And while the unemployment rate is reasonably
low, many Americans are worried about the future and fear their
children will be the first generation to have a lower standard of
living than its parents.
The economy's sub-par performance
has triggered a debate on how best to stimulate economic growth and
boost income. The good news is that all sides of the debate agree
that the key to economic growth is capital formation -- increasing
the levels of savings and investment (including investments in
human capital). The bad news, however, is that there is a
significant disagreement over the policy changes that will best
meet that goal. On one side are those who argue that high tax rates
dampen incentives and believe that correcting the anti-savings,
anti-investment bias of the current income tax code will improve
the economy's performance. The flat tax, they would argue, offers
the best opportunity to generate a substantial and positive impact
on job creation and income growth. The other side of the debate is
dominated by those who believe the most important variable is the
budget deficit. They argue that a lower budget deficit will lead to
significant reductions in interest rates and that lower interest
rates will spur higher levels of investment.
Finally, no discussion of economic
growth would be complete without addressing the size of government.
Regardless of whether it is financed through taxes or borrowing,
government spending represents a transfer of resources from the
private sector to the public sector. If government spends that
money in a way that generates a sufficiently high rate of return,
the economy will benefit. If the rate of return is below that of
the private sector, however, then the rate of growth will be slower
than it otherwise would have been.
Needless to say, the debate over
growth has important policy implications. Should taxes be increased
or decreased? Should the budget be balanced and, if so, how
quickly? Is the deficit the real problem, or is it a symptom of an
underlying problem of too much government? What is the impact of
tax reform? What types of government spending count as investment?
If certain policies increase growth, should that higher growth be
included in government economic and revenue estimates?
Careful analysis of the historical
and theoretical evidence yields three important conclusions that
can help guide policymakers as they focus on the nation's economic
- The tax system is taking too much money out of the productive
sector of the economy. Perhaps even more important, the structure
of the tax system is grossly flawed and imposes a particularly
steep penalty on the very behaviors -- saving and investing -- that
are needed to promote growth.
- Government borrowing is morally wrong because it imposes bills
on future generations,2 but the deficit should not drive
economic policy. Contrary to what both political parties argue,
there does not seem to be a strong relationship between the budget
deficit and interest rates. Nor is there much reason to believe
that lower interest rates, by themselves, will have a pronounced
effect on investment. Moreover, focusing on the deficit can
undermine sound economic policy by leading some to view higher
taxes as an appropriate policy option.
- Government spending is too high. Many programs fail to generate
an adequate rate of return (and many, such as welfare programs,
almost certainly have a negative return and have made things
worse). Not all government spending, needless to say, is dependent
on "rates of return," but legislators should fully understand that
funding programs with money that could be more productively used by
the private sector will result in less economic growth. Finally,
for those who do view the deficit as the key variable, there is
ample evidence that slowing the growth of spending -- not higher
taxes -- is the only way to achieve a balanced budget.
Why Capital Matters
As stated above, there is very
little controversy about what causes growth. There is
near-unanimous agreement that salaries and wages are linked closely
to productivity. The only way to raise the income of workers
permanently -- assuming no change in their skills -- is through
savings and investment. Simply put, workers are paid on the basis
of what they produce, and giving them better tools allows them to
produce more. The level of capital formation, for instance, largely
explains why workers in the United States, Germany, and Japan earn
more than workers in Brazil, India, and Nigeria. Similarly, workers
in America today earn more than their parents because of net
investment (increases in the capital stock). As a result, they are
more productive, generating more output per hour of labor.
Economists of all persuasions
recognize this relationship between investment and wages. Paul
Samuelson, for example, a Nobel Laureate economist who endorsed
Bill Clinton for President, has written:
What happens to the wage rate now that each person
works with more capital goods? Because each worker has more capital
to work with, his or her marginal product rises. Therefore, the
competitive real wage rises as workers become worth more to
capitalists and meet with spirited bidding up of their market wage
Another example is taken from a 1991
report on economic growth prepared by the staff of the Joint
Committee on Taxation, then controlled by the Democrats:
When an economy's rate of net investment (gross
investment less depreciation)4 increases, the economy's
stock of capital increases. A larger capital stock permits a fixed
amount of labor to produce more goods and services. The larger a
country's capital stock, the more productive its workers and,
generally, the higher its real wages and salaries. Thus, increases
in investment tend to cause future increases in a nation's standard
According to a 1989 report on
economic growth published by the Congressional Research
Capital deepening has been and will likely continue to
be a central force for accelerating growth and potential output
over the medium term. But as we have seen, a permanent increase in
the long-term rate of growth will hinge on the United States'
ability to increase the pace of technical advance and innovation.
