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Tax hype

With the "fiscal curb" (it's not a cliff) being the big topic in DC we are talking a lot about taxes. We always talk a lot about taxes, at least Republicans do. They are important. But they are overhyped, especially if you are talking about economic growth. Matt Yglesias explains:

The case against returning to the kind of 90 percent marginal income tax rates that we had in the 1950s seems pretty ironclad to me—the 1950s tax code raised way less money than the 1990s tax code (90 percent tax rates are a great stimulus to tax avoidance strategies) so what would the point be? But there's no doubt that tax rates that high were compatible with robust economic growth. This is a somewhat embarassing fact for people who put a lot of emphasis on low marginal tax rates as a key to growth.
The argument here, which certainly makes sense, is that the postwar US economy grew fast not because of high tax rates but despite them. But Lindsey locates the true cause of the rapid growth in wartime economic planning which led to "technological and organizational breaktrhoughs." I don't think we can attribute air conditioning to the war, but certainly the "big advances" in transportation and communication were a direct result of World War II and then the Cold War. Similarly, the "rapid upgrades in human capital" he lauds were a matter of state-led investment, not bottom-up economic competition.
Indeed, the thrust of Lindsey's initial analysis is that massive government-directed investments in education, transportation, and communications infrastructure are so amazingly beneficial that they swamp the negative impact of other bad aspects of our 1950s and 1960s policy paradigm.

Which makes sense to me. But I think we'll be waiting a long time for the followup post on the Cato blog about the need to spend lots of money on upgrading our air traffic control system, building a smart grids, building fiber-to-the-premises broadband networks, establishing a universal preschool program, upgrading Northeast Corridor passenger rail, and so forth. And yet that seems to be precisely the point. The politicial system is highly predisposed to spend tons of time arguing about tax rates. But even a really silly tax code—90 percent rates that don't raise any revenue!—was compatible with ultra-fast growth as long as other aspects of the policy mix were constantly pushing rapid improvements in education and rapid deployment of state-of-the-art technology in key sectors.

So the economy grew at a very high rate despite incredibly high marginal tax rates. Yet the economy shrank at a very high rate in 2008 despite pretty low rates and recent tax cuts by the Bush administration and a Republican congress. As Matt says, the economy seems to grow and shrink despite of, not because of, tax rates. They just don't seem to have a huge effect because there are other things that matter much more, such as investment in infrastructure and education.

In our current debate about taxes we aren't talking about huge tax increases and a return to 1950s marginal rates. We are talking about a return to Clinton era rates for income above $250k (it's only the income you make beyond $250, we all pay the same rates on the income levels below that). And as in the 1950s, the economy grew at a good rate during those higher tax Clinton years, higher than the lower tax Bush years.

So when politicians (even some Democrats) talk about this "fiscal curb" situation or any time they talk about the deficit/debt and spending, don't let them overhype the role marginal income tax rates play on the economy. Republicans fetishize it and really only care about rich people's rates while at the same time want to gut as much of the gov't as they can. So if you care about the gov't helping people I'd strongly advise not listening to them.

And some Democrats either just don't understand the fact that we won't go bankrupt if we deficit spend or don't care as much as the rest of us about entitlements. So if you hear those Democrats (Obama being one of them) being open to regressive cuts like raising social security's retirement age, don't listen to them either. We can continue to deficit spend in order to help those who need it or we can raise taxes to keep spending without increasing the deficit (which is also overhyped). Don't let them scare you with tax hype.