Do tax cuts for the wealthy boost economic growth?
This has been a very important question for quite some time. Those on the left call the belief that tax cuts for the wealthy benefit society as a whole, “trickle-down economics.” In their view, these tax cuts only serve to increase inequality and reduce the amount of revenue the government takes in.
On the other hand, supply-side economists believe that cutting taxes on the wealthy, in addition to everyone else, has beneficial effects on the economy. Specifically, these economists believe that tax cuts for higher income people will lead to increased savings, boosting investment, resulting in higher economic growth.
Keynesian economists, on the other hand, tend to see savings in a negative light. They believe that a dollar’s worth of tax cuts for lower-income people has “more bang for the buck” than tax cuts for the wealthy since the former tend to spend a higher percentage of their income than the latter. More spending means higher aggregate demand and a larger economy.
In order to assess the validity of competing theories, it is important to test them empirically. Luckily, there have been quite a number of relevant empirical papers on this matter. First, let’s consider how tax cuts for the wealthy impact income inequality.
Despite progressives blaming rising income inequality over the last few decades on the top marginal tax rate reductions which have occurred since the 1960’s, Koyak and Poschke (2015) find that, since 1960, there has only been a “negligible role for tax policy in the rising of income inequality,” and that other factors, like skill-biased technological change, are much more important factors.
Gale et al. (2015) used economic modelling to predict how income inequality would respond to the raising the top marginal income tax rate to 50 percent and having all the revenues generated from said tax increase redistributed to the poorest Americans.
According to their results, “the resulting effects on overall income inequality are exceedingly modest…That such a sizable increase in the top personal income tax rate leads to a strikingly limited reduction in overall income inequality speaks to the limitations of this particular approach.” It’s thus not all that clear that raising taxes on the wealthy is a real solution to income inequality.
On the other hand, there is evidence that higher taxes on the wealthy do impose economics costs, probably by reducing incentives to work and invest. Using time series from 1946 to 2012, economist Karel Mertens of Cornell University examined the causal effects of the dreaded tax cuts for the wealthy on economic activity and found that, “tax cuts targeting the top 1% alone have positive effects on economic activity and incomes outside of the top 1% but increase inequality in pre-tax incomes.” Taylor and Taylor (2014) similarly find that, “there is strong empirical evidence that real per capita GDP grows faster in the years after a [top marginal] tax cut.”
Higher progressive tax rates may also reduce economic mobility by inducing labor market distortions or reducing the after-tax returns on educational attainment, thus leading to reduced incentives to pursue higher education. Progressives typically scoff at such a suggestion, but in a new research paper, Alloza (2016) finds that, “lower marginal tax rates foster mobility along the income distribution,” and that, “higher marginal tax rates reduce income mobility.” In other words, higher taxes result in less economic opportunity, which is especially important for people trying to escape poverty.
There is also evidence of the harm of higher taxes on the wealthy at the state-level. A new working paper published by the Federal Reserve Bank of San Francisco finds that top scientists move away from states which raise taxes on the wealthy. Similarly, Akcigit et al. (2015) find that the top inventors in the country typically reside in states with lower taxes on the wealthy. A loss of these brilliant minds and the innovative activities that accompany their presence certainly imposes costs on local economies.
Perhaps this is one of the reasons why Compton et al. (2012) find that reductions in state top marginal tax rates are actually associated with increases in after-tax income growth for all income quintiles (and vice versa), though the effect on any given income quintile is not always statistically significant. But remember, according to progressive pundit Robert Reich, the proposition that higher taxes on the wealthy impose economic costs ‘is a lie.’
Another very good paper is Zidar (2015). He finds that, in line with Keynesian presumptions, tax cuts for the wealthy (at the state level) have considerably less “bang for the buck” than tax cuts for the bottom 90% of income earners. The graphs below show the difference.
The graph on the left shows that employment growth doesn’t respond to tax increases for the rich. On the other hand, the right graph shows that tax increases for the bottom 90% of income earners has significant negative effects on employment growth.
So what conclusions are to be drawn? For one, there seems to be a lack of evidence that increasing taxes on the wealthy reduces income inequality by more than a small amount. There is also some evidence that these tax increases do have adverse effects on the economy, but that tax increases for the bottom 90% of income earners are more deleterious (i.e tax cuts for the poor and middle class have more bang for the buck when it comes to enhancing economic performance.)
Overall, I think that the proper course of action is to not raise taxes on the wealthy, but not to cut them either. Instead, if we are going to cut taxes to make people better off, we should cut taxes for the poor and middle class. Not only do these tax cuts immediately increase after-tax income, they also grow the economy much more than equivalently sized tax cuts for the wealthy.
Raising taxes on the wealthy to finance tax cuts for the bottom 90% would also likely be beneficial on net, for the economy and for most people. Of course, this is my own conclusion. I would love to hear your conclusions based on the evidence in the comments section.
Note that this post does not examine the ethical concerns of taxation and wealth redistribution. As libertarians, many of us do not believe in coerced wealth redistribution via taxation. Opposing taxing the wealthy on ethical grounds is, in my view, very valid, but not the purpose of this post. The purpose of this post was to examine the costs and benefits of taxing the wealthy from an economic perspective.
Zidar (2015): http://www.nber.org/papers/w21035
Compton (2012): http://goo.gl/SRmorF
Akcigit et al (2015): http://www.nber.org/papers/w21024
Federal reserve (2015): http://www.frbsf.org/economic-research/files/wp2015-06.pdf
Alloza (2016): http://www.ucl.ac.uk/~uctp041/Research_files/AllozaJMP.pdf
Taylor (2014): https://goo.gl/Ww1bPY
Mertens (2012): https://goo.gl/H7wdoP
Koyak and Poschke (2015): http://goo.gl/bqOq1i
Gale (2015): http://www.brookings.edu/~/media/research/files/papers/2015/09/28-taxes-inequality/would-top-income-tax-alter-income-inequality.pdf