However, both of these routes to faster growth will be contingent
upon the ability to increase the level of investment spending --
more spending for capital equipment and more spending for research
and development. To finance higher investment will, in turn,
require that Americans raise the national rate of
Or consider the views of the White
House. In the 1994 Economic Report of the President, the
Administration noted that:
The reasons for wanting to raise the investment share
of the GDP [gross domestic product] are straightforward: Workers
are more productive when they are equipped with more and better
capital, more productive workers earn higher real wages, and higher
real wages are the mainspring of higher living standards. Few
economic propositions are better supported than these -- or more
Competing Theories of Growth
Every economic school of thought --
even Marxism -- agrees that capital formation is the key to rising
living standards. This happy consensus, however, does not translate
into agreement about how to spur more savings and investment. In
the political economic debate, at least in America, there are
basically three (actually two and one-half) views on how to promote
economic growth. These are:
- Old-Fashioned Keynesianism. This is the half-theory
because it has so few adherents in America. In periods of economic
sluggishness, Keynesians believe the government should increase
spending, financed by borrowing, to give the economy a shot in the
arm. This spending is supposed to stimulate aggregate demand, which
causes private sector behavior to perk up. With a handful of
exceptions, such as the failed 1993 stimulus bill, this approach
does not receive much attention in Washington.
- 1950s Republican/1990s Democrat Balanced Budget
Orthodoxy. The title is made up because this school of thought
does not really have a name. Proponents of this approach, which is
dominant in Washington, believe that the economy hinges on changes
in the budget deficit. Contrary to old-fashioned Keynesianism,
however, this orthodox approach argues that reducing the budget
deficit is the key to economic growth. The theory works as follows:
A lower budget deficit leads to lower interest rates, lower
interest rates lead to more investment, more investment leads to
higher productivity, and higher productivity means more growth.
Although some of the proponents favor smaller government as a
philosophical goal, the balanced budget crowd does not think taxes
have a major effect on incentives to engage in productive behavior.
As a result, they are skeptical of tax cuts and instead are willing
to raise taxes.
- The Free Market. Another made-up title because other
options -- supply-side, conservative, classical liberal -- do not
capture the central tenet, the free-market approach believes that
the keys to economic growth, at least in terms of fiscal policy,
are the size of government and the structure of the tax system. In
short, the free-market approach believes that total spending,
regardless of whether it is financed by taxes or borrowing, hinders
the economy's performance by transferring scarce resources from
those in the private sector who have incentives to use them wisely
to politicians and bureaucrats who oftentimes respond to political
incentives. Because the size of government matters, free market
advocates would prefer a government with a $1 trillion budget and a
$200 billion deficit to a government with a $2 trillion budget that
was balanced. On the tax side of the ledger, free market supporters
believe taxes affect incentives to work, save, and invest. A major
goal of these folks, therefore, is radical tax reform designed to
minimize tax rates and eliminate multiple taxation of capital.
These reforms, it is believed, will boost capital formation, which
will increase productivity, which means faster economic
Who Is Right?
The policy debate in Washington
largely revolves between Options 2 and 3 (though there is also a
fight amongst supporters of Option 2 over the size of government --
Should the budget be balanced at level "X" or level "X+Y?").
Stripping away much of the rhetoric, the victor in this struggle
depends on which set of relationships is more robust:
Are balanced budget proponents right that interest rates will
fall significantly once deficit spending comes to an end? And are
they correct in believing that investment is very sensitive to
Are free market supporters correct in believing that there is an
inverse relationship between economic growth and the size of
government? Even more important, are they accurate in stating that
decisions to work, save, and invest are significantly altered by
the tax code?
In some sense, both sides are right.
Unless economists want to repeal the laws of supply and demand,
there can be no doubt that lower budget deficits will lower
interest rates. And, all other things being equal, lower interest
rates should mean more investment. It is also unambiguously true
that lower taxes will reduce the price of providing labor and
capital to the economy. And it is certainly accurate to note that a
large government, by reducing the cost of not working, will
adversely affect the economy's performance.
