Will Tax Cuts Pull Us Out of this Sluggish Economy?

Categories: Business, Economy, Politics, Tax Policy
Will Tax Cuts Pull Us Out of this Sluggish Economy?

The ongoing debate in economic philosophy is the effect of tax policy on economic growth.  Some argue that tax increases to the wealthy can provide additional funding to federal and state agencies and provide much needed aid to the middle and lower class. Furthermore, centrally planned investment in infrastructure can create jobs and spur economic growth. The alternate theory is that reducing tax rates for everyone, including the rich, and austere government spending can produce the desired effect of private sector investment and job creation. What is the right approach, and is there evidence to support either philosophy?

The graph below illustrates the data obtained from the Bureau of Economic Statistics and the Tax Policy Center. From 1970 to 2011, the fluctuating Gross Domestic Product (GDP) growth rate (blue line) is compared to the top marginal tax rate (red line).

Tax Cuts Compared to GDP Growth

Effect of Tax Increases

Analysis of this date indicates that tax rate increases while the economy is in an upswing does not appear to reverse the trend. The GDP growth rate continued to increase in the mid-1990’s, despite the top marginal rate increase from 31% to 39.6%. Marginal rate increases, however, may exacerbate the downward trend in the economy. After the rate increase from 28% to 31% in 1990, we see a reduction in GDP growth from 3.6% in 1989 to -0.2% in 1991.

Effect of Tax Cuts

There is evidence that tax rate cuts do provide an initial boost to a struggling economy. Most notably, the Reagan tax cuts from 70% to 50% in the early 1980′s resulted in an immediate GDP growth increase from -1.9% in 1982 to 7.2 % in 1984. The subsequent marginal tax rate reduction from 50% to 28% reversed the apparent downward trend in 1985 and 1986 and maintained strong economic growth for another 2 years. Lastly, the gradual tax cuts from 39.6% to 35% from 2000 to 2003 shows a reversal of the downward trend and we saw an improvement in GDP growth from 1.1% in 2001 to 3.5% in 2004.

In conclusion, this simple analysis considers only changes to top marginal tax rate. If we assume that the top marginal tax rate changes outweighs any other tax law changes at the time (e.g. lower marginal tax brackets, payroll taxes, capital gains, state/local taxes), the data shows evidence of the following:

  • Tax rate changes do not have a permanent effect on long term GDP growth.
  • Tax increases do not necessarily negatively influence a good economy.
  • Tax increases can aggravate a struggling economy.
  • Tax cuts consistently kickstart a bad economy.

Under the current economic conditions, what do you think we should do?

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