Asymptosis

Do higher taxes result in slower growth? That’s the basic assertion made by tax-cut advocates. If we lower taxes, we’ll grow faster and all boats—rich and poor—will rise. It’s a great idea. Too bad it’s not true.

Few will disagree that in the short term (generally), tax increases impede growth. But over the long term (recent decades) it’s hard to find any support for the assertion—at least for developed nations like the U.S.

Let’s take a look at those nations (data from the OECD—total taxes including federal, state, and local):

If taxes have a profound effect on growth, you’d expect to see a trend from the upper left (low taxes, high growth) to the lower right. And there is the faintest glimmer of one—check out the trend line.

Over twenty years the difference between low (23%) and high (46%) taxers was a profound several percentage points of GDP growth.

And in the cluster of six lowest-taxing countries, four are below the trend line. (Why hasn’t the lowest-taxing country, Greece, seen explosive growth? Lots of reasons. But taxation doesn’t seem to be a factor.)

But how about if we drill down into the details? Maybe the ’75/’06 tax average is misrepresenting things, because some countries raised taxes more. To check, let’s look at Spain, Australia, Canada, and the US, which lead the main pack of developed countries:

1975–2006     Spain    Australia    Canada    US
Average tax      28%         36%           42%        27%
Tax increase    99%          6%             50%       10%

There doesn’t seem to be any pattern there.

Just to be sure, let’s compare the increase in total taxes for these countries to the growth in their real GDP:

There’s definitely more of a trend here. On the other hand, look at the top of the pack again: Australia, US,  Canada, and Spain. They’re spread all across the graph.

And the Netherlands, the one country that actually cut total taxes over this period, has had just average growth.

So there’s somewhat iffy evidence here that raising taxes (within these ranges) slows long-term growth. But there’s not a shred of evidence that taxes in the range of 30–50% of GDP are the catastrophe that American anti-taxers assert.

In fact, since all of these stable, prosperous, successful countries tax in the range of 25–50% GDP, the strongest evidence we see here is that taxes (or actually, expenditures) in that range are necessary to that prosperity.

Obviously, you have to wonder about Ireland. What happened there? As you can see, it wasn’t total tax burden; Ireland’s in the low-middle range of OECD countries. And it wasn’t a reduction in overall taxes; total tax burden in Ireland increased by 10% from 1975 to 2006. Tax activists will point to low corporate taxes, and that was certainly a factor. (Though it’s not crazy to argue that international corporate tax competitions just shift GDP from one country to another, rather than creating wealth.) Fact is, there were many reasons for the “Irish Miracle” (largely monetary, fiscal, and EU-related). See “Tiger Tiger Burning Bright: An economic miracle with many causes” from The Economist. (Free PDF here.)

Update: I’m not the only person who’s pointed this out. There have been dozens of studies by economists, and the results are resounding: in developed, prosperous countries taxing in the range of 28-50% of GDP, there’s no correlation between tax burden and growth. It’s a myth.

Update: For those who prefer the (in this case unequivocal) aggregate opinions of economists and econometricians who have studied this subject, I recommend this review of those experts’ efforts. Their conclusions resoundingly debunk the faith-based spending-and-taxes-kill-growth belief system (even as some of those experts continue to cling to it in direct contradiction of their own data and analyses).

In the previous post I pointed out that in America, the rocket ship of prosperity and GDP growth didn’t take off until after the New Deal, and after WWII—when taxes as a percentage of GDP were higher (45%) than at any time before or since.

Here are the visuals to prove it:

Source. Note that this chart does not include state and local spending.

Data source.

GDP growth, dismal for 140 years, took off at the same time that taxes and spending increased. Once again: this doesn’t prove that the higher government spending caused the GDP growth. (Though it certainly suggests it.) I does prove that the increased spending did not prevent the spectacular growth in prosperity over the last 70 years—a direct contradiction of what the anti-tax zealots would have you believe.

