The positive correlation between marginal tax rates and real economic growth

[eridani]

http://www.angrybearblog.com/2010/12/why-economy-stubbornly-insists-on.html?utm_source=twitterfeed&utm_medium=twitter

I've been writing for years about the fact that a basic piece of economic theory does not apply to real world US data: unless one engages in the sort of assumptions that can justify eating ceramic plates as a cure for leprosy, there is simply no evidence that lower taxes lead to the good stuff we've been led to believe over non-cherry picked data sets. Recent examples include this look at the effect top federal marginal rates on various measures of growth, this look at the effect of top federal marginal rates on tax revenues, a different look at federal marginal rates and growth, and this look using state tax levels. I've also shown that effective tax rates also have fail to cooperate with theory when looking over the length of presidential administrations - examples include myriad posts and Presimetrics, the book I wrote with Michael Kanell.

I think the reason a lot of people have trouble accepting this is that they see some sort of conflict between this macro fact and and what seems to be a self-evident micro truth - if tax rates get high enough, people will work less. Now, such micro-macro conflicts have existed in the past, and are certainly aren't unique to economics. One obvious example we all live with is that to each of us, from where we're standing, the Earth does a pretty good job of appearing to be flat, and yet we know that its actually round(ish). For most applications, from running a marathon to building a house to making toast, assuming that the earth is flat doesn't hurt, and even simplifies matters. That is to say, for most applications facing critters roughly our physical size, a flat earth is a good model. On the other hand, we'd be much impoverished by sticking to that model at all times, as we'd lose out on satellites, our understanding of weather and geology, a great deal of transoceanic shipping, and Australia.

The same thing is true when it comes to the economy - failing to understand and account for the dichotomy between micro and macro truths is harmful. It has cost us, all 6.8 billion of us, economic growth and wealth, which is to say, it has cost us in quality and length of life.

<snip>

But that is one single player. In a big enough economy, there can be many, many companies and/or individuals of many different sizes in just such a situation. With 310 million people and who knows how many companies in the economy, probabilities add up. (I note that the second benefit of biasing companies toward their largest available projects goes away when you consider the whole economy. After all, while company X saves on accountants/attorneys and economists by picking the larger projects, by leaving the smaller projects to smaller players, those players will be hiring accountants/attorneys and economists as well.)

Note that relaxing a few assumptions makes it even easier to understand why US macro data shows a positive correlation between marginal tax rates and real economic growth. For instance, it isn't difficult to imagine that the government actually does something useful (i.e., growth generating) with the some of the tax money it collects. Additionally, smaller firms are often more innovative than larger firms, even within the same space (one has to compete somehow). Our little story is one where under many circumstances, smaller firms are more likely to enter the market when tax rates rise than when tax rates fall.

Thus, this little story, while requiring only a few realistic assumptions, does something that as far as I know is unique in the field of economics: it explains why US macro data shows a positive correlation between the top marginal tax rates and economic growth for all but the most cherry picked data sets, and it does it by sticking to micro foundations.

[dkf]

1. Or maybe under higher rates, higher value and more plentiful deductions guide better decisions

[jtuck004]

2. This is a great time of year to discuss this - A Christmas Carol

plays on television, Jack London and Upton Sinclair stories detail the worst of unrestrained capitalism.

Remember the Ghost of Christmas Future - when he revealed the children, "Ignorance" and "Want", and "across their foreheads
it spells Doom"?

Capitalism has always been a snake that eats itself. It's goal is the pursuit of profit. As such, it doesn't concern itself with the future, with education, hunger, or anything else that serves to reduce profit. We had a fairly prosperous era, with a couple of terrific booms and deep busts, or periods of "Doom" until the Great Depression, at which point we enacted laws such as Glass-Steagall, put in some safeguards for the unions, and raised taxes on those who would seek to avoid paying their fair share. Government used that money for education, insisted on reducing the work week, on time off, on reducing poverty. In other words, we took money from the capitalist and used it to fight "Ignorance" and "Want".

Those laws stood us in good stead for about 40 years, but a succession of administrations starting with Reagan, then Clinton, Bush, and now, seemingly, Obama who pandered to the wealthy, seeking to profit in the short-term from what it took this country 200 years to build, have destroyed much of that.

We are paying the price for their bad policies. 14 million homes in foreclosure, over 40 million people on food stamps, over 30 million people unemployed or underemployed.

It's as if we no longer have a Republican or Democratic party that represents the people. It's more like the left and right wings of Goldman Sachs. Socialism (surely you remember they brought a lot of the things you enjoy to the workplace, right?) is looking more and more attractive all the time.

Perhaps it's time to get back to FDR's thinking. Look people in the eye and tell them yes, it is politics, it is wealth distribution, it is necessary, and organize enough people to make it happen. Because all these excuses for giving the very, very wealthy tax breaks that will continue to hurt this country are sounding more like pronouncements of Doom.