The real question is the magnitude
of these effects. Would balancing the budget really reduce interest
rates by two percentage points? Is the level of investment
primarily driven by the interest rate? Just how sensitive are
decisions to work, save, and invest to the rate of taxation? To
what extent do government spending programs actually undermine work
Doubts Regarding Balanced Budget
There is ample reason to question
the robustness of the interest rate argument. According to the
theory, lower budget deficits should result in lower interest
rates. Yet there is little evidence to suggest that interest rates
are significantly affected by changes in the U.S. budget deficit.
This does not mean that the laws of supply and demand have been
repealed. It simply means that in world capital markets, a shift of
$30 billion, $40 billion, or $50 billion is unlikely to have a
dramatic effect and can easily be overwhelmed by other factors such
as monetary policy and demand for credit. 7
Even if interest rates fall by a
significant amount, the second link in the balanced budget chain of
reasoning is very weak. Yes, interest rates must affect investment
choices, but it appears that this variable is dwarfed by other
influences.8 Why invest, for instance, if there is no
hope of making a profit? Real interest rates were negative during
the 1930s in America, yet investment was moribund because investors
did not see many opportunities to earn an adequate rate of return.
Likewise, real interest rates were high in America during much of
the 1980s, yet investment rose because people saw ways to make
money. Moreover, since a large portion of investment is
self-financed on the part of business, it is difficult to see how
interest rates would have a dramatic impact.
All things being equal, it is a good
idea to balance the budget. And, yes, lower interest rates will
promote investment. Balancing the budget, however, is not a silver
bullet for the economy. This approach is especially short-sighted
if it is used as a reason to raise taxes or block pro-growth tax
cuts. As the following section illustrates, changes in tax policy
can have a pronounced effect on the economy's performance.
Why Free Market Supporters Are Right
About Taxes and Capital Formation
The attached appendices provide a
sampling of empirical work on the impact of taxes. To put that work
in context, however, it is useful to walk through an example
illustrating just how heavy the tax burden is on savings and
investment. Between personal income taxes, corporate income taxes,
capital gains taxes, and estate taxes, a single dollar of
investment income can be subject to as many as four layers of tax
in America. Added to that burden are provisions of the law, such as
depreciation and the alternative minimum tax, which force taxpayers
to overstate their income. Adding insult to injury is the heavy
compliance cost of the current system.
The following example illustrates
why savings and investment suffer in the current tax climate. A
taxpayer has $100 of income and must decide what to do with it. He
can consume the $100, spending it on food, vacations, clothing,
haircuts, or some other product or service, in which case (with the
exception of possible sales taxes) he will receive close to $100 in
goods and services for his money. Or he can invest in the stock of
a start-up company with the potential to provide new jobs to the
community and produce goods that consumers desire. If the company
succeeds, the investor most likely will profit. If it fails, he
will lose his $100.
In this case, the investment bears
fruit and yields a 10 percent rate of return, enabling the company
to produce $10 of annual income for every $100 invested. Under the
current tax code, 35 percent is skimmed off to pay the corporate
income tax, leaving only $6.50 out of the original $10. This $6.50
then goes to the investor as a dividend. But there are other taxes.
Depending on the investor's income, the personal income tax will
take as much as 39.6 percent of his $6.50, leaving him with less
than $4.00 of annual income from a "successful" $100 investment. In
addition, he may face applicable state and local income taxes.
Finally, if the investor ever
decides to sell the stock, he will be hit by one of the highest
capital gains taxes in the industrialized world. To make a bad
situation even worse, he will be taxed on the nominal gains, often
meaning that taxes are paid on assets that have lost value in real
terms (and do not forget that the person who sold him the stock
originally may have been subject to capital gains taxes on that
sale). The final insult is the estate and gift tax. Successful
entrepreneurs who try to accumulate an estate to pass on to their
children are penalized by inheritance taxes which can confiscate 55
percent of a deceased's assets.
