Taxing Questions

August 16, 2011

Between now and the 2012 election the country will engage in a great debate about taxes.  One question in this debate is the extent to which wealthy Americans ought to pay more in taxes. They can afford to pay more, the argument goes, and with the country facing a growing fiscal hole, the wealthy ought to pay more. Warren Buffett, one of the world’s richest men and the greatest investor of his generation, recently advanced this argument in the New York Times.

Other things being equal, this argument has a lot of intuitive appeal. But are other things equal?  In addition to fiscal woes, the country also needs to generate jobs and economic growth.  Indeed, more growth will do a lot to help remedy the fiscal situation.  So what do we know about taxes on the wealthy and the effect on economic growth? Specifically, what do we know about taxes on entrepreneurs, the primary job creators in the economy?

Fortunately there is a lot of research that’s been done on these questions, so it’s useful to review some of it now. In a recent survey of the academic literature, researchers Tino Sanadaji and Arvid Malm found that taxes have a profound negative effect on economic activity. They cite the work of former Obama advisor Christina Romer and her husband David Romer who found that “tax increases appear to have a very large, sustained, and highly significant negative impact on output.” What of the effect of taxes on jobs? “Princeton Professor Harvey Rosen and co-authors investigated the effect of the personal income tax of business owners on their hiring activity. Business owners who received larger tax cuts expanded their hiring more.”

As my NCF colleague Bret Swanson has noted, the importance of jobs and growth to the broader fiscal picture should not be overlooked. Bret frames the issue nicely:

“A 4% growth rate would mean almost $4 trillion in additional output in the year 2020, $10 trillion more in 2030, $21 trillion more in 2040, and an astounding $38 trillion more in 2050, when the economy would be more than twice as large had we kept growing at 2%. Over this period, with an arbitrarily chosen 20% tax-to-GDP ratio, a 4% growth rate would generate $109 trillion more revenue than a 2% growth rate. “But 4% is wildly optimistic, you say. Perhaps. The consensus long range projection is just 2.5%. Fine, what if we could bump growth to a measly 3%? We would still generate an additional $25 trillion in tax revenue over the 40-year period. Didn’t the Medicare actuary just tell us the program’s unfunded liability is $24.6 trillion?”

Here’s the bottom line: Any discussion of taxes (or spending) has to include an honest discussion about the effect on economic growth. Some Democrats like to say the country has a revenue problem, so we need to raise taxes.  Some Republicans counter that the country has a spending problem, not a revenue problem.  But the reality is the country has a growth problem. And any policy change – be it on the tax or spending side -- needs to be analyzed with respect to its effect on growth.