Kevin Drum takes issue with a study by Obama’s nominee for chair of the Council of Economic Advisors that says that tax increases reduce GDPÂ – a 1% tax increase leads to a 3% decline in GDP over the long term, relative to a taxes-constant baseline.
Drum’s first objection is that the study only concerns “exogenous” tax changes (those intended to reduce deficits or improve long-term growth) and excludes “endogenous” tax changes (those intended to respond to temporary economic conditions). My response to this is that there’s legitimate reason to think that endogenous tax changes affect the economy differently, as they’re designed to be short-term measures whose long-run effects are cancelled out by other changes later.
Drum’s second objection is that the study takes politicians’ words as to what the goal of a tax change is. This is a legitimate concern, as politicians tend to lie. But looking through the text of the earlier Romer study which classified the tax changes, it appears that the Romers do a very thorough job of looking not only at proponents’ political statements, but also congressional debate and internal economic analyses. They might still get it wrong occassionally, but she appears to be doing a good job of preempting this problem.
Drum’s third objection is that the analysis only examines the size of tax changes, not the nature. I agree with this criticism — under standard economic theory, effective average tax rates matter, but marginal rates matter at least as much, which is why revenue-neutral tax reform is generally considered a net win for the economy. But I’d classify this as an important area for future research rather than a reason to discard the findings of the study. Most tax law changes change both the effective average tax rate and the marginal tax rate in the same direction.
Drum’s fourth objection is the difficulty of separating the effects of overlapping tax changes from each other. The text of the study addresses this, which compares tax law changes as a time series to GDP growth anomalies also as a time series. The technique if familiar to anyone who’s read Capitalism and Freedom or Free to Choose and seen Milton Friedman’s superimposed graphs of sixth-month-lagged monetary growth over time and inflation over time.
Drum’s fifth and largest objection is this:
can it really be true that a 1% tax increase produces a 3% GDP reduction over the long term? European countries tend to have total tax rates that are upwards of 15% higher than ours, which should mean their GDPs are 45% lower. For the most part, however, GDP per hour worked in Europe is only modestly lower than ours.
Emphasis is mine. Economic theory proposes three mechanisms for taxation to reduce GDP:
- Fewer hours worked because when marginal taxes are higher, people are more likely to prefer an additional hour of leisure to the last hour of after-tax wages.
- Productivity is lower because people invest less in learning skills, because much of the return on investment is eaten by taxes.
- Productivity is lower because investors invest less in capital improvement, because much of the return on investment is eaten by taxes.
By comparing GDP per hour, Drum is completely ignoring the first effect. Europeans do work fewer hours than Americans — shorter work weeks, longer vacations, and much higher unemployment.
Effect two is cancelled out by government subsidies to education, which I suspect are higher in Europe.
Effect three is interesting because it concerns investment taxation specifically. European countries have much higher overall levels of taxation than the US, but their taxes on investment are much lower. Here is a table of all Western European countries where I could find both the corporate income tax and the long-term capital gains tax rate on shares:
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Note that of 15 countries, only Sweden and Denmark have higher marginal tax rates on corporate investment income than the US. Based on this data, it’s surprising Europe doesn’t have higher hourly labor productivity than the US.
As for Drum’s final note, that the Romer study shows taxes negatively correlated with GDP growth when tax changes are indended to affect long-run economic growth, but shows a positive correlation for GDP growth when taxes are increased to reduce the deficit:
That is interesting, but Drum is reading more than the data says. Note the error bars. The overall study conclusion (that exogenous tax increases hurt GDP and exogenous tax cuts help it) is statistically significant, as is the same conclusion about supply-side tax changes, but the study’s results about raising taxes to reduce the deficit are not statistically significant. The most you can conclude from the study about deficit-reduction tax increases is that it’s very unlikely that in general they hurt the economy by more than a little bit.
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Deadweight loss.
I’m often amazed at people on the left who actually think it’s some sort of right-wing mind trickery to suggest that higher taxes are a drag on the economy. Clearly, they are. There’s just no disputing it. Denying this is like denying that water’s wet.
Where I lose patience with right-wingers is that they have a tendency to take this indisputable fact and spin it into a "taxes are the only thing keeping us all from getting rich" mentality. No, taxes are A drag on the economy, not THE drag. The Bush tax cuts did not bring about a roaring recovery; they were a minor stimulus that was marginally helpful.
Cut taxes to 0% can you can still have a great deal of economic misery and massive poverty. Taxes are not the thing to obsess on. It’s like saying we can all get perfect fuel economy if we just take all the windows out of our cars. Yes, you’ll get less wind drag if you remove all your car windows (especially your windshield and rear window). You will not eliminate all drag that way, sorry, and you actually NEED those windows by the way.
