Do Tax Increases Negatively Affect the Economy?

Continuing on with an examination of the U.S. debt crisis, let’s look at another oft talked about issue: that raising taxes leads to a decrease in gross domestic product (GDP).  As I said yesterday, feel free to download the What My Intuition Tells Me Now U.S. Budgetary Data spreadsheet to see my sources and calculations.

Does Raising Taxes Stifle Economic Growth?

I cannot emphasize enough how very difficult a thing it is to use data to disprove or to verify whether raising taxes stifles economic growth.  Why?  Because there are many things that affect economic growth, not just the amount of taxes paid in an economy.  Things like the economic cycle, the level of innovation, energy prices, war, budget deficits, interest rate levels, and other major events also strongly affect economic growth.  So I am going to try and look at this issue from multiple directions to see if the collection of methods lends any insight.

Method 1: Average GDP Growth vs. Average Tax Growth

First, let’s look at a very basic comparison.  Since 1934 U.S. GDP growth has averaged 7.6%, while tax growth as a % of GDP has averaged 2.0%.  You would expect that if taxes negatively affected economic growth that GDP growth would not have been so much higher than tax growth.  Instead, GDP grew 3.8x (= 7.6% ÷ 2.0%) faster than taxes.

Method 2: GDP Growth in the Years Following Tax Increases & Decreases (A)

A second method would be to look at gross domestic product growth in the years following either a tax hike or a tax cut to see what happens.

After This Many Years  •  Growth in GDP After Tax Increase  •  Growth in GDP After Tax Decrease

1                                               8.0%                                                                 6.9%

2                                              7.3%                                                                 7.4%

3                                              6.4%                                                                 8.0%

4                                             7.0%                                                                 7.6%

5                                             7.8%                                                                 7.1%

Looking at the above data, it looks like raising taxes actually benefits the economy after the first and fifth years.  Whereas, raising taxes hurts the economy in the second, third, and fourth years following a tax increase.  What about the average for all of the above?  The average increase in GDP following a tax increase from the above chart is 7.3%, whereas the average increase in GDP following a tax cut from the above chart is 7.4%.

Frankly, a difference of 0.1% is hardly a difference at all, right?  Here I have sucker punched the hard core budgetary Republicans out there.  How?  Because of that 0.1% difference I am certain that they are holding on to the notion that cutting taxes benefits the economy, even if it is only by 0.1%.  But I strategically left off the effects of tax increases and decreases after year six.  Let’s look at those results now.

After This Many Years  •  Growth in GDP After Tax Increase  •  Growth in GDP After Tax Decrease

6                                             7.7%                                                                7.1%

Now if you average the benefits attained by a tax increase or of a tax decrease you get tax increases benefiting the economy by 7.37% on average vs. a tax decrease benefiting the economy by 7.35% on average.  Now I am certain that you will agree with me that a difference of only 0.02% is a dead on heat.  It also highlights a couple of things.

First, the number of years out from a tax increase or decrease is arbitrary.  The Democrats could make a strong case for the economic benefits of a tax increase by quoting the figures after year one and year five.  If they did they would look convincing.  But Republicans could argue the same thing by pointing out the economic benefits of a tax decrease in year three, year two, or year four.  Whatever.  It’s clearly arbitrary.

Second, if anything, the above data massively suggests that the current U.S. budgetary bloodsport over a tax increase or decrease is all the more foolish.  This is another way of saying that both Democrats and Republicans have an inflated sense of the importance of their policies since the economy grows about the same regardless of their tax policies.

This is also a strong argument for either a flat tax or a balanced budget amendment.  However, Congress has typically not voted for these policies because wielding the power to tax and spend is how Congressional members do wield their power.  Thus, they are highly unlikely to ever surrender this power.

Method 3: GDP Growth in the Years Following Tax Increases & Decreases (B)

One possible objection to the above method is that by using taxes as a relative % of GDP, rather than taxes as an absolute burden relative to GDP, that the data might be skewed.  That’s because income taxes, in particular, tend to rise and fall with GDP.

So let’s look at GDP growth the year after an absolute increase in tax dollars collected:

After This Many Years  •  Growth in GDP After Tax Increase  •  Growth in GDP After Tax Decrease

1                                               7.7%                                                                 6.3%

2                                              7.2%                                                                 7.9%

3                                              7.1%                                                                 8.0%

4                                             7.1%                                                                 8.4%

5                                             7.2%                                                                 8.4%

6                                             7.9%                                                                 4.9%

As you can see, a very similar pattern emerges as in the first data set.  With this data series the average GDP growth after a tax increase is 7.37%.  Conversely, GDP growth after a tax decrease is 7.30%.  Again, this is basically a wash since the difference is just 0.07%.  But if you want to quibble then you would have to say that it makes more sense to raise taxes if you want to increase GDP in the 5+ year period.

I would not be confident presenting the case of raising taxes to anyone though.  No, I think the strongest conclusion that can be made from these data is that tax policy really doesn’t affect GDP growth in the long run.

Method 4: R-Squared of GDP Growth Relative to Tax Growth

The next method I want to look at is the r-squared of gross domestic product relative to growth in taxes.

For those of you not familiar, r-squared is a statistical method and it is very easy to understand.  R-squared measures the cause and effect relationship between variables and ranges from 0-100%.  A score of 100% means that a change in one variable absolutely determines the change in the other variable.

Here we want to understand the effect on GDP growth of changing tax policy.  Here the r-squared turns out to be 18.3%.  That is changing tax policy can only explain 18.3% of the change in GDP.  This is a very low percentage, and it suggests that tax policy has very little effect on economic output.

Furthermore, for you statisticians out there, the correlation coefficient of the relationship is weakly positive at 42.8%.  What that means for everyone is that an increase in taxes tends to weakly, but positively effect gross domestic product.

Conclusion

In conclusion, the notion that raising taxes squelches economic growth just is not borne out by the data.  Economic growth is almost exactly the same regardless of whether taxes are raised or lowered.

Jason

[This post has been edited to correct a typo.]