Thursday, June 21, 2007

A Touch of Gravitas (or, Go Ahead and Skip This Post)

The Star Tribune allowed some pretty shabby economic analysis on their opinion pages last Tuesday. I will pause while you get over the shock.

Okay, I trust that the smelling salts have now kicked in. The opinion piece purported to show that decreasing taxes did not increase economic growth, as measured by the increase in real GDP. Laughably, it looked at GDP data per decade, and then guessed at the tax policy of each decade. Couldn’t the Star Tribune opinion page find someone to write a commentary who knew how to google for more specific statistics?

Well, we here at NIGP did manage to dig up some more specific data. It is summarized in the following chart (I could only find effective tax rate data for 1979-2004):

The source for the tax data is here, and the source for the GDP data is here.

If the Strib had looked at this data, they would have found that there is indeed a positive correlation between the effective federal tax rate and the growth in GDP, albeit the correlation is a relatively small 0.13. Yes, a naïve look at the data does suggest that as the tax rate goes up, the growth of GDP tends to be higher than when the tax rate goes down. If the Star Tribune had gone this far, their argument would have seemed more persuasive, but let’s take a closer look.

The year of the lowest growth over the 15 year period from 1979-2004 was 1982 (-1.9%), the first full year of the Reagan tax cut. Wow, maybe the moonbats are correct and the tax cuts did have an adverse effect on growth. Alas, no. When we look at the next year, we see that economic growth increased 4.5% and the year after, GDP was up a whopping 7.2%, the strongest economic growth of the period – and all while the tax rate remained low!

Now let’s look at the year 2000, the last year of the Clinton administration and the year with the highest effective federal tax rate of the period, 23.0. That year had a respectable GDP increase of 3.7%, but the next year growth was down to an anemic 0.8%.

Tax cuts do not instantaneously stimulate the economy; they need time to work. If we look at the correlation between the tax rate and the growth of GDP for the NEXT year, we find a stronger, negative correlation of -0.27. Thus when the tax rate goes down, the growth of GDP tends to be lower that year (probably due to the effects of previous poor tax policy), but considerably higher the next year.

Sorry Strib, you can maybe get by with higher taxes for a few years if you have an artificial internet bubble or something, but in the long run, lowering taxes stimulates economic growth. (Learned Foot and his commenters go into some of the other problems with the Star Tribune's analysis.)


Anonymous selma hayek said...

Another problem with the Strib analysis is that what often spurs the need for tax cuts is a recession. Obviously if you institute a tax cut in the midst of a recession, you're not going to immediately see GDP growth as a result.

9:36 AM  
Blogger Chungsiew O said...

There should be inter connection between tax cut and GDP growth.

10:02 AM  
Blogger Nordeaster said...

The effective tax rates you used have to be wrong. They show the tax rates going down in the 2000's for all 5 quintiles, even the lowest 20%. I've always heard the tax cuts were only for the rich and the poor had to pay more. It was in the papers and on the TV news so it must be true.

Of course there is a 1 to 2 year lag in GDP growth, exactly for the reasons you stated (started in a recession and it takes a while for the effects to really be felt).

1:51 PM  

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