Thursday, November 13, 2008

Higher Taxes Does Not Equal Socialism

On the day after the presidential election, I asked a hardcore Republican colleague of mine how he felt about the election. He said he was scared.

I asked him what he was scared of.

Among the many things that frightened him, one was that Obama is a "socialist". First of all, it's clear that the guy is listening to too much Hannity and Limbaugh, or watching too much Fox News.

Second of all, the fact that Obama wants to raise the highest marginal tax rate a bit does not make him a socialist. In fact, not only are Obama's proposals to raise taxes pretty modest, they won't have much effect on will just put more money in the government's coffers at a time it desperately needs the money.

A book I'm reading right now, The Big Con by Jonathan Chait, had a segment discussing the "high" tax rates, while also showing that supply siders, those Republicans who believe that the only key to economic growth is lower taxes, are wrong. In fact, it shows that we could probably stand to raise taxes even more:

Pure supply-siders see changes in tax rates as the single driver of all economic change. What caused the Great Depression? Mainstream economists blame different factors to various degrees, but supply-siders insist that the single cause was the 1930 Smoot-Hawley Tariff. (The tariff surely added to America's economic woes, but to blame a higher tax on imports, which accounted for just 6 percent of the economy, for causing the entire economy to contract by a third is just plain loopy.) Likewise, most economists pinned the 1991 recession on mistakes by the Federal Reserve, but supply-siders blame George H. W. Bush's tax hike. Bush raised the top tax rate from 28 to 31 percent. To think that a three-percentage-point jump in the top tax rate would discourage entrepreneurs and investors enough to tip the entire economy into recession requires attributing to tax rates powers bordering on magical.

Indeed, it doesn't take a great deal of expertise to see how implausible this sort of analysis is. All you need is a cursory bit of history. From 1947 to 1973, the U.S. economy grew at a rate of nearly 4 percent a year — a massive boom, fueling rapid growth in living standards across the board. During most of that period, from 1947 until 1964, the highest tax rate was 91 percent. For the rest of the time, it was still a hefty 70 percent. Yet the economy flourished anyway.

None of this is to say that those high tax rates caused the postwar boom. On the contrary, the economy probably expanded despite, rather than because of, those high rates. Almost no contemporary economist would endorse jacking up rates that high again. But the point is that, whatever negative effect such high tax rates have, it's relatively minor. Which necessarily means that whatever effects today's tax rates have, they're even more minor.

This can be seen with some very simple arithmetic. As just noted, Truman, Eisenhower, and Kennedy taxpayers in the top bracket had to pay a 91 percent rate. That meant that if they were contemplating, say, a new investment, they'd be able to keep just 9 cents of every dollar they earned, a stiff disincentive. When that rate dropped down to 70 percent, our top earner could now keep 30 cents of every new dollar. That more than tripled the profitability of any new dollar — a 233 percent increase, to be exact. That's a hefty incentive boost. In 1981, the top tax rate dropped again to 50 percent. The profit on every new dollar therefore rose from 30 to 50 cents, a 67 percent increase. In 1986, the top rate dropped again, from 50 to 28 percent. The profit on every dollar rose from 50 to 72 cents, a 44 percent increase. Note that the marginal improvement of every new tax cut is less than that of the previous one. But we're still talking about large numbers. Increasing the profitability of a new investment even by 44 percent is nothing to sneeze at.

But then George Bush raised the top rate to 31 percent in 1990. This meant that instead of taking home 72 cents on every new dollar earned, those in the top bracket had to settle for 69 cents. That's a drop of about 4 percent — peanuts, compared to the scale of previous changes. Yet supply-siders reacted hysterically. The National Review, to offer one example, noted fearfully that, in the wake of this small tax hike, the dollar had fallen against the yen and the German mark. "It seems;' its editors concluded, "that capital is flowing out of the United States to nations where “from each according to his ability, to each according to his need” has lost its allure.

Here is where a bit of historical perspective helps. If such a piddling tax increase could really wreak such havoc on the economy, how is it possible that the economy grew so rapidly with top tax rates of 70 and 91 percent? The answer is, it's not. It's not even close to possible. All this is to say that the supply-siders have taken the germ of a decent point — that marginal tax rates matter — and stretched it, beyond all plausibility, into a monocausal explanation of the world.

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