“When Higher Marginal Tax Rates Helped The Economy”

Prof. Paul Caron’s TaxProf.com blog recently linked to a paper by Northeastern University professor Nicholas Palaveda entitled “When Higher Marginal Tax Rates Helped The Economy: Professor Palaveda’s Paradox” (PDF).  I suspect that liberals will be citing this paper often in the coming political fight over higher tax rates and President Obama’s support for the “Buffett Rule.”

Paleveda’s study covers the period from 1951 to the present (roughly 60 years) and attempts to correlate the top marginal income tax rate with economic growth in order to test the claim by conservatives that lower tax rates lead to economic growth; however, he doesn’t (or can’t) explicitly show how the top marginal tax rates directly influenced the economy.

Prof. Paleveda begins his study by stating that the top marginal rate was at its absolute highest during the period from 1951 to 1963.  Yet with a top rate of 91%, the S&P 500 index posted a mean growth rate of 11.92%.

The Kennedy tax cuts reduced the top marginal rate from 91% to 77% in 1964, and from 1964 to 1970 the top marginal rate stayed in the 70% to 77% range.  Yet during this period the economy grew only at a mean rate of 3.6%.  (I assume he is still using the S&P 500 number, although he doesn’t explicitly say.)

During the decade from 1971 to 1981, the top marginal rate remained in the 70% range but the economy stagnated and posted a mean growth rate of 4.35%.

In 1982 the top marginal rate was lowered to 50% and between 1982 and 1986 the economy boomed at a rate of 14.8%.  In 1987 the top marginal rate was lowered to 28%, then increased only 3 percentage points to 31% in 1991.  Yet between 1987 and 1992 economic growth slowed to 10.9%

In 1993 the top marginal rate was raised to 39.6% and remained at this rate until 2002.  During the period from 1993 to 2001, the S&P grew at an astounding rate of 15.8%.  The top marginal rate was reduced to 35% in 2002.  During the period between 2002 and 2010, S&P growth was charted at a pathetic 1.69%

Within this study are a number of periods described as “Paleveda Paradoxes,” periods when top marginal tax rates either remain relatively steady or decrease, yet the rate of economic growth remains stagnant or shrinks.  From his data, Prof. Paleveda concludes that a top marginal tax rate in the 40% to 50% range appears to be an optimal scenario for strong economic growth.

I hate to challenge the work of a distinguished professor of tax law with three graduate degrees, but there is simply too much relevant information that is omitted from this study.

First, when we look at the top marginal rates we also need to look at the income levels represented by the top marginal income tax bracket.  In order to make this comparison more relevant, I’ve converted everything to 2010 dollars:

1951          91.0%          $400,000          $3,700,000 (2010 equivalent)

1964          70.0%          $400,000          $2,800,000 (2010 equivalent)

1970          71.75%          $200,000          $1,100,000 (2010 equivalent)

1981          69.13%          $212,000          $509,000 (2010 equivalent)

1993          39.6%          $250,000          $377,000 (2010 equivalent)

2002          35.0%          $307,050          $372,000 (2010 equivalent)

We immediately see that before 1970, the top marginal rate only applied to those earning what we would consider “millionaire” incomes.  In other words, middle and upper middle class professional wage earners were not affected by the top marginal tax rate.  But after the inflation debacle of the 1970’s and early 1980’s, the top tax bracket began to swallow more and more wage earners and small business owners from the upper middle class.

Another way to look at this is to take 2002’s $307,000 tax bracket level and convert it into 1951 dollars.  If the income level of the top tax bracket in 2002 had been kept steady throughout the previous 50 years, the top tax bracket in 1951 would have started at $44,000.  Hopefully this helps everyone understand how the size of the top tax bracket has grown, particularly during the last 30 years.

How many more people during the 1950’s would have been deeply and negatively impacted by high marginal tax rates if those rates would have kicked in at income levels below $50,000 a year?  How many upper middle class professionals and small business owners would have been prevented from accumulating the wealth that drove the investment booms of the 1980’s and 1990’s?  How many more families would have been unable to afford new automobiles, new television sets, vacations, a new suburban home, or a college fund for their children – all of which contributed greatly to the economic boom of the 1950’s and early 1960’s?

The Reagan tax cuts of the early 1980’s effectively eliminated the WWII-era top marginal rate and introduced a 50% top rate for anyone earning over $106,000 a year.  Previously, anyone who had earned over $60,000 a year paid 54% tax, and there were 4 more tax brackets for incomes between $85,000 and $215,000.  This drastic simplification for upper income earners, along with with the elimination of high inflation and a major reduction in interest rates, paved the way for the Reagan Recovery.  But it was the combination of deregulation, smarter monetary policy, and significant tax rate reductions that led to the economic boom.  The tax rates did not do it alone.  And the strong economy provided increased revenue for the government during every year of the recovery, even though tax rates were lowered.

It’s also worth noting that the real economic boom of the 1990’s began in 1997, when the tax rates for capital gains were significantly reduced.

Nevertheless, Reagan’s recovery, along with the Eisenhower era economic boom, are both probably more attributable to effective leadership than to marginal tax rates.  The effects of psychology on economics cannot be underestimated; real, sustainable growth occurs when people are excited about the benefits to be gained when they spend or invest their money.  When a consumer feels he is benefiting from extra spending (interest rate savings, or a sales price, or additional productivity/enjoyment from new computer technology, etc.) or an investor feels that he will earn enough money back through growth or dividends to offset risk, they will pump money into the economy.

Eisenhower outlined a vision of an America that would be the world standard-bearer for engineering, manufacturing, farming, and overall quality of life.  Reagan largely restored that vision after the navel-gazing and guilt tripping of the 1970’s.  Bill Clinton encouraged the growth of the Internet and the tech sector and Americans reaped a whirlwind of benefits from the World Wide Web and the growth of ubiquitous digital technology.

But today, we suffer under leadership in Washington DC which seems more interested in targeting successful individuals and businesses as enemies of “fairness.”  Industries are crippled financially by regulations based more on ideology than on common sense or good economics.  Government spending is out of control and our current debt trajectory is unsustainable.  Business managers are spooked by the uncertainty caused by massive new regulatory requirements, plus they have begun bracing for the inevitable tidal wave of new taxes in the near future (which will be a necessity unless the government starts spending less) and as a result they are not growing their businesses.  Unemployment remains high, therefore consumers are spending less.

And how does our President respond to this?  He says that we have grown “a little soft.”

The truth is, as far as economic growth is concerned it probably matters little what the top marginal tax rate is in terms of absolute percentages.  What we must have is positive motivation and incentives, which are generally based on people feeling that the benefits gained by spending and/or investing their money will be far more beneficial or exciting that the associated costs and risks.  Lowering tax rates can help create this kind of excitement, but it is not the only method that works.

Unfortunately our current leadership couldn’t inspire its way out of a wet paper bag, which seems to tell me that any changes they make to marginal tax rates – either up or down – will have little or no positive effect on our economy.

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