Congress has raised and lowered personal income tax rates for more than a century, and the performance of the economy associated with those changes is well-documented.
Examined closely, this history shows that bumping up the top bracket to 70 percent—as some politicians are suggesting—would temporarily reduce gross domestic product (GDP) by an estimated 11 percent.
Top Rate Affects Investment
This analysis recognizes that 70 percent would be a marginal tax rate, not the average or “effective” rate that people pay. The marginal tax rate is the levy someone must pay out of the next dollar of income earned, and therefore governs their motivation to earn that income.
The marginal tax rate varies by income bracket. Because high rates impose greater disincentives than low rates, the top rate will have the greatest influence on the use to which the highest-income earners put the large pools of capital they own. The investment of that capital is hugely important in determining the rate of economic growth. Thus, though tax rates have always varied by income, it greatly simplifies calculations to use the top rate to represent the entire tax structure.
Beginning with a maximum tax take of 7 percent, U.S. rates jumped temporarily during World War I. Astonishingly, they were raised in the midst of the Great Depression and advanced in World War II to a 94 percent top rate.
Near-record rates prevailed until Presidents Kennedy and Johnson cut the top bracket to 70 percent. The highest marginal tax rate was reduced to a low of 28 percent by President Reagan, and today it is at 37 percent.
Wars Overwhelm Other Effects
The central obstacle in calibrating the impact of tax rates on economic growth is the simultaneous effect of many other factors. This impasse can be partially bridged by aggregating years into multiyear periods for analysis, because the omitted factors tend to cancel out, especially over decades. Thus, the nearby table compares decadal growth of real GDP with decadal changes in the top income tax rate.
The decades in which World Wars I and II occurred are separated out because wars overwhelm other influences on real GDP growth as long as they last.
The economy clearly responds to taxation very differently in peacetime than when fully mobilized for war. Otherwise, decade by decade, the growth of real GDP and the performance of the stock market rank inversely with the change in the top income tax bracket.
Calculating the Effects
We can make a rough estimate of how much real GDP would fall if the top rate were raised, by using the data in the first and second columns of the table.
Subtracting the two peacetime decades in which the top rate was cut by more than 10 percentage points (row 4) from the two decades in which the top rate was increased by more than 10 percentage points (row 2), the difference of 69.4 percentage points in tax rate change corresponds to a difference of 21.3 percentage points in the growth of real GDP. That is just about a three rate-point change for each point of change in GDP. According to that rule of thumb, an increase of, say, 33 points in the top rate from 37 percent today to 70 percent would reduce GDP by 11 percent.
The table doesn’t say how rapidly this loss would occur or how long it would be sustained. To examine these questions, we must turn to the annual data, recognizing that results are less accurate because many other factors influence economic activity from year to year.
GDP Declines for Two Years
The accompanying graph depicts the annual consequences on real GDP of increases and declines in the top tax bracket. These results show more about the time profile and persistence of GDP effects from tax-rate changes.
The impact on cumulative growth peaks after two years, and then declines. After two more years, all economic paths have converged, and there remains no net GDP difference between the effect of a tax hike and the effect of a tax cut.
It appears that taxpayers are able to change their business practices enough to avoid or mitigate changes in the tax-rate structure, and as a result the economy slowly returns to normal.
What the Data Tell Us
It is well-substantiated by logic and common sense that tax-rate hikes degrade economic activity. But not everyone agrees, and there is no consensus on the extent of the effects.
As long as professional economists hired by politicians use complex methods opaque to the layman, work from theoretical prejudgments, and operate in the atmosphere of a courtroom contest, we cannot expect their views to converge. As a result, politicians propose and debate their prescriptions for the economy as if there were no experience or evidence of the consequences.
If rival economic assumptions are put aside and we ask what the data show, the entire U.S. peacetime history fits the rule of thumb that every three-point change in the top income tax bracket subtracts from or adds to GDP by 1 percent.
David Ranson ([email protected]) is head of research at HCWE & Co. and a policy advisor to The Heartland Institute.