What Is the Evidence on Taxes and Growth?

By William McBride of The Tax Foundation. Excerpts:

"So what does the academic literature say about the empirical relationship between taxes and economic growth? While there are a variety of methods and data sources, the results consistently point to significant negative effects of taxes on economic growth even after controlling for various other factors such as government spending, business cycle conditions, and monetary policy. In this review of the literature, I find twenty-six such studies going back to 1983, and all but three of those studies, and every study in the last fifteen years, find a negative effect of taxes on growth. Of those studies that distinguish between types of taxes, corporate income taxes are found to be most harmful, followed by personal income taxes, consumption taxes and property taxes.

These results support the Neo-classical view that income and wealth must first be produced and then consumed, meaning that taxes on the factors of production, i.e., capital and labor, are particularly disruptive of wealth creation. Corporate and shareholder taxes reduce the incentive to invest and to build capital. Less investment means fewer productive workers and correspondingly lower wages. Taxes on income and wages reduce the incentive to work. Progressive income taxes, where higher income is taxed at higher rates, reduce the returns to education, since high incomes are associated with high levels of education, and so reduce the incentive to build human capital. Progressive taxation also reduces investment, risk taking, and entrepreneurial activity since a disproportionately large share of these activities is done by high income earners.

Some of these items are long-term mechanisms, particularly human and physical capital formation. Most of these empirical studies focus on the long-term effects, over a period of five years or more, but many investigate short-term dynamics as well. The evidence for short-term, demand-side effects of tax policy is less robust and less compelling, perhaps owing to the difficulty of disentangling short-term factors and matching events. However, there is some evidence that longer-term, supply-side effects occur sooner than previously thought, such as within the first few years of a policy change.

In any case, the lesson from the studies conducted is that long-term economic growth is to a significant degree a function of tax policy. Our current economic doldrums are the result of many factors, but having the highest corporate rate in the industrialized world does not help. Nor does the prospect of higher taxes on shareholders and workers. If we intend to spur investment, we should lower taxes on the earnings of capital. If we intend to increase employment, we should lower taxes on workers and the businesses that hire them."

"This review of empirical studies of taxes and economic growth indicates that there are not a lot of dissenting opinions coming from peer-reviewed academic journals. More and more, the consensus among experts is that taxes on corporate and personal income are particularly harmful to economic growth, with consumption and property taxes less so. This is because economic growth ultimately comes from production, innovation, and risk-taking.

This review of empirical studies also establishes some standards by which a tax system may be judged. If we apply these standards to our national tax system, the U.S. has probably the most inefficient tax mix in the developed world. We have the highest corporate tax rate in the industrialized world. If it came down 10 points—still higher than most of our trading partners—it would add 1 to 2 points to GDP growth and likely not lose tax revenue, because the tax base would expand from in-flows of foreign capital as well increased domestic investment, hiring, and work effort. The preponderance of evidence is such that virtually everyone agrees that the corporate rate should come down, although many continue to claim, opposite the evidence,[29] that such a move would lose revenue.

We are also threatened with a fiscal cliff that would give us the highest dividend rate and nearly the highest capital gains rate in the industrialized world. Most studies do not look separately at shareholder taxes, due to the fact that they raise relatively little revenue and many countries have no such taxes.[30] However, shareholder taxes represent additional, double taxes on corporate income and therefore have the same type of detrimental effects on investment and economic growth that are now widely attributed to corporate taxes.

The fiscal cliff would also push the top marginal rate on personal income to over 50 percent in some states, such as California, Hawaii, and New York—higher than all but a few of our trading partners.[31] We already have the most progressive tax system in the industrialized world, according to the OECD, and this would make it more so. The OECD finds such steeply progressive taxation reduces productivity and economic growth.[32] Further, the U.S. is unique in that a majority of businesses and business income are taxed under these progressive individual rates, businesses such as sole-proprietorships, partnerships, and S corporations.[33] One study finds that increasing the average income tax rate by 1 percentage point reduces real GDP per capita by 1.4 percent in the first quarter and by up to 1.8 percent after three quarters.[34]

In sum, the U.S. tax system is a drag on the economy. Pro-growth tax reform that reduces the burden of corporate and personal income taxes would generate a more robust economic recovery and put the U.S. on a higher growth trajectory, with more investment, more employment, higher wages, and a higher standard of living."