What Really Matters for Growth (It’s Not Tax Rates)

What Really Matters for Growth (It’s Not Tax Rates)

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When Republicans talk about economic growth, they tend to talk as if there is only one factor that affects it: tax rates. Thus, last week former Minnesota Gov. Tim Pawlenty, a candidate for the Republican presidential nomination, put forward an economic plan that he said would raise growth rate of the real gross domestic product to 5 percent per year from its historical level of about half that. His only specific proposal for achieving this ambitious goal was to slash tax rates on the wealthy.

Pawlenty would cut the top individual income tax rate from 35 percent to 25 percent, cut the corporate rate from 35 percent to 15 percent, and eliminate completely all taxation of capital gains, interest and dividends – the principal sources of income for the wealthy. Implausibly, Pawlenty asserted that despite reducing revenues by some $8 trillion over the next 10 years – from the lowest level of federal revenues as a share of GDP in 60 years – that his plan would balance the budget. I could find no data or analysis of how Pawlenty’s plan would actually achieve this goal.

My purpose today is not to criticize the particulars of Pawlenty’s plan, which is very much in the Republican mainstream, but rather to talk about the nature of economic growth and how one-dimensional the GOP view is. The truth is that economists know a lot about what causes growth and what policies will raise the growth rate, and tax rates have a far smaller role than most people and all Republicans believe.

To present the textbook view of what determines long-term economic growth, I turned to an actual textbook by Harvard economist Gregory Mankiw, who served as chairman of the Council of Economic Advisers for George W. Bush.

Mankiw begins by noting that economic growth is essentially a function of productivity – output per man-hour. How much a worker can produce is a function of several things: physical capital (machines, equipment, public infrastructure), human capital (education and training), natural resources (energy, land), and scientific and technological knowledge.

The key determinant of the amount of capital available to workers is saving – foregone consumption from current production. In general, more saving will lead to more investment, and more investment will raise productivity and growth.

Economists have spent many years trying to figure out how to increase the rate of saving, without much success. Insofar as individuals are concerned, their saving is largely determined by the need to save for retirement, get the down payment on a house, pay for their children’s education, and have a financial cushion for unforeseen circumstances. These are all things people would have to save for even if they got no return on their savings at all. Consequently, reducing the tax rate on saving is very unlikely to raise the personal savings rate. Research on the impact of tax-favored savings accounts, such as Individual Retirement Accounts and 401(k) plans, shows that people mostly shift their saving and don’t increase the total amount. Of vastly more importance, economically, is saving and investment by businesses and governments.

What matters for business investment is not the corporate tax rate, but the ultimate tax rate on capital including the tax on the corporation’s owners, the shareholders. In 2003, that was almost 58 percent – 35 percent at the corporate level and as much as 35 percent at the individual level. Now, that combined rate is at most 45 percent because in 2003 the tax rate on dividends was reduced to a maximum of 15 percent.

Unfortunately, there’s no evidence that the 2003 tax cut did anything to stimulate corporate investment. Indeed, according to the Federal Reserve, nonfinancial corporations have increased their holdings of liquid assets to $1.8 trillion from $1.2 trillion since 2003. Thus it’s implausible that a further reduction in the corporate rate, as Pawlenty and other Republicans favor, would do much to raise investment.

What is holding back business investment is not taxes, but poor economic prospects. For some time, members of the National Federation of Independent Business have listed “poor sales” as their number one problem. Businesses are not going to invest, no matter how low the tax rate is, if there is no demand for their output.

Government mainly affects savings not so much through tax rates as through the budget deficit, which constitutes negative saving. When government borrows, it takes funds out of the economy that would otherwise be available to finance domestic investment. Alternatively, the U.S. must borrow more from foreigners, which increases the trade deficit. In the national income and product accounts, the trade deficit is subtracted from GDP, thus lowering growth.

The bottom line is that neither taxes nor spending by themselves are the most important government contribution to the investment climate; it’s the budget deficit. Consequently, a reduction in tax revenue which raises the deficit is unlikely to stimulate domestic investment because more money will have to be borrowed from abroad. Conversely, a tax increase dedicated to deficit reduction could well be stimulative, as was the case with the 1982 and 1993 tax increases. Contrary to Republican dogma, rapid growth followed on both occasions.

A big cut in the budget deficit would be destabilizing in the short-run, but a reduction in the long-term deficit would free up more national saving for private investment. But if taxes are cut at the same time, as Republicans insist, then the economic consequences are ambiguous. With federal taxes at a historical low – they are currently just 14.8 percent of GDP versus a postwar average of about 18.5 percent – it’s implausible to argue that further tax cuts will stimulate growth. Indeed, there is good reason to think that undermining the government’s ability to raise revenue will raise prospects for future deficits, which will drain saving from the economy and reduce investment. For this reason, I am also very skeptical of the idea just floated by the White House to further cut the payroll tax.

If we want to raise the long-term rate of growth, we have to go back to the textbook and increase saving and investment, channel more public investment into education and basic infrastructure, and do everything in our power to promote scientific research and technological advancement. It’s not sexy and it takes a lot of time, but it works.

Related Links:
Tax the Rich: The Battle Cry Paul Ryan Rejects (The Fiscal Times)
GOP “No New Taxes” Position Is Rapidly Crumbling (The Fiscal Times)