In the long term, the institutions that taxes pay for are the very things that allow for increasing prosperity. We need a certain amount of government. And we need to pay for it with taxes—not with money borrowed against our grandchildren’s earnings. Not complicated.

Added 12/20/07:

Spencer over on Megan McCardle’s blog makes the very good additional point:

From 1854 to 1919 their were 16 business cycles with an average contraction of  22 months and an expansion of 27 months.  So the economy was in a recession some 45% of the time.

From WW II until 2001 there were 10 cycles with an average contraction of 10 months and an expansion of 57 months. So since the advent of big government and the modern Fed the US economy has been in recessions only 15% of the time.

Are government, taxes, and spending really such irredeemably bad things?

Is their only effect to reduce prosperity and retard growth—the very things that have been improving everyone’s lot, worldwide, for decades?

Should taxes be reduced to 10 or 20% of gross domestic product (GDP)? (The current figure for the U.S. is about 26%—local, state, and federal combined.)

So-called conservatives have been making these claims for the last thirty years—notably by hurling the "tax-and-spend Democrats" brickbat—and with a great deal of success. Even so-called progressives like Bill Clinton have let them frame the debate as if those things were true.

The problem is, they’re simply not true. I’ll show you all the charts and graphs in later posts. Here’s the short story.

• For 140 years starting in 1789, U.S. tax rates and government spending were very low. And U.S. GDP growth was dismal—downright Zimbabwan—for all that time. GDP took off like a rocket ship following A) the New Deal and its accompanying tax and spending increases, and B) WWII—when government spending as a percentage of GDP was at the highest levels ever (>45%), before or since.

• OECD member countries—the club of modern, stable, successful, prosperous countries—all tax between 25 and 50% of GDP (Turkey and Greece are at 24 and 22 percent, respectively), with an average of 36%. None of these successful countries taxes less than 25% of GDP. With the exception of a few small tax havens and (mostly oil-rich) city states, there is no stable, prosperous, developed country—one that most Americans would consider to be a good place to live—that taxes less than that. If the rhetoric of the red-ink Republicans were true, wouldn’t there be a least one country in the world that demonstrates its truth?

• In a scatter-plot of these prosperous countries—comparing taxes/GDP to GDP growth—the correlation between taxes/GDP and GDP growth over recent decades is almost nonexistent.

• GDP per capita, a reasonably good measure of prosperity, is highest in the US—if you measure it according to purchasing power parity (PPP: how many loaves of bread can you buy?). But measured at market exchange rates, Norway, Iceland, Switzerland, and Denmark are all more prosperous than we are, despite much higher tax and spending levels. Sweden, the Netherlands, and Finland are just behind us.*

This doesn’t prove that taxes and government spending in those ranges increase prosperity. (Though I will argue that government spending in that range is necessary to long-term prosperity.)

It does prove, incontrovertibly, that taxes in the range of 30-50% of GDP have not prevented and do not prevent the spectacular worldwide growth in prosperity that we’ve seen since the 1930s. When so-called conservatives argue that drastic tax cuts are needed to avoid precipitous crashes in prosperity and growth (often invoking apocalyptic language that makes An Inconvenient Truth seem soft-spoken), we need to point out that it’s just not true. In fact, the evidence—all these prosperous countries with high tax rates—suggests the opposite.

They will counter with economic, ideological, and—frequently—moralistic arguments pitched with a fervor and belief worthy of Marxism in its heyday. We need to simply point out that while their arguments seem hermetically logical to them, the empirical facts contradict that logic. (cf. Chico Marx: "Who you gonna believe, me or your own eyes?")

In future posts I’ll go into more detail—with the facts, figures, charts, and graphs—demonstrating that the catastrophic rhetoric which has dominated debate for three decades is, in fact, empty.

* Wikipedia says, quite wisely, regarding PPP and market-rate/"nominal" GDP measurements:

"Often people who wish to promote or denigrate a country will use the figure that suits their case best and ignore the other one, which may be substantially different, but a valid comparison of two economies should take both rankings into account, as well as utilising other economic data to put an economy in context."