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What Do Tax Rates’ Ups and Downs Mean for Economic Growth?

December 12, 2011 at 12:00 AM EST
Do higher tax rates slow economic growth? As part of his reporting on Making Sen$e of financial news, economics correspondent Paul Solman takes a look at the history of taxes.
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JEFFREY BROWN: Now, what the ups and downs in tax rates means for economic growth.

NewsHour economics correspondent Paul Solman offers a history lesson for some insights. It’s part of his ongoing reporting Making Sense of financial news.

SEN. JOHN KERRY, D-Mass.: I am deeply disappointed that this committee wasn’t able to find an agreement.

PAUL SOLMAN: The super committee doomed in part by a deadlock over taxing the rich. Same for the bill to extend the payroll tax and unemployment benefits, held up by the issue of taxing millionaires.

And so the question: Do higher taxes on the rich retard economic growth, or don’t they? We thought we’d look to history for an answer, visiting landmarks of New York with nonpartisan tax professor Alex Raskolnikov — first stop, a memorial to World War I, which the U.S. entered in 1917, soon after the federal income tax began, with rates from 1 percent on a net income of up to $20,000 — today’s half-a-million or so — en route to 7 percent on all earnings above $500,000, today’s $11 million or more, higher rates on the extra or marginal income — thus the term marginal tax rates.

In 1917, given the expensive war, Congress jacked the top marginal rate upward.

ALEX RASKOLNIKOV, Columbia Law School: From 7 percent to 77 percent. And, by the way, the phrase “soak the rich” emerged at that time, too.

PAUL SOLMAN: The new top marginal tax rate of 77 percent applied only to income starting at a million 1918 dollars. The average rate for the very rich, however, was only 15 percent.

ALEX RASKOLNIKOV: Fifteen percent average rate means the wealthiest Americans paid 15 percent of their overall income in taxes. It’s not nothing, but it’s not 77 percent.

PAUL SOLMAN: But 15 percent of your total income, that’s not soaking the rich, is it?

ALEX RASKOLNIKOV: Well, it depends on your perspective. Compared to zero, which is what these people paid just a few years before, it’s a substantial burden. Certainly, it was perceived as such.

PAUL SOLMAN: Was there a big political movement to try to reverse this?

ALEX RASKOLNIKOV: There was a huge movement to try to reverse that. President Harding advocated return to normalcy after the end of the First World War, and his treasury secretary, Andrew Mellon, who himself was not poor, was instrumental in reversing that trend.

PAUL SOLMAN: Banker and industrialist Andrew Mellon, whose foundation is on the Upper East Side of Manhattan, served Republican presidents throughout the 1920s.

ALEX RASKOLNIKOV: Andrew Mellon was one of the richest men in America, and he had a plan for repaying the wartime debt and stimulating economic growth. And his plan was to cut down the tax rates dramatically. And that’s what Republicans proceeded to do. The top marginal rate came down from 77 percent all the way down to 25 percent.

PAUL SOLMAN: And stayed down. For evidence of tax cut effectiveness, proponents like Arthur Laffer say, just look at the next decade, starting in the 1920s.

ART LAFFER, former White House economic adviser: And we had the only boom in the world during that period. It was called the — remember, the Roaring ’20s. On Jan. 1, 1932, the highest marginal income tax rate was raised from 24 percent to 63 percent. We know what followed. It wasn’t a pretty picture.

PAUL SOLMAN: Does Professor Raskolnikov agree about the roaring growth of the Roaring ’20s?

ALEX RASKOLNIKOV: So the question is whether the rate cut at the top contributed to that growth, accounted for that growth, or did nothing in particular for that growth. And that’s not exactly clear. The ’20s was a fairly good period for the economy, until the end of ’20s, when things went dramatically bad.

PAUL SOLMAN: A symbol of the era’s end: Republican Herbert Hoover, who presided over the crash of ’29, hiked taxes in 1931, was thumped in ’32, and moved to the Waldorf Astoria hotel as the Great Depression deepened.

Do you read anything into this, I mean, that perhaps the Great Depression continued for another nine years because rates were jacked up that high?

ALEX RASKOLNIKOV: There were many factors going into Depression. Tax policy was only one of them, so it’s hard to know.

