Revised August 5, 1996
By Richard Kogan
Talk of tax cuts is in the air. A number of people are suggesting that income tax rates should be reduced "to increase economic growth." What does history tell us does cutting income tax rates increase the nation's growth rate?
This analysis makes a number of points useful in understanding tax rate cuts and proposals to boost economic growth.
1) Those who claim that the Reagan tax cuts were a great success fail to distinguish between underlying economic growth rates on the one hand and the business cycle on the other. Why is this distinction important?
The business cycle reflects the reality that there are recessions from time to time, and recoveries from those recessions. The purpose of the proposed income tax cuts is not to stimulate recovery from a recession (we are not currently in a recession, after all); rather, the stated purpose is to increase the permanent, underlying rate of economic growth above the 2.1 percent that the Congressional Budget Office (CBO) projects.
So any analysis of the relationship between income tax rates and economic growth must focus on the underlying rate of economic growth such analyses must remove the booms and busts of the business cycle, discovering instead the underlying trends. Those who claim the Reagan tax cuts caused an increase in economic growth generally measure the economy from the depths of the recession in 1982 through to the next business cycle peak in 1989, concluding that the economy grew at an average annual rate of 3.8 percent. But they have been misled; showing that the economy recovered from the recession says nothing about whether the 1981 income tax cuts caused the underlying growth rate to be greater than it would otherwise have been.
2) To avoid being misled by the business cycle, one must look at underlying economic growth rates. The following table accomplishes this result in two ways. First, it measures economic growth and other data from one business cycle peak to the next, rather than from a recession to a later peak. Second, it uses CBO calculations of "potential" economic growth that is, CBO's estimate of the size of the economy in any year if unemployment were at normal levels, rather than abnormally high or low levels. In effect, CBO directly calculates the size of the underlying economy, ignoring the business cycle.
Both approaches give the same answer: economic growth rates have slowed from decade to decade; if income tax rates have made any difference to economic growth, that difference has been too small to be obvious. Specifically, the CBO data show that the underlying rate of annual economic growth was lower in the 1980s than the 1970s. It averaged 3.4 percent from 1969 to 1980, then slipped to 2.7 percent in the 1980s (not the 3.8 percent that comes from measuring from the depths of the recession in 1982), and is now projected at 2.1 percent. It is plausible that the underlying annual growth rate might have been slightly less than 2.7 percent in the 1980s were it not for the 1981 tax cut, but surely only slightly.
3) The following table also portrays components of economic growth, such as the private saving rate, labor productivity, and labor force growth. By measuring from one business cycle peak to the next, the table focuses on underlying trends. It can be seen that
The private saving rate has continued to decline slowly and steadily from decade to decade. From 1973 to 1980, private saving averaged 7.8 percent of the economy, dropping to 6.4 percent in the 1980s. In other words, the saving rate was lower after the 1981 tax cut than before it.
Overall productivity (the productivity of the entire labor force) grew quite rapidly before 1973 and much less rapidly since then. In the entire period after 1973, the annual growth rate of productivity has been very close to 1.1 percent. It was not higher than 1.1 percent in the 1980s.
The size of the labor force and the number of jobs and the total number of hours worked in the economy has closely tracked the size of the working-age population. Tax cuts seem to make only a small difference in how much people work. The size of the working age population grows from year to year, but while it grew quickly in the 1970s (1.9 percent per year on average), it is now growing more slowly (0.8 percent per year). In exactly the same way, the total number of hours worked in the economy grew quickly in the 1970s and now grows slowly. The conclusion is that the total number of hours worked is largely determined by the size of the total working age population. Neither cutting nor increasing income tax rates seems to make any major difference.
Economic growth, at its simplest, is the result of more people working and more output per hour (i.e., increased productivity). Given two facts annual productivity growth of about 1.1 percent for more than two decades, and a slowdown in the growth of the working-age population slower economic growth is the inevitable result. Since cutting (or raising) tax rates has made no obvious, large difference in productivity, the idea that tax rate cuts will noticeably increase underlying, long-term economic growth is without merit.
As noted, this table measures data from one business cycle peak to the next. The data for the current period reflects CBO's estimates of underlying trends; there is no peak-to-peak comparison possible for the 1990s since the next business cycle peak following 1990 has not yet been reached.
|Business Cycle -- Peak to Peak||Potential||Actual||Trend Productivity||Private Saving||Total Hours Worked||U.S. Population Age 20-64|
|1960 to 1969||4.2%||4.3%||3.0%||8.4%||1.2%||1.3%|
|1969 to 1973||3.4||3.5||2.1||8.2||1.9||1.7|
|1973 to 1980||3.4||2.8||1.4||7.8||2.2||1.9|
|1980 to 1990||2.7||2.8||1.0||6.4||1.7||1.3|
Notes:Data on growth, productivity, and hours worked are from CBO. Data on saving is from the Bureau of Economic Analysis. Data on population is from the Economic Report of the President. Total Hours and Population are measured on a calendar year basis; other data are measured from the calendar quarters in which business cycle peaks occurred. Private saving is measured as a percent of GDP; other data are measured as the average annual percent change during the period. Potential economic growth, trend productivity, and total hours worked are all CBO calculations in which the major effects of the business cycle have been removed.
One final point must not be overlooked tax cuts lose revenues. Thus, unless large tax cuts are offset by large spending cuts, the deficit will rise faster than CBO projects. An increase in the deficit is a dollar-for-dollar reduction in net national saving. As a result, any extra private saving that might be generated by lower tax rates is more than offset by higher government borrowing. In the words of a Republican analysis :
Because of the effect of government borrowing on investment, there is no tax incentive that promotes growth as effectively as deficit reduction. [emphasis in original]
1. Budget and Economic Analysis, Volume 1, #3, House Committee on the Budget, U.S., House of Representatives.