Taxes and Economic Growth

Studies | Economy | Taxes

No. 292
Tuesday, November 21, 2006
by Gerald W. Scully

Executive Summary

Some activities of government clearly contribute to economic growth. The United States, for instance, would not be nearly as productive without physical infrastructure (roads and bridges), protection of property and an educated work force. These activities are largely funded by taxation. At least initially, each tax dollar taken from the private economy to fund these activities yields more than a dollar increase in total output.

Beyond some minimum level, however, government becomes a net drain on the economy. Empirical evidence shows that as the tax burden rises beyond a certain level, the rate of economic growth slows. As government grows, money flows to less productive projects (think "bridges to nowhere"), and taxes are increasingly used to redistribute income through transfer payments (such as Social Security and Medicare) and to fund myriad special interest group projects. Whereas private decision-makers tend to make decisions based on economic costs and economic benefits, elected officials tend to make decisions based on political costs and political benefits (as reflected, for example, in votes, campaign contributions and so forth). High tax rates reduce the incentives of taxpayers to produce, while beneficiaries of government largesse are discouraged from additional effort.

There is a point, however, at which economic resources are allocated most productively between public and private uses. At this level of government taxing and spending, the economy will grow at the fastest sustainable rate, benefiting the poor and middle class as well as the rich. What is this optimal level of government? A reliable econometric model developed for this study finds:

  • To maximize economic growth, federal, state and local taxes combined should average about 23 percent of gross domestic product (GDP).
  • Tax revenues as a share of GDP have not been at that level since 1950, and for years have averaged between 30 percent and 34 percent of GDP.

Real GDP increased at a compound growth rate of 3.5 percent per year from 1950 to 2004. If instead of rising to 30 percent and more, an average tax burden of about 23 percent of GDP had been in effect throughout the 54-year period, the growth rate would have been 5.8 percent per year. As a result:

  • Real GDP would have been $37 trillion by 2004, more than three times greater than it was with the higher tax burden.
  • The average American family would have more than three times as much real income today as it actually has.

Would Americans have had to sacrifice important government programs in order to keep the overall tax rate down? Not at all. At the lower rate of taxation, higher growth would have produced more government revenue than the amount government actually collected at higher tax rates. Specifically:

  • At a 23 percent rate of taxation, government at all levels would have collected $61.9 trillion more in taxes.
  • This is enough money to have funded all actual spending programs enacted during that period with no public debt.

Going forward, the model implies that if the U.S. tax burden were reduced to the growth-maximizing rate and the rate of economic growth were raised, by 2030 real GDP would be almost twice as great as it would be at the lower average rate of growth over the last half century.

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