Taxes and Economic Growth

Studies | Economy | Taxes

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


Introduction

"High tax rates discourage work and investment, increase efforts to avoid taxes and reduce government revenues."

In the 18th century, economist Adam Smith observed that raising tariff rates beyond a certain level was self-defeating because imports, and hence tariff revenue, fell. One reason was that high tariffs encouraged smuggling. In the 20th century, President John F. Kennedy recognized the same inverse relationship between tax rates and government revenue when he proposed broad tax cuts - cuts that were passed in 1964, after his assassination. "It is increasingly clear that no matter what party is in power, so long as our national security needs keep rising, an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget - just as it will never produce enough jobs or enough profits," Kennedy said in a speech in 1962. "It is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out."2

Ironically, the insight of John F. Kennedy was a basis for what has become known as the supply-side revolution, later popularized by Arthur Laffer. It furnished the impetus for President Ronald Reagan's cuts in marginal tax rates. As a practical matter, the income tax is somewhat progressive. A progressive tax structure discourages additional productive effort, and as a result, tax revenue is lower than it would be with a flatter income tax structure. Lower marginal and average tax rates encourage work and investment, and reduce efforts to avoid taxes.3

The supply-side emphasis on the tax revenue consequences of high levels of taxation ignored the more important question of their effect on economic growth. The Reagan tax cuts led to a tremendous expansion of the economy during the 1980s, and arguably into the 1990s.4 Economic growth raised revenues as the income of Americans grew. In recent years, a number of economists have explored the relationship between the overall tax burden - measured as a percentage of the output of goods and services or personal income - and the rate of economic growth.5

Empirical evidence shows that as the tax burden rises beyond a certain level, the rate of economic growth slows. [See Figure I.] Why economies grow and what government policies (if any) allow some societies to grow rapidly or cause countries to stagnate or decline has been debated for many years. Determining the tax structure that leads to the greatest creation of private wealth, and with it the largest amount of tax revenue, is a key to solving some major economic problems of our time.


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