CUT TAXES

You’ll recall that one of the reasons why economists like Lucas were dissatisfied with the Solow model is that it did not provide any direction to an eager policy maker. Romer’s model does.

Romer is a Democrat in the United States. Or at least that’s what the economics rumor mill tells us. His father was a Democrat who was the governor of Colorado. But the idea that low tax rates can affect long-term growth by encouraging innovation is one that US Republicans have come to dearly love. From Reagan to Trump, Republican politicians have consistently promised to cut taxes, and the perennial justification is that they promote growth. Low tax rates are necessary at the top, because the likes of Bill Gates need to be given the incentive to work hard, be creative, and invent the next Microsoft to make us all more productive.

It was not always like that. Top tax rates were above 77 percent for the period 1936–1964, and above 90 percent for about half of that period, mostly in the 1950s under a solidly right of center Republican administration. The top tax rate was brought down to 70 percent in 1965 by a more left-wing Democratic administration, and since then it has drifted down to mid 30 percent. Every Republican administration has tried to cut it down further and every Democratic administration has tried to raise it a little, though always with great trepidation. Interestingly, for the first time in over fifty years, the idea of a top marginal tax rate above 70 percent has gained some traction among Democrats in 2018.

Yet, looking at growth rates since the 1960s, it is evident the low tax rate era ushered in by Reagan did not deliver faster growth.

Of course, as the Republican Paul Ryan, former Speaker of the House of Representatives, pointed out, there is no evidence that they did not. Many other things were happening at the same time. Ryan painstakingly explained to a journalist why all of these things lined up to make tax increases look good and tax decreases look bad:

I wouldn’t say that correlation is causation. I would say Clinton had the tech-productivity boom, which was enormous. Trade barriers were going down in the Clinton years. He had the peace dividend he was enjoying.… The economy in the Bush years, by contrast, had to cope with the popping of the technology bubble, 9/11, a couple of wars and the financial meltdown.… Some of this is just the timing, not the person.… Just as the Keynesians say the economy would have been worse without the stimulus [that Mr. Obama signed], the flip side is true from our perspective.⁵³

Paul Ryan is right about one thing. Just looking at the variations over time, it is hard to conclude whether there is any causal effect of tax rates on growth. It is indeed possible there is a true relationship, but it is obscured by the many other things that are happening. The same lack of correlation between growth rates and tax rates remains true, however, when we look at changes in taxes across countries. There is absolutely no relationship between the depth of the cut between the 1960s and 2000s in a country and the change in growth rate in that country during the same period.⁵⁴

Within the United States, the experience of individual states is also telling.

A recent study from the University of Chicago’s Booth School of Business (not a place known for its socialist tendencies) uses a clever trick to answer whether tax cuts that benefit the rich have more or less of a growth effect than tax cuts that benefit the rest of the economy. Different states have very different income distributions, and therefore tax cuts for the rich should have very different consequences in different states. Connecticut, for example, has many more rich people than Maine. Using the thirty-one tax reforms since the war, the study shows that tax cuts benefitting the top 10 percent produce no significant growth in employment and income, whereas tax cuts for the bottom 90 percent do.⁵⁶

One can also directly look at the question of whether high-income earners slack off when taxes are higher. This question can be answered much more precisely than the effects on overall growth, because tax reforms affect different people differently, so it is possible to compare the changes in behavior for people who are more or less affected. The key conclusion from a very large literature, summarized by two of its most respected experts, Emmanuel Saez and Joel Slemrod, is that “there is no compelling evidence to date of real economic responses to tax rates at the top of the income distribution.”⁵⁷

By now, there seems to be a consensus among a large majority of economists that low taxes on high earners are not guaranteed to, on their own, bring about economic growth. This was reflected in the response of the IGM Booth panel of top economists to the Trump tax cut of 2017. The tax cut provides deep and durable tax cuts for businesses, including a cut in the corporate tax rate from 35 percent to 21 percent.

Despite this consensus, a memo from the government’s treasury department on the fiscal impact of the bill assumed (without any stated justification) an increase in 0.7 percent in annual growth rates from reducing taxation.⁵⁹ How could they get away with a statement that had nothing to do with what anybody seriously believes? One answer, of course, is that it was not the only instance where the administration asserted a non-truth to support its decision. But we suspect that part of the reason the public so easily bought into the idea that tax cuts for the wealthy lead to economic growth is that they have heard this particular message for so many years, from so many prominent economists of a previous era. In those days, evidence was scarce and it was normal to argue from “first principles” based on intuition and no data. The repetition of this mantra by generations of serious economists has given it the soothing familiarity of a lullaby. We still hear it every day from a gaggle of business experts, who even today feel unconstrained by the data. It is now part of the “common sense.” When we asked respondents in our survey the question similar to the one asked by the IGM booth panel, 42 percent of respondents agreed or strongly agreed with the proposition the tax cut would increase growth within five years (only one economist did).

It did not help that nine conservative academic economists, mostly with solid reputations but also part of this older generation, wrote a supporting letter to the administration arguing that growth would go up and “the gain in the long-run level of GDP would be just over 3 percent, or 0.3 percent per year for a decade.”⁶⁰ It was immediately pointed out that this letter was based, once again, on first principles and a very selective reading of the empirical literature.⁶¹ But it was so much in line with what the public and the press expect from economists that it sounded perfectly legitimate.

Once again, this underscores the urgent need to set ideology aside and advocate for the things most economists agree on, based on the recent research. In a policy world that has mostly abandoned reason, if we do not intervene we risk becoming irrelevant, so let’s be clear. Tax cuts for the wealthy do not produce economic growth.