Laffing All the Way to the Bank

For more than three decades, Republicans have argued that higher taxes, especially higher taxes on the rich, hurt the economy by discouraging work and investment, or alternatively, that the economy will be stimulated by tax cuts. This prediction was illustrated by the Laffer curve, named for economist Arthur Laffer, who claimed that under most circumstances government revenue increases when taxes are cut, since economic growth more than compensates for loss of revenue due to the tax cut itself.

That this rhetoric is still central to the Republican message is illustrated by Sen. Marco Rubio's rebuttal to President Obama's State of the Union speech:

[A]s you heard tonight, his solution to virtually every problem we face is for Washington to tax more, borrow more and spend more. . . . And the idea that more taxes and more government spending is the best way to help hard-working middle-class taxpayers—that's an old idea that's failed every time it's been tried.

True to his word, Rubio was one of eight senators who voted against last month's “fiscal cliff” agreement, presumably because it raised taxes on Americans earning over $400,000 per year ($450,000 for couples).

What's the actual relationship between marginal tax rates and economic growth? An article by economist Gerald Friedman in the latest issue of Dollars and Sense addresses this issue with two important charts.

As I've noted before, when it is impossible to do a controlled experiment to test a hypothesis about social policy, we must turn to two types of quasi-experiment. In a time series design, you look at how the outcome variable (economic growth in the United States) changes from before to after a change in the social policy (a tax cut) that is hypothesized to affect it. This table shows the relationship between tax rates on the wealthy and gross domestic product (GDP) growth during all the presidencies after World War II.

The biggest tax cuts came under Reagan and Bush II. You might object that it takes time for tax cuts to stimulate the economy, but Bush I and Obama presided over even lower GDP growth than their predecessors. The main counterargument to a time series design is that the results might be explained by other historical changes that happened to coincide with tax policies.

The alternative is a comparison group design. Since tax policies are national decisions, the United States must be compared to other similar countries that have different marginal tax rates. The historical change argument is partially negated by the fact that the countries are compared over the same time period.

This chart is particularly stark in its condemnation of U. S. tax policy. The main counterargument to a comparison group design is that the countries are simply not comparable—for example, that all these other countries have some advantage that the U. S. lacks which accounts for their greater economic growth. Really?

I don't mean to suggest that these two charts exhaust the arguments against low taxes or tax cuts for the wealthy. For example, Friedman also shows that there is no relationship between top marginal tax rates and investment. Returning to Sen. Rubio's argument, it appears that it is not tax increases but tax cuts that have failed every time they have been tried.

The evidence that higher taxes and tax increases do not harm the economy seems so clear that it may be time to call into question the media's policy of false balancing, or quoting statements like Rubio's without comment or evaluation. It is difficult for public attitudes to change when the media merely act as a conduit for false information.