The Effect of Tax Rates on the United States Economy

Michael Murawski

Intermediate Macroeconomics

Final Paper

The Effect of Tax Rates on the United States Economy

In the current deliberation among public intellectuals, economists, and the media, the most shared inquiry about the economic health of the United States is condensed to one topic: taxes. The dialogue in this script has been fairly predictable: Paul Krugman, Robert Reich and other liberal democratic ideologues advocate raising the federal income tax, particularly on the rich, to help close trillion dollar deficits and to redirect funding to welfare programs for the unemployed, poor, and middle class. Conversely, partisan conservative figures and institutions, most notably the Heritage Foundation and recently the tea party leadership, see taxes as a ruthless intrusion of an over-expanding government, stifling the economic engine of the United States.

If the current political atmosphere is any indication, there is seemingly never a time where taxes are not a crucial part in any economic or political debate. As recent as 5 months ago, taxes were a crucial component of the so called “Fiscal cliff” as coined by former Secretary of the Treasury Timothy Geithner. A plethora of taxes, including the Bush tax cuts, were set to expire, which would have increased a large number of taxes across the board. During this fervent period we were plummeted with assertions from the right side of the political isle that tax cuts are an economic fix-all and that all said taxes should be not only extended, but decreased.

In fact, since President Obama has taken office, those with substantially above-average incomes, “the rich” or “the one percent,” have been labeled as “job-creators” by Republicans who have consistently, and without fail, advocated not to raise marginal tax rates on these individuals on the grounds that doing so will hurt the economy. That is to say, recent years have simply been a continuation of the conventional American paradigm: conservatives advocate lowering taxes, specifically on the rich, and liberals support higher taxes, specifically on the rich. However what are the results of these economic ideologies? My task was to investigate this claim: Do lower marginal and effective tax rates correlate to more or less economic growth? Are tax rates a good predictor of economic growth?

Theoretical Approach

Classical economic theory provides a simple solution to this dilemma: there is a negative relationship between taxes and economic growth. That is, increased taxes will lead to decreased economic activity and growth and decreased taxes will cause an increase in economic growth. This is because taxes shift the demand and supply curve, moving theoretical points on the classic supply-demand curve away from their preferred equilibrium state. Taxes raise the cost of production and transfer costs from producers to consumers in the form of higher prices. Moreover, it is a fundamental assumption that businesses and individuals have incentives to escape this upward pressure in prices. Thus, increased taxes mean that consumers will substitute goods, leading to the purchase of less ideal goods, sacrificing preference and quality.

Specifically, taxes on income should theoretically decrease the purchasing ability of the individual. In turn spending habits are altered leading the individual to buy less because they are unable to purchase items at prices they were previously able. Ultimately this will shift the demand curve down, decreasing economic productivity and growth.

In all, economic theory states that taxes will, almost always, in varying amounts, distort the supply and demand curves further away from its preferred equilibrium point, decreasing economic growth. There is however certain situations where taxes could increase efficiency, as is the case with negative externalities. Nevertheless, this issue is not being addressed in this paper. Rather, the fundamental assumption we are testing is the relationship between taxes on income and economic growth.

Method

In order to test my hypothesis I ran several regression analyses, testing the variables of varying methods of taxation and changes in economic growth. If the current political paradigm and the conservative narrative—and the classic economic theoretical perspective—is right, we should see that years of high forms of taxation are correlated with low economic growth.

I aggregated data from a multitude of sources, including the Bureau of Labor Statistics, Bureau of Economic Analysis, the Congressional Budget Office, The Tax Policy Center, the Cato Institute, and the National Bureau of Economic Research. From these sources, I amassed a collection of data ranging from various forms of tax rates to annual changes in GDP. Data was then combined and arranged into two tables: Taxes and Income, and Annual Changes in GDP. The former would serve as all possible independent variables and the latter all possible dependent variables—although I primarily used “Percent change in GDP in 2005 dollars” as the dependent variable. A variety of regression analyses were then performed coupling various forms of data to examine whether a relationship would be present between low taxes and economic growth.