The problem I see is too many people equate "higher taxes on the rich" with "free money". Taxes comes with both a moral and a practical cost, which both must be recognized and justified by weighing the benefits of the tax-funded program against the costs.
Well, I think that’s a very good argument, Eric, and I do respect it.
But I’m coming around from the other side these days: wait a minute, this whole economic engine only exists because the government makes it possible. The government doesn’t just provide the monetary system, and secure that economic system (which by the way it does), but it also gives us these magical fictional beasties called "corporations." Which conservatives used to be deeply suspicious of, by the way.
At some point I don’t think it’s wrong to look at the very wealthy and say, "wait a minute, you couldn’t possibly have gotten that wealthy if we hadn’t set up this system to let you do that."
And you SHOULD do that, by the way. Go, create, work your butt off. Hurrah! Do it, there’s nothing wrong with it! We WANT you to do it! Go Donald Trump, go Bill Gates, go Henry Ford, go Thomas Edison, go Steve Jobs–go go go! Let your creative genius spring forth, and let you make scads of money from it. Let’s reward you, let’s celebrate you! Go go go!
BUT: you owe something to the greater overall society that made your wealth possible. The greater society that protects it, nurtures it, makes it possible. A miraculous society that makes it possible for you to have riches beyond the dreams of Midas.
Now. Pony up. You owe some of it back. You wouldn’t have gotten there in the first place without us, and we’ve got kids to teach and poor people to give a leg up.
Doggone it, this is what makes me crazy about today’s "progressives": they just can’t put their arguments in these terms. They damn well should. YOU WOULDN’T BE THAT RICH, MISTER FORBES, IF WE HADN’T HELPED YOU. Because we damn well did. And it wasn’t just the cops and firemen who did it, it was all those things in our society that we created to make sure you wouldn’t starve to death on your mother’s breast.
This really isn’t that hard, and it’s not Marxism goddamn it.
We already got something back from Trump, Gates, Forbes, Edison, and Jobs. We got hotels, computers, informative financial publications, light bulbs, and iPods. Many of us also got good jobs in industries they created or at greatly contributed to. And half the people in this country get a free ride on the federal government services we benefit from as well, because even in a flat-rate tax system (let alone our current progressive tax code) Steve Jobs’s tax returns would pay for government services for tens of thousands of people like us, above and beyond what he uses himself.
There’s a limit to how much we should ask of these people, when they’ve done so much for us already.
Well I’ll say this:
One of the wackiest mind-benders of the last few years has been claims on the left that the Bush tax cuts hurt the economy. I’m amazed at the mental gymnastics you have to go through to believe that. Just agog at it, actually.
"Oh yes, we cut taxes on the wealthiest by 5 percentate points–THAT’S why we’re all screwed up right now."
Excuse me?
I don’t blame "the rich" (as a class) for a damned thing in this current mess. Let ‘em be rich, and God bless ‘em for it. I’ll never be one of them, but so what? My brother’s prosperity does NOT create my poverty.
That said, I still have no problem at all looking at my rich sister and saying, "pony up a little more, you can afford it." Sorry, I just don’t. You wouldn’t have been rich in the first place if we didn’t help you get there–and the righties and the libertoids get it wrong when they deny it.
I can actually understand the argument that the tax cuts lead to our current economic problems. I don’t agree with it, but I understand it.
It’s based on the theory popularized by Robert Rubin during the Clinton administration that a balanced budget is very good for the economy in the long run because deficits bid up interest rates. And the budget did get balanced during the Clinton years and there was an economic boom, which lends popular credibility to the theory, although it seems more likely to me that the balanced budget was the result of the boom (combined with a rare moment of bipartisan fiscal discipline on the spending side) than the other way around.
Applying this theory to the Bush administration, you see the inherited surplus turning into a huge decifit and the economy tanking. And due to the widespread misconception that the tax cuts are the primary driver for the deficit (it’s actually been nondefense domestic spending, mainly Medicare part D), it’s easy to see how the tax cuts get the blame.
Of course, if you look at interest rates over the past eight years, it’s hard to argue that they’re too high now but were just right in the 90s.
The proposition that deficits bid up interest rates is not at all controvercial. However, Rubin takes this much further than most economists. The competing propositions are Ricardian Equivilence (it’s government spending that determines effect of government finance on the economy; the drag of deficit spending and taxation are equal), the Keynsian position that deficit spending stimulates demand because the spending benefits the economy by more than the negative effect of increased interest rates, and the Supply Side argument that deadweight loss is higher for taxation than for borrowing.
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