Higher Income Taxes Are Benign? It Just Ain’t So.

Jue, oct 6, 2011

Economía, Impuestos

By Jeb Bleckly and Joshua C. Hall

In a recent issue of the online magazine Slate, former New York Governor Eliot Spitzer attempts to debunk the alleged myth that higher taxes reduce growth. Spitzer opens with the undeniable truth that the “American debate over taxes is ferocious and highly partisan.” If only he had continued to state the obvious, we would not feel compelled to write this response.

Spitzer, however, does not stop there. He begins by longing for a simpler time, a time before people took notice of obscenely high levels of taxation. After all, Spitzer reminds the reader, it was the great Franklin Delano Roosevelt who argued in 1942 that in a time of “grave national danger” no American ought to have an after-tax income in excess of $25,000 (about $325,000 in today’s dollars). “Can you conceive of a modern president suggesting that no American should earn more than $323,000 after taxes?” he wistfully notes.

Taxes and Growth

Sadly, Spitzer’s defense of high marginal tax rates did not end with normative statements in favor of higher taxes on the wealthy. After a brief and surprisingly lucid explanation of how correlation is not causation, he states, “[I]t’s obvious that there is no correlation between higher marginal tax rates and slowing economic activity. During the period 1951-63, when marginal rates were at their peak—91 percent or 92 percent—the American economy boomed, growing at an average annual rate of 3.71 percent. The fact that the marginal rates were what would today be viewed as essentially confiscatory did not cause economic cataclysm—just the opposite.”

Then he adds, “And during the past seven years, during which we reduced the top marginal rate to 35 percent, average growth was a more meager 1.71 percent.”

We could, of course, play the same game by choosing different starting and ending points (say, the late 1940s or 1990s). However, we prefer to stick to a discussion of the peer-reviewed academic literature, as Spitzer promises to do when he cites a Yale Law Review article while defending his claim that “more sophisticated efforts” to find a relationship between marginal tax rates and economic growth have produced “murky” results. According to Spitzer, this review of the literature in the Yale Law Review “concludes that there is scant, if any, legitimate academic support for the proposition that moderate, as opposed to dramatic, increases in marginal tax rates have any impact on the willingness of the wealthy to participate in the economy.”

Setting aside the question of what “moderate” increases in marginal tax rates are, it needs to be pointed out that this article is not a review of the literature at all but a book review! It is hard to fathom that a book review—even a review of a book on how the wealthy respond to changes in taxes—can overturn the basic economic conclusion that higher income tax rates inhibit growth.

Marginal taxes are the ones that matter for behavior because, as the Austrian economist Carl Menger first pointed out his 1871 book, Principles of Economics, individuals behave according to their subjective valuation of the marginal benefits and costs of an action. Higher income tax rates therefore reduce the marginal utility of working—since after-tax income goes down—and will usually reduce the number of hours worked or the amount of income realized. This is because if you are getting less reward you will be less willing to suffer the least pleasant parts of your job, giving an incentive to cut back on your hours or some similar action.

Plenty of Evidence

Thus it is no surprise that if you were to look at the economics literature you would see plenty of research showing that higher marginal income tax rates reduce growth. In a 2006 issue of Tax Notes, for example, Harvard economist Martin Feldstein estimates that a 1 percent increase in marginal income tax rates would cause taxable income to fall by $6.6 billion. When combined with the decline in payroll tax revenues, Feldstein estimates that every additional dollar of revenue raised costs taxpayers $1.76 when all the costs of raising the revenue are included. As we are unaware of any government projects or programs that yield more than $1.76 in output for every $1 spent, we feel it is pretty safe to say that higher marginal tax rates will lower growth.

These results hold at the state level as well. University of Colorado at Boulder economists Barry Poulson and Jules Gordon Caplan looked at state marginal income tax rates and economic growth from 1963 to 2004 in a 2008 article in the Cato Journal. They found clear evidence that “higher marginal tax rates had a negative impact on economic growth in the states.” The same has been found across major developed countries, as a 2002 article in the European Journal of Political Economy pointed out.

Growth and Well-Being

As you can see, had Spitzer delved a little deeper into the academic economics literature, he would have found ample evidence in favor of the conclusion that marginal tax rates affect economic behavior, including economic growth. Even if the empirical evidence showed otherwise, of course, this would not have made the case for higher marginal tax rates. Maximizing growth is not the same thing as maximizing well-being. Even if growth does not fall in response to higher marginal income tax rates because people work more to pay the higher tax bill, that doesn’t mean they are better off. Clearly they would prefer a world where they had more after-tax income and the liberty to spend it as they wanted. Whether the criterion is economics or liberty, however, the answer is the same: Higher marginal tax rates are a bad idea.

There Are 10 Responses So Far. »

    1. Comment by Mark Biernat on 30 June 2010:

      For myself, who lives in a post socialist/communist country it is clear, the more the state is involved in people’s economic lives, the more the country’s culture and people grow poor.
      When restrictions on economic freedom are lightened (lower taxes), a country prospers. This means there is more money for culture, the poor, better medicine, roads, charity, schools etc.
      Governor Eliot Spitzer might want to live for a while in a post communist country and and see the realities of economics of big government first hand.

