extreme tax reductions.
In terms of percentage increases, the Obama recovery has been weaker than some previous recoveries. One possible factor is demographics. In 1960 the baby boomer generation was just starting to enter the work force. Today, they are reaching retirement age and qualifying for Social Security and Medicare.
In addition, in 1960 women made up only one-third of the workforce. Today they are close to half. Thus, that source of workforce growth could be scraping against its limit.
Central to free market theory is the notion of consumer sovereignty — the consumer rules. The output mix is dictated by the tastes and preferences of the consumers. It is more accurate to call consumers the “job creators” than businesses. Businesses in the free market are responding to consumers and recessions result when consumers stop buying because they are worried about their future income.
Underlying both the Trump and Ryan tax proposals is a different theory. It posits that producers, not consumers, are sovereign. The unspoken assumption is that a weak economy is due to producers being unhappy about their taxes and regulations. If so, policy should be aimed at keeping producers happy so they won’t go on strike. That is what both Trump and Ryan propose to do.
But the historical data offers, at best, conflicting evidence to back up the theory that lower taxes on higher earners helps the economy. What we do know is the big tax cuts can cause big deficits, which can be a drag on the economy. That’s what reputable non-partisan experts have predicted about the Trump and Ryan plans.