The Link Between Economic Growth and Tax Cuts Is Tenuous

The Trump administration and congressional Republicans are counting on an overhaul of the U.S. tax code to rev up the anemic U.S. economic growth rate. History suggests that isn’t a sure outcome.

John F. Kennedy, a Democrat, in 1963 proposed and Lyndon Johnson, also a Democrat, in 1964 signed into a law a cut in the top tax rate from 91% to 70% and a slightly lower corporate tax rate. Economic output expanded at a swift 4.7% rate for the rest of the decade. Republican Ronald Reagan signed a tax cut into law in 1981 and later reduced the corporate tax rate, and economic output expanded at 3.8% for the rest of the decade.

Those examples suggest a strong connection between tax cuts and growth. Other examples cut the other way.

George H.W. Bush, a Republican, and then Bill Clinton, a Democrat, advanced increases in the top tax rate that became effective in 1991 and 1993, and U.S. output nevertheless expanded at a robust 4.1% annual rate for the rest of the 1990s. George W. Bush, a Republican, cut taxes in 2001 and 2003, and growth expanded at an anemic 1.7% rate for the rest of the decade. And back in the 1950s, when a top rate of 91% prevailed, the economy nevertheless expanded at a steaming 4.5% annual rate.

Joel Slemrod, a University of Michigan economics professor and co-author of the book, “Taxing Ourselves,” a study of tax-policy changes over time, looked all the way back to the 1870s and found a tenuous connection between economic growth rates and taxes.

He also found tenuous connections when comparing tax and growth between countries. For example, output per person in Sweden, a high-tax country, grew faster between 1970 and 2012 than in Switzerland, a relatively low-tax country, during the same period. Turkey, a low tax country, didn’t keep up with Luxembourg, a relatively high tax country, during the same period.

“It’s really hard to just look at countries’ growth rates over time, relate that to what their tax rates and structures are, and say, ‘Ah, here’s the silver bullet,’ ” said Mr. Slemrod.

One complicating factor is the interplay between taxes, interest rates and growth. The U.S. economy boomed in the 1980s in part because the Federal Reserve beat down inflation with high interest rates and then, after a deep recession, cut interest rates aggressively. In the 1990s, interest rates were held down by a worker-productivity boom that helped to keep inflation lower than the Fed expected.

Tax and deficit policies can directly affect the level of interest rates and growth. In the 1990s, for example, U.S. policy makers counted on deficit cuts to keep interest rates low and spur economic growth. Some economists say big deficits, by pushing up public debt, crowd out private investment and growth. Some warn that deficit increases now could spur the Fed to raise interest rates faster than expected, potentially offsetting some of the benefits of lower tax rates.

Economists generally agree tax cuts that aren’t offset by a decrease in government spending will boost the deficit. “Can tax cuts pay for themselves? The evidence overwhelmingly suggests that this is not true,” Mr. Slemrod said.

“If it takes a modest deficit to get really good tax policy, I suppose that’s fine,” said Columbia Business School dean Glenn Hubbard, former chairman of the Council of Economic Advisers under George W. Bush. “If it were a gigantic deficit I don’t think that would be fine at all.”

The Trump administration is aiming for a 3% growth rate, compared with the 1.9% rate that has prevailed since 2000.

Many factors affect a nation’s economic growth rate. The productivity of the workforce—driven not just by policy change in Washington but also by innovations like the internet and the education of workers—is critical. When productivity boomed in the 1990s, it spurred growth, and when it slowed in the 2000s, it held growth back.

Labor-force participation is also key. The 1970s, a decade marred by high inflation and slowing productivity, nevertheless produced a 3.4% growth rate, which was better than the 2000s, because baby boomers and women joined the workforce in droves.

The key to effective tax policy is thus whether it can drive productivity and labor-force participation higher.

Lower income-tax rates in theory should increase labor-market participation because it means individuals get a bigger after-tax payoff from working. That is offset to some degree because it means individuals also don’t need to work as many hours to keep their after-tax income and standard-of-living level stable.

The net effect of individual-tax-rate reductions on participation seems to be modestly positive. Raj Chetty, a Stanford University professor, found that a 10% increase in after-tax wages led to a 4% increase in hours worked.

Matthew Shapiro, another Michigan economics professor, said tax-policy changes can have important short-run effects on business investment as well, but the effects tended to fade over time.

“Most changes are fairly temporary, and there’s a big incentive to take advantage of those temporary changes,” he said. In other words, firms might shift investment plans forward to take advantage of a temporary change. The impact of permanent changes to the tax code lasted longer but were less pronounced, Mr. Shapiro said.

The Trump administration’s proposals are meant to boost labor supply by lowering individual rates and boost business investment by reducing corporate taxes and incentivizing investment, Kevin Hassett, the recently confirmed chairman of the Council of Economic Advisers, said in an interview.

A permanent increase in the growth rate is “very, very difficult,” he acknowledged. But even a temporary increase would raise standards of living.

 

 

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