Independent variables

*Data only available from 1979-2009

Taxes and Income: 1979-2009
Taxes / Income
Average Federal Income Tax Rates for All Households / Average individual Income tax / Share of
After-Tax Income
Year / All Quintiles / Top 1% / All Quintiles / Top 1% / Highest Quintile
1979 / 22.0 / 35.1 / 11.0 / 7.4 / 42
1980 / 22.0 / 33.1 / 11.6 / 7.6 / 42.4
1981 / 22.2 / 30.4 / 11.9 / 7.9 / 43
1982 / 20.5 / 26.7 / 11.0 / 8.6 / 44.1
1983 / 20.2 / 26.7 / 10.2 / 9.3 / 45.2
1984 / 20.6 / 27 / 10.0 / 9.7 / 45.3
1985 / 20.7 / 26.1 / 10.1 / 10.4 / 46.2
1986 / 20.6 / 24.6 / 10.3 / 13 / 48.2
1987 / 21.3 / 30.3 / 10.2 / 9.7 / 45.7
1988 / 21.5 / 29 / 10.3 / 11.8 / 47.3
1989 / 21.2 / 28.3 / 10.1 / 11.1 / 46.9
1990 / 21.2 / 28.1 / 10.0 / 10.8 / 46.5
1991 / 21.1 / 29.1 / 9.8 / 9.9 / 45.7
1992 / 21.1 / 30 / 9.8 / 10.6 / 46.5
1993 / 21.6 / 33.5 / 9.9 / 9.8 / 45.8
1994 / 21.9 / 34.8 / 9.9 / 9.7 / 45.5
1995 / 22.1 / 35.3 / 10.1 / 10.1 / 45.9
1996 / 22.3 / 35.2 / 10.5 / 11.2 / 46.9
1997 / 22.6 / 34.1 / 10.9 / 12.3 / 48.1
1998 / 22.3 / 32.6 / 10.9 / 13.3 / 48.7
1999 / 22.6 / 32.8 / 11.3 / 14.1 / 49.5
2000 / 22.7 / 32.4 / 11.7 / 15.2 / 50.5
2001 / 21.0 / 32.1 / 10.2 / 12.3 / 47.7
2002 / 20.3 / 32 / 9.5 / 11.1 / 46.8
2003 / 19.4 / 30.4 / 8.3 / 11.9 / 47.6
2004 / 19.6 / 30.1 / 8.5 / 13.6 / 48.7
2005 / 20.1 / 30.4 / 8.8 / 15.2 / 50.1
2006 / 20.3 / 30 / 8.9 / 15.9 / 50.8
2007 / 19.9 / 28.3 / 9.2 / 16.7 / 51.4
2008 / 18.0 / 28.1 / 7.8 / 14.1 / 49.1
2009 / 17.4 / 28.9 / 7.2 / 11.5 / 47.2

Source: Tax Policy Center, Congressional Budget Office

Note: Effective tax rates are calculated by dividing taxes by comprehensive household income. Comprehensive household income equals pretax cash income plus income from other sources. Pretax cash income is the sum of wages, salaries, self-employment income, rents, taxable and nontaxable interest, dividends, realized capital gains, cash transfer payments, and retirement benefits plus taxes paid by businesses (corporate income taxes and the employer's share of Social Security, Medicare, and federal unemployment insurance payroll taxes) and employees' contributions to 401(k) retirement plans. Other sources of income include all in-kind benefits (Medicare, Medicaid, employer-paid health insurance premiums, food stamps, school lunches and breakfasts, housing assistance, and energy assistance). Income categories are defined by ranking all people by their comprehensive household income adjusted for household size—that is, divided by the square root of the household’s size.

Quintiles, or fifths, contain equal numbers of people. Households with negative income (business or investment losses larger than other income) are excluded from the lowest income category but are included in totals. Individual income taxes are attributed directly to households paying those taxes.

