Taxes and Economic Growth

Policy Reports | Economy | Taxes

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

The Growth of Government

A low tax burden was a major contributor to America 's early economic growth:

  • In the 18th century, federal, state and local taxes combined were less than 5 percent of GDP, and 95 percent of federal revenue came from tariffs.
  • In the 19th century, tax revenue as a share of GDP gradually rose, but it never exceeded 10 percent.

"The income tax has allowed government to grow."

The personal income tax, introduced by the federal government in 1913, made it possible to transform the United States from a low-tax to a high-tax economy, and two world wars supplied the impetus.8 Most state governments, and some city governments, have since enacted their own income taxes - essentially piggybacking on the federal tax system.9

  • With America 's participation in World War I, total (federal, state and local) tax revenue exceeded 10 percent of GDP for the first time.
  • The 20 percent barrier was broken with America 's entrance into World War II.
  • By 1969, at the beginning of the Nixon administration, tax revenue had reached 30 percent of GDP.
  • Since then, total federal, state and local taxation has ranged from about 30 percent to 34 percent of GDP.

Today, federal, state and local taxation is about 31 percent of GDP. Government spending, however, is about 35 percent of GDP - with the difference paid for in the short run by government borrowing and in the long run by higher taxes.

How has the increasing tax burden affected economic growth? Economic growth occurs as a result of increases in productivity. Empirical studies have found that as the burden of government rises, productivity growth slows.10 There is evidence pointing to the growth in the size of government since World War II and the accompanying increase in taxes as a cause of slower growth in the post-war period.

This line of reasoning suggests that there is an optimal size of government. It further suggests that this optimal size is defined by the level of taxation that maximizes economic growth.

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