It has become an article of the Republican/tea party faith that tax increases will harm the economy and slow job growth.
It is a narrative that President Barack Obama parroted when he sought to justify the extension of the Bush tax cuts at the end of 2010. Republicans frequently cite President Ronald Reagan's tax cuts during his administration as proof that tax cuts spur economic growth.
But do the data really support this proposition?
First, we probably need to review where tax rates have been historically. I suspect most Americans will be shocked to learn that immediately after World War II, the highest marginal tax rate on earned income was 91 percent. That rate was not lowered until President Lyndon B. Johnson lowered the rate to 77 percent in 1964 and then to 70 percent in 1965.
The rate remained at 70 percent until Reagan lowered the rate to 50 percent in 1982. In 1987, he lowered the rate again to 38.5 percent and then in 1988 to 28 percent. The rate stayed at 28 percent for only three years. In 1991, President George H.W. Bush, faced with a growing deficit, raised the rate to 31 percent.
Immediately after Bill Clinton was elected president, the tax rate was raised again, to 39.6 percent. The rate remained at that level until the now famous Bush tax cuts, which lowered the rate over three years to 35 percent. And that is where we sit today.
The initial problem in trying to correlate changes in the tax rate and economic performance is that we have relatively few cases to examine. Statisticians would say that we do not have a statistically significant population. That is, there are not enough instances to filter out the effects of other factors.
The second problem is that not all changes are equal. For example, a cut in the tax rate from 70 percent to 50 percent as occurred in 1982 probably has a much different effect than a reduction from 39 percent to 35 percent that occurred between 2002 and 2004.
And, unfortunately, the examples we have do not produce any clear correlations. When one looks at the history of tax rates since World War II, Reagan's cut from 70 percent to 50 percent in 1982 stands out as a watershed. Top rates before 1982 averaged 79.5 percent. Since 1982, the average top rate has been 38.2 percent. So if the argument that the economy does better with lower income tax rates is true, one would expect to see higher gross domestic product growth and lower unemployment since 1982. However, exactly the opposite is true.
GDP growth before 1982 averaged 3.7 percent. Since we have been lowering the highest marginal tax rate, GDP growth has averaged only 2.8 percent.
The same is true with unemployment. Before 1982 unemployment averaged 5.3 percent. However, since 1982 it has averaged 6.3 percent.
So, at least at the most global level, there is no positive correlation between lower tax rates and higher economic growth and lower unemployment.
Looking at the individual instances of changes in the tax rate also offers little help. When Johnson lowered the tax rate in 1963-1964, GDP grew for a couple of years, but then was in a general state of decline for the rest of decade.
Reagan's cut in 1982 from 70 percent to 50 percent was followed by a remarkable recovery from the 1982 recession to a 7.2 percent GDP growth in 1984. However, unemployment lingered above 7 percent until late 1986 and GDP growth quickly slowed to historical averages. Reagan's subsequent cut in the rate in 1986-88 had little effect on GDP or unemployment and by 1991, with the rate still at 28 percent, the country was headed into recession.
The economy quickly recovered out of the 1991-92 recession, notwithstanding George H.W. Bush's increase in the rate from 28 percent to 31 percent. Similarly, Clinton's increase in the rate to 39.6 percent in 1992 seems to have had little detrimental effect on economic growth. During his presidency, GDP grew at an average rate of 3.9 percent, the highest level since the 1960s, and unemployment fell steadily throughout his eight years in office. The George W. Bush tax cut in 2002 was followed by a brief and modest increase in GDP in 2004. But, of course, since that time, the economy has suffered mightily and unemployment soared notwithstanding the relatively low tax rates.
There are those who argue that it is the capital gains tax rates and not the earned income rate that has the greater effect. But the data on the capital gains is similar to the earned income rate.
The capital gains rate was 25 to 38 percent pre-1982. Since 1982, it has ranged from 25 percent to 15 percent. Therefore, just as with the lower income tax rates, the lower capital gain rates have not coincided with improved economic growth or lower employment. In fact, the period since 2006, when the rate was lowered from 20 percent to 15 percent, represents the worst economic growth and the highest unemployment since World War II.
So while the argument that higher taxes hurt the economy while lower taxes spur growth is appealing, there is little evidence to support it. If any conclusion is possible from the data, it would seem to be that tax cuts may have a short-term stimulative effect, but that other economic factors quickly swamp any change in tax policy.
© 2011 Houston Chronicle