Thanks to the tax code, a fortunate
investor -- one who actually earns money on his investments -- may
have to send more than 80 percent of his earnings to the
government, not to mention having already paid taxes on the money
used for the investment in the first place. Thus, government tax
policy has created a very tilted playing field. By punishing saving
and investment, the tax code encourages both individuals and
businesses to consume rather than to build for America's
Since taxes have such a dramatic
impact on incentives to work, save, and invest, it should come as
no surprise that major tax changes almost always have a significant
impact on the economy. Herbert Hoover's decision in 1930 to
increase the top tax rate from 25 percent to 63 percent certainly
contributed to the Depression. Lyndon Johnson's surtax on income
tax liabilities, enacted in 1968, together with an increase in the
capital gains tax helped end the 1960s expansion. Large tax
increases, including inflation-induced bracket creep, contributed
to the economy's dismal performance under Jimmy Carter. George
Bush's record tax increase in 1990 was a principal cause of the
recent recession and subsequent anemic recovery. And the sub-par
performance of today's economy, particularly the decline in median
household income, almost certainly is attributable in part to the
record tax increase pushed through Congress in 1993 by Bill
The Answer: The Flat Tax
Each of the tax code's many
shortcomings can be addressed by targeted legislation, but a far
better approach is simply to replace the existing system with a
flat tax. There have been many flat tax proposals over the years,
but they all share certain key features. These are:
- One low tax rate. All flat tax proposals have a single
tax rate that applies to all income subject to tax. The actual rate
imposed varies, but the upper limit would be about 20 percent. The
Armey-Shelby flat tax legislation, for instance, begins with a 20
percent rate which phases down to 17 percent after a couple of
- Tax income only once. Flat tax proposals are designed to
eliminate the tax code's bias against capital formation by ending
the double- (and sometimes triple- and quadruple-) taxation of
income generated through savings and investment. The key principle
is that the tax code not discriminate against income that is used
for savings and investment as opposed to income that is
- Elimination of deductions, credits, and exemptions. All
pure flat tax proposals eliminate provisions of the tax code that
bestow preferential tax treatment on certain behaviors and
activities. Included in this would be special tax breaks for
businesses and corporations and, for individual taxpayers, the home
mortgage interest deduction, the charitable contributions
deduction, and the state and local mortgage interest deduction.
Eliminating these "loopholes" solves the problem of complexity,
allowing taxpayers to file their tax returns on a postcard-sized
Benefits of a Flat Tax
By addressing the many problems of
the existing tax code in one fell swoop, the flat tax would have an
immediate and dramatic positive impact. Included among the benefits
- Faster economic growth. A flat tax would spur increased
work, saving, and investment. According to many economists, the
rise in productive behavior would likely add one percentage point
to the annual rate of economic growth. How significant is this? An
increase in the growth rate of just one-half of one percentage
point would boost an average family of four's yearly income by more
than $5,000 after ten years.
- Instant wealth creation. Eliminating the second, third,
and fourth layers of taxation on capital income would significantly
boost the value of all income-producing assets. According to
Professor Dale Jorgenson of Harvard University, enactment of a flat
tax would immediately boost wealth by some $1 trillion.
- Simplicity. The 600-plus tax forms of the current system
would be swept into the trash and replaced by two simple
postcard-sized forms. Wage, salary, and pension income would be
reported on the individual form and business and capital income
would be reported on the business form. Neither form would require
more than a few minutes to complete, substantially reducing the 5.4
billion-hour yearly burden of today's tax code.
- Fairness. All taxpayers and all income would be treated
equally. A taxpayer with ten times the taxable income of his
neighbor would pay ten times as much in taxes. Successful
entrepreneurs no longer would be penalized by discriminatory tax
rates, and no longer would the politically well-connected by able
to benefit from special loopholes and preferences.
- An end to micromanagement and political favoritism. All
deductions, credits, exemptions, loopholes, and preferences would
be eliminated under a flat tax. Politicians would lose their
ability to pick winners and losers, reward friends and punish
enemies, use the tax code to impose their values on the economy.
Investment decisions would be guided by economic forces rather than
- Increased civil liberties. The complexity of the tax
code makes it nearly impossible for either taxpayers or IRS agents
to follow the law. A greatly simplified tax code would eliminate
virtually all of the conflicts and controversies that make the IRS
one of the most feared agencies of the federal government.
The Spending Problem
While current tax policy represents
a huge impediment to economic growth, policymakers also must focus
on the size of government. To the extent that politicians and
bureaucrats do not spend money as wisely or efficiently as it would
be spent in the private sector, economic growth will lag as
government increases in size. More specifically, many government
programs do not generate benefits (or minimize costs) to the
economy that exceed those which would have occurred had the money
remained in private hands.