    2. Comment by DD5 on 30 June 2010:

      It seems that even many free market advocates do not fully comprehend the affects of taxation on the economy.
      The authors are, unfortunately, resorting to only a secondary affect of taxation to explain why taxes hurt productivity:

      “Higher income tax rates therefore reduce the marginal utility of working”

      This is true. But what if that were not the case? Would Splitzer have a point then?

      Obviously not! because the authors ignore the affects of the government actually spending those taxes. The spending must, by definition, divert resources from productive activity to non-productive activity, thus, resulting in a lower productivity. This is before any talk of an additional disincentive to produce. The proof is that all those servicing the government cannot contribute anything to the pool of taxable funds since they themselves are funded by those funds.

    3. Comment by Richardhg on 5 July 2010:

      A major problem with taxation is oversight on how taxes are spent. The reporting standards for business are clearly defined, and full disclosure is insisted upon, because the information is a two-edged sword.

      First, it tells shareholders how their management is doing, and corporate efficiency, which results in increased profits, directly affects the stock price.

      Secondly, the information is used by the Government to determine the taxes on the corporation.

      In Government departments, there is no audit process that shows efficiency. In fact, there is every effort to bloat every departmental budget, and a race to spend any unused funding before the end of the department’s fiscal year to ensure their budgets are not cut the following year.

      In this current financial crisis, the Government is not making changes and embracing new efficiencies. Instead, they are using the same old fear tactics to persuade people to accept rising taxes, by cutting services such as law enforcement and education in a time-honored arm-twisting ritual.

      Until citizens insist on common audit standards for Federal, State, County, and City Governments, which analyze costs along with an independent analysis of efficiency and work habits, bloat of Government budgets will continue under a cloak of silence.

      Transparency? Management? Oversight? The lack of them guarantees inefficient Government will continue.

    4. Comment by Cry_Aboutit on 3 August 2010:

      I live in a state where an attempt was recently made to increase cigarette taxes by 100%. It is a popular tactic to try to raise revenue, usually for a worthy cause (but through the most unworthy of means).
      The spokesperson, a pro-taxation type, said that the tax will be a strong incentive for people to quit smoking–another worthy cause, and so clearly the government’s choice to make!
      Ignoring the obvious conflict of interest involved when a program is funded by an activity the creators of the program are encouraging people to quit, this spokesperson unwittingly shot the party’s tax increase agenda in the foot (or would have, if anyone at the time had cared to notice).
      If increasing taxes on cigarettes encourages people to quit, can’t it be said that higher taxes are a disincentive of any activity?
      Higher income taxes–a disincentive to increase income.
      Higher property taxes–a disincentive to own property.
      Higher sales taxes–a disincentive to buy and sell goods or services.
      ..and I’m beating this to death.
      But I was taken aback that none of the reporters or even opponents brought up this clear parallel.

    5. Comment by NickJihad on 3 August 2010:

      Re Cry_Aboutit and the cigaratte tax:

      It’s even somewhat contradictory on its own terms,
      since proponents claim that the tax increase will:

      – increase revenue
      – decrease smoking

      To the extent that it decreases smoking, it will decrease revenue.
      And they don’t mention that, to the extent that it increases smuggling,
      it will decrease revenue.

      But hey, when your intentions are good, the outcome doesn’t matter, right?

    6. Comment by Joe Schmoe on 26 August 2010:

      Here’s how, from what I understand, taxes reduce growth.

      1. Like the article mentions, higher taxes reduce the incentives for working (as employees) or starting a business (as employers).

      2. Like a commenter notes, taxes, divert profits from productive ventures (that is, the businesses that consumers indicate are efficiently and effectively using scarce resources for the price they charge) and gives it to ventures that the consumers have clearly indicated are unproductive or wasteful.

    7. Comment by Joe Schmoe on 26 August 2010:


      “The spokesperson, a pro-taxation type, said that the tax will be a strong incentive for people to quit smoking – another worthy cause, and so clearly the government’s choice to make!
      If increasing taxes on cigarettes encourages people to quit, can’t it be said that higher taxes are a disincentive of any activity?
      Higher income taxes–a disincentive to increase income.
      Higher property taxes–a disincentive to own property.
      Higher sales taxes–a disincentive to buy and sell goods or services.”


    8. Comment by Jerry Hill on 12 January 2011:

      Over the last 7 years a million plus New Yorkers have moved out of the State , followed by nearly 450,000 residents of New Jersey.

      Gee Governor, I wonder why???? Duhaaaaa !!!!!

    9. Comment by Jay Evans on 12 January 2011:

      Prof Hall – you owe us more than simply arguing that the academic literature does not support Spitzer’s contention. Spritzer has presented some hard facts. It would be more powerful if you could tear those facts apart. Loop holes, marginal tax rates, taxes as % of GDP, pick your counterpoint but give us a hard refutation (like commentator Jerry Hill’s post as an example). Yes, Spitzer is wrong theoretically, but why didn’t high marginal rates cripple growth in the ’50s.

    10. http://www.thefreemanonline.org/columns/it-just-aint-so/higher-income-taxes-are-benig

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