Higher Taxes Mean Slower Economic Growth

December 17, 2012

President Obama believes his reelection gave him a mandate to raise taxes on high earners. However, top earners already pay high taxes and a further increase could depress overall economic growth and production, say Edward C. Prescott, co-winner of the 2004 Nobel Prize in Economics and director of the Center for the Advanced Study in Economic Efficiency at Arizona State University, and Lee E. Ohanian, the associate director of the center and a senior fellow at the Hoover Institution.

  • U.S. growth is currently weak, with an overall output of 13.5 percent lower than what it would be had we continued on the pre-2008 trend.
  • The average marginal effective tax rate is around 40 percent when all taxes on earnings and consumer spending, federal, state and local income taxes, and Social Security and payroll taxes are taken into account.
  • The effect of tax increases would slightly increase revenues but reduce overall economic activity.
  • This is because high tax rates on labor income and consumption reduce the incentive to work by making consumption more expensive relative to leisure.

Workers have less of an incentive to work and produce goods when they make less money for their work. The incentive to work is reduced even more when the government increases cash transfers that may not require work.

Other economies around the world provide an example of the negative effects that a higher tax rate would have on the U.S. economy.

  • When tax rates were low in the 1950s, many Western Europeans worked more hours per capita.
  • However, as tax rates increased over the decades, there has been a 30 percent decline in work hours.
  • Furthermore, entrepreneurship is much lower in Europe because people are discouraged from business creation.

Higher marginal tax rates in the United States will have similar effects. On top of depressing the number of work hours, the increased revenue may prompt the government to continue policies such as Dodd-Frank, bailouts and subsidies to different sectors in the economy, which are fraught with economic inefficiency.

Instead, the government should make the economy more productive by lowering marginal tax rates and removing burdensome regulations. Furthermore, immigration policies need to be altered to attract the best and brightest from other countries to reinvigorate the entrepreneurial spirit that has kept the United States competitive for decades.

Source: Edward C. Prescott and Lee E. Ohanian, "Taxes Are Much Higher Than You Think," Wall Street Journal, December 11, 2012.


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