Marginal tax rates and U.S. growth: flaws in the 2012 CRS study.

• Author: Taylor, Jason E.

In September 2012, seven weeks before the presidential election-one in which top marginal tax rates were a major policy difference between the two major-party candidates--the Congressional Research Service (CRS) published a paper (Hungerford 2012) suggesting that there is no empirical evidence that top marginal tax rates impact U.S. economic growth. After all, top marginal tax rates were above 90 percent during the 1950s and early 1960s when the economy experienced rapid growth. Furthermore, marginal tax rate cuts in 2001 and 2003 were followed by the worst financial crisis since the Great Depression. The CRS study was widely reported in blogs, newspapers such as the New York Times, and The Atlantic magazine. It was portrayed as evidence refuting Republican candidate Mitt Romney's position that cutting the top marginal tax rate from 35 to 28 percent would spur economic growth and supporting Democratic President Barack Obama's position that top marginal tax rates could be raised to 39.6 percent with no cost to economic growth (Leonhart 2012, Thompson 2012).

Republicans claimed that the study was methodologically flawed and asked that the CRS report be pulled. On November 1, 2012, five days before the election, the report was pulled, and its content, as well as the controversy surrounding it, were back in the headlines again. The New York Times quoted Sen. Charles Schumer (D-NY) saying, "This has hues of a banana republic. [Republicans] didn't like a report, and instead of rebutting it, they had them take it down" Weisman (2012). The study was reissued by the CRS in an "updated" form on December 12, 2013, with no major changes to the original.

Entin (2013) claims that the CRS study's model is flawed in that it does not control for several other factors that could have affected growth and thus "poisons its results by not holding other factors constant." Furthermore, Entin notes that it takes years for firms to fully adjust to changes in tax structure and that looking only at the effects of tax changes one year out "misses the point." In fact, the CRS study analyzes year-over-year changes rather than levels (because the data are not stationary), and hence it effectively asks whether GDP growth rates were different in years such as 1964, 1987, 1993, or 2003, when there was a change in the top marginal tax rate, relative to years in which there was no change in top marginal tax rates. But the key issue of interest is not whether a tax rate change has an effect on economic performance during that same year, but whether it changes the growth trajectory in subsequent years. Even very small changes in the rate of economic growth, if they are persistent, can have a very large impact on the size of the economy over time because of compounding.

Indeed, the vast literature examining tax rates and economic growth strongly suggests that marginal tax rates and GDP growth rates are negatively related. This result is well established both through the use of time series data for the United States and via large panels of international data. In this article, we employ the exact data and specifications from the CRS study but change the methodology to analyze how changes in top marginal tax rates "affect growth over the following three to five years rather than just the year of the change. After this modification, the regressions suggest that tax cuts have brought faster economic growth in subsequent years in the postwar United States, consistent with the theoretical and empirical literature.

Literature Review: Marginal Tax Rates and Growth

A large literature exists in which the theoretical "optimal tax" is sought (Mirrlees 1971; Diamond and Mirrlees 1971; Saez 2001; Mankiw, Weinzierl, and Yagan 2009). It is widely recognized in this literature that there is a tradeoff between income redistribution and efficiency. Proponents of progressive taxation (graduated taxes) argue that social welfare may rise when resources are more equitably distributed. (1) Furthermore, Conesa and Krueger (2006) argue that a progressive tax acts as a partial substitute for missing insurance markets. Still, taxes that vary with income distort behavior since they place a wedge between the market values of effort and reward. If taxes are highest on the successful drivers of growth, such as with a progressive tax, this will cause particularly large efficiency losses by distorting their labor supply and capital accumulation decisions. Along these lines, Cullen and Gordon (2002) suggest several avenues through which taxes affect entrepreneurial activity. Economists have long noted that a lump-sum tax, in which tax liabilities are independent of behavior, is the most efficient form of taxation since there is no distortive effect. Still, such a tax would be highly regressive, thus working strongly against the goal of fairness. Clearly the most efficient tax is unfair while taxes geared toward income redistribution are inefficient; high marginal taxes distort behavior and affect growth, even if they may be considered desirable from a perspective of income redistribution.

A large empirical literature has arisen to ascertain the importance of tax rates in determining growth in the real world--that is, how much of a tradeoff there is between income redistribution and efficiency. For example, Koester and Kormendi (1989) examined the relationship between effective tax rates and GDP of 63 countries during the 1970s. They found that although marginal tax rates do not affect GDP growth rates, a 1 percent tax cut would raise the level of per capita GDP by between 0.6 and 1.3 percent--creating a parallel shift in a nation's growth path. Following up on Koester and Kormendi, Engen and Skinner (1992) examined 107 countries between 1970 and 1985 and found a negative correlation between average tax rates and economic growth. Padovano and Galli (2001) expanded the time frame to 1950 to 1990, and examined a panel of 23 OECD countries. They found that effective marginal income tax rates are negatively correlated with economic growth. Lee and Gordon (2005) found that increases in corporate tax rates...