PAUL SOLMAN: Many factors, the vexing problem with trying to pin economic growth on tax rates, as the raised rates of President Roosevelt make clear. We airlifted to an island named after him across New York’s East River.

So, next stop, Roosevelt Island, the Franklin Delano Roosevelt Drive over there. What happens under Roosevelt?

ALEX RASKOLNIKOV: Two big things happen under Roosevelt. One, the top marginal rates increase even more. They go up all the way to 94 percent, very high top marginal rates.

And, two, the income tax, our income tax, changes from a class tax to a mass tax. The percentage of potential taxpayers who are actually paying taxes goes from just 6 percent to 34 percent. So now it’s around 50 percent.

PAUL SOLMAN: Why was there suddenly a need for so much revenue?

ALEX RASKOLNIKOV: Revenue was needed to fund The New Deal, to build public projects like the FDR Drive and highways and dams and public works.

PAUL SOLMAN: And the rich mainly paid for them.

ALEX RASKOLNIKOV: Not only the marginal rates were very high. Average rates for the top 1 percent of income earners went from 20 percent to 40 percent, one year to 60 percent. So this is a very high average rate.

FORMER PRESIDENT FRANKLIN DELANO ROOSEVELT: You may have heard that I was driving the nation into bankruptcy, and that I breakfasted every morning on a dish of grilled millionaire.

(LAUGHTER)

PAUL SOLMAN: Conceivably, high taxes on the rich prolonged the Great Depression, but, then, how to explain the postwar boom, right through the Republican administration of Dwight Eisenhower, when the top marginal rate remained in the 90s? And when President Kennedy cut the top rate, growth didn’t exactly soar.

President Reagan? Cut rates drastically, as advisers like Arthur Laffer urged.

ALEX RASKOLNIKOV: Two big tax cuts, one in ’81 and another one in ’86. The top rate came down from 50 percent to 28 percent, and that’s the lowest it’s been since Andrew Mellon.

PAUL SOLMAN: What was the rationale for that?

ALEX RASKOLNIKOV: That if you cut taxes, you will stimulate growth and that growth will trickle down from the top all the way to the bottom of the income distribution.

PAUL SOLMAN: And what happened?

ALEX RASKOLNIKOV: Not a whole lot of trickling down.

PAUL SOLMAN: So does that refute the notion that, if you cut taxes, you stimulate growth?

ALEX RASKOLNIKOV: It’s not exactly clear, but — but there’s no strong support for the proposition that trickle-down works.

PAUL SOLMAN: Of course, strong political support for the proposition continues to the present. But, sadly, says the professor, there’s no academic consensus.

And the evidence gets no more definitive at the next major stop, outside President Clinton’s office on 125th Street in Harlem. Clinton boosted the top marginal rate from 31 percent to 39.6 percent.

ALEX RASKOLNIKOV: Economic growth spiked after the Clinton tax increase. And although no one says that high tax rates lead to economic growth, this kind of fact is certainly not the greatest fact if you want to argue that higher tax rates, top marginal rates impede economic growth. So relationship is complicated.

PAUL SOLMAN: And complicated, it remains. Economic growth hasn’t exactly spurted in the wake of the tax cuts of George W. Bush, which President Obama reluctantly agreed to extend through next year.

We ended our day trip at Zuccotti Park, when Wall Street Occupiers were still protesting the inequality gap between the top 1 percent and the rest. But, when it comes to taxes, is that a bum rap?

We hear that the top 1 percent pay the lion’s share of income taxes, and more than they used to.

ALEX RASKOLNIKOV: Both of these statements are absolutely true. In fact, the share of total tax burden paid by top 1 percent almost doubled in the past 30 years.

PAUL SOLMAN: But doesn’t that show that America has become more fair?

ALEX RASKOLNIKOV: Well, it depends on how you think about fairness, because even though the burden borne by top 1 percent has doubled, if you look at the rate of the income growth, it’s been 10 times the growth of the middle 20 percent. So the income inequality increased dramatically. And right before financial crisis, it was at the highest level since 1928, since Andrew Mellon was cutting taxes in the ’20s.

PAUL SOLMAN: At the end of the day, then, high inequality and a sluggish economy.

Unfortunately, if history is any guide, there’s no conclusive evidence that economic growth is stimulated by lowering marginal tax rates on the rich, or, for that matter, raising them.