Dependent Variables

Annual Changes in GDP: 1979-2009
Percent change of
Year / GDP in billions of chained 2005 dollars / GDP in billions of current dollars / GDP based on chained 2005 dollars / GDP based on current dollars
1979 / 5,850.1 / 2,562.2 / 3.1 / 11.7
1980 / 5,834.0 / 2,788.1 / -0.3 / 8.8
1981 / 5,982.1 / 3,126.8 / 2.5 / 12.1
1982 / 5,865.9 / 3,253.2 / -1.9 / 4.0
1983 / 6,130.9 / 3,534.6 / 4.5 / 8.7
1984 / 6,571.5 / 3,930.9 / 7.2 / 11.2
1985 / 6,843.4 / 4,217.5 / 4.1 / 7.3
1986 / 7,080.5 / 4,460.1 / 3.5 / 5.8
1987 / 7,307.0 / 4,736.4 / 3.2 / 6.2
1988 / 7,607.4 / 5,100.4 / 4.1 / 7.7
1989 / 7,879.2 / 5,482.1 / 3.6 / 7.5
1990 / 8,027.1 / 5,800.5 / 1.9 / 5.8
1991 / 8,008.3 / 5,992.1 / -0.2 / 3.3
1992 / 8,280.0 / 6,342.3 / 3.4 / 5.8
1993 / 8,516.2 / 6,667.4 / 2.9 / 5.1
1994 / 8,863.1 / 7,085.2 / 4.1 / 6.3
1995 / 9,086.0 / 7,414.7 / 2.5 / 4.7
1996 / 9,425.8 / 7,838.5 / 3.7 / 5.7
1997 / 9,845.9 / 8,332.4 / 4.5 / 6.3
1998 / 10,274.7 / 8,793.5 / 4.4 / 5.5
1999 / 10,770.7 / 9,353.5 / 4.8 / 6.4
2000 / 11,216.4 / 9,951.5 / 4.1 / 6.4
2001 / 11,337.5 / 10,286.2 / 1.1 / 3.4
2002 / 11,543.1 / 10,642.3 / 1.8 / 3.5
2003 / 11,836.4 / 11,142.2 / 2.5 / 4.7
2004 / 12,246.9 / 11,853.3 / 3.5 / 6.4
2005 / 12,623.0 / 12,623.0 / 3.1 / 6.5
2006 / 12,958.5 / 13,377.2 / 2.7 / 6.0
2007 / 13,206.4 / 14,028.7 / 1.9 / 4.9
2008 / 13,161.9 / 14,291.5 / -0.3 / 1.9
2009 / 12,757.9 / 13,973.7 / -3.1 / -2.2

Regression Analyses

Results

Regression Analysis Results
R-squared
Independent Variable: Taxes and Income
Average Federal income Tax Rates for All Households, All Quintiles / Average Federal income Tax Rates for All Households, Top 1% / Average Individual Income Tax, All Quintiles / Share of After-Tax Income, Top 1% / Share of After-Tax Income, Highest Quintile
GDP Percent Change, Based on Chained 2005 Dollars / 0.246026683 / 0.012195379 / 0.111641897 / 0.018394055 / 0.031683882

According to the data there is no correlation between low taxes, even low taxes on the top one percent of earners, and economic growth. All r-squared numbers displayed are significantly below what would be expected to conclude any type of relationship.

Moreover, the strongest relationship, average federal income tax rates for all households and GDP percent change only, only produces a r-squared statistic of 0.24, indicating a statically insignificant relationship. The second strongest relationship, average individual income tax for all quintiles and GDP percent change, produced a r-squared of only 0.11. All other statistics showed a relationship of less than 0.1.

From these regressions taxes on the top one percent of earners resulted in the two lowest correlations meaning that there is no relationship between taxing “job creators” and economic growth. Rather, while still statistically insignificant, there is a higher correlation between tax rates and income on all individuals than simply on the highest earners.

Moreover, additional regressions measuring average individual income tax for all quintiles and the annual average unemployment rate show that the aforementioned variables are unrelated. This produced an r-squared of 0.0054.

Even when a regression is run for the average annual income tax for the top one percent of earners and the average annual unemployment rate, the r-squared produced is 0.022.