Do Tax Cuts Stimulate the Economy?

 Draft 2/22/2009
 

It seems self-evident that tax-cuts should stimulate the economy. It seems so self-evident, that we discuss the theory as if it were a known fact. We don't even question the claim. But history offers us some evidence that tax cuts don't stimulate the economy.

 
 
  • In 1921 & 1925, major taxes cut were passed. In the following years a stock market bubble formed while working class wages stagnated, then in 1929 the bubble burst and the economy crashed into the Great Depression.
  • In 1981 a tax cut was passed. The economy sank deeper into recession and stayed in recession for nearly two years.
  • In 1987 major tax cuts were passed. By 1990 growth declined leading into the 1991 recession.
  • In 2001 a tax cut was passed, and another rebate was given in 2008. From 2001 through 2008 the economy grew slower than it did in the preceding 8 while a bubble formed in stocks, housing, and executive salaries. In 2008 the bubble burst, and now the economy in sinking into the worst recession since the Great Depression.

So what do we see in the data overall? Perhaps we should look at the data more thoroughly. We start by looking at the marginal tax rate on the richest citizens.

When we look at the tax rate charged to the richest citizens, we see that low taxes correlate to slow growth. When marginal taxes on the rich were below 40% growth remained below 4.5%. When top taxes were above 65% growth tended to be higher, even going above 6%. Historically, higher taxes on the rich have correlated to higher growth.
Making the comparison:
 
Max Tax below 40%
Max Tax above 65%
Average Growth
3.0%
3.5%
25 percentile
2.5%
2.0%
75 percentile
4.0%
5.7%
Maximum Growth
4.5%
8.7%
Overall, higher taxes on the rich historically have correlated to higher economic growth for the country. It's counterintuitive, but it is the historical fact.

Let's look closer at how the economy changed after tax cuts. We can look at how both GDP and employment grew just before the tax cut, and then just after the tax cut. Did they grow faster or slower?

Year of tax cut
GDP growth
 Employment growth  
  before after change before after change  
1964 4.6% 5.7%
+1.1
No
Data   In the last 50 years there were 5 tax cuts to the rich. Three of them were followed by a decline in GDP growth, 3 were followed by a decline in employment growth. The evidence suggests that tax cuts do not promote growth and probably promote decline.
1971 2.9% 2.6%
-0.3
 0.6% 2.3% +1.7
1981 2.8% 3.5%
+0.7
 1.8% .1.4% -0.4
1987 3.7% 2.3%
-1.4
 2.6% 1.1% -1.5
2001 3.3% 2.7%
-0.6
 1.2% -0.4% -1.6
Typical change   -0.25%   -0.6%
Year of tax increase before after   before   after In the last 50 years there was just one tax increase to the rich. After that tax increase both the GDP and employment growth rates increased significantly.
1993 1.9% 3.7% +1.7% 0.8% 2.5% +1.7%

The historical evidence suggests that an economic decline will follow a tax cut to the rich, and economic growth may follow a tax increase to the rich. The evidence suggests that the optimum tax marginal tax rate on the rich is higher than 60%.

Can we make similar conclusions for taxes rates on the middle class and poor?

For the lower classes, the historical data does not have an apparent pattern. The scatter is wide and fails to show a tendency in either direction.

Historically, taxes on the middle class and poor have shown no correlation to economic growth. Other factors must have greater influence than tax rates.

Data Sources
Tax Rates
GDP
 

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