The appropriate approach for
policymakers is to determine whether spending for a given program
will yield enough benefits to offset the loss of the money to the
private sector (including the incentive and compliance costs of
collecting taxes). A certain level of transportation spending, for
instance, will facilitate economic growth by permitting the
efficient flow of goods and services. Policymakers should debate,
of course, whether the spending could be privatized or conducted at
the state and local level. And to the extent they believe it has to
be conducted by Washington, they should do their best to ensure
that funding is allocated according to sound guidelines rather than
pork-barrel politics. Other types of spending, such as crime
prevention, also may help the economy by reducing the cost of
In too many cases, however, there is
strong reason to believe that the federal government is spending
money in ways that do not produce good results for the economy.
Some programs, such as welfare, reduce the cost of not working and
inevitably undermine productive economic behavior. Other types of
spending, such as the budgets for regulatory agencies, can have
significantly negative rates of return because of the heavy costs
they impose on the private sector. Unfortunately, policy makers
usually do not subject government programs to this type of
Note that one important conclusion
from using this approach is that the deficit is not the critical
variable. The key is the size of government, not how it is
financed. Taxes and deficits are both harmful, but the real problem
is that government is taking money from the private sector and
spending it in ways that often are counter-productive. As a result,
fiscal policy should focus on reducing the level of government
spending, with particular emphasis on those programs that yield the
lowest benefits and/or impose the highest costs. The importance of
reducing spending, it should be noted, exists regardless of whether
the budget happens to be balanced and is not contingent on changes
in the tax system (just as reforming the tax system and adopting
other pro-growth tax changes should not be contingent on what
happens to the spending side of the ledger).
There is no magic formula to boost
growth. The economy can only grow if people work more or work
better. Unfortunately, much of the world has adopted policies that
impose increasingly steep tax penalties on those who add to the
economy's wealth. Compounding the damage of these policies are
spending programs that shield people from taking responsibility for
their own lives. The combination has been an unmitigated
This raises a particularly important
issue for those on the left. They must decide what is more
important: keeping a tax system that may satisfy an ideological
impulse to punish success, or adopting a system that helps boost
the living standards of the less fortunate. It is certainly true
that modest reforms like reducing the tax rate on capital gains or
big reforms like the flat tax will boost after-tax income of the
rich. The empirical evidence, however, shows that other income
classes will benefit as well -- and may benefit even
Critics of tax reform complain that
it is nothing more than "trickle-down" economics that relies on tax
cuts for the "rich" to boost wages. Such rhetoric may be useful
politically, but it cannot change economic reality. Economist John
Shoven has explained:
The mechanism of raising real wages by stimulating
investment is sometimes derisively referred to as "trickle-down"
economics. But regardless of the label used, no one doubts that the
primary mechanism for raising the return to work is providing each
worker with better and more numerous tools. One can wonder about
the length of time it takes for such a policy of increasing saving
and investments to have a pronounced effect on wages, but I know of
no one who doubts the correctness of the underlying mechanism. In
fact, most economists would state the only way to increase
real wages in the long run is through extra investments per
For a profession usually chided for
its lack of agreement, economists are nearly unanimous in their
recognition that capital formation is the key to economic growth.
Policymakers seeking to boost living standards and take-home pay
face two competing options for how best to achieve the goal of more
savings and investment: Should they focus on the deficit or should
they shrink the size of government and reform the tax system? While
these goals need not conflict, to the extent there is a division,
there should be little doubt that a myopic fixation on the deficit
will not necessarily produce the right policy results. Adopting a
flat tax, by contrast, combined with long-overdue reductions in the
level of government spending, will generate the desired outcome of
a more prosperous economy.
Taxes Affect Decisions to Work
Joint research by economists from
Princeton University and Brigham Young University, based on a
random survey of physicians, found that a one percentage point
increase in marginal tax rates is associated with a reduction of as
much as 1.11 percent in hours worked.11
A University of California economist
found that because of the Tax Reform Act of 1986 (which lowered tax
rates), the work effort of high-income married women rose by 0.8
percent for every one percent their after-tax wages
Another economist found that
"Husbands of retirement age, 60 and over, show substantial
variation in hours of work, related systematically to wages and
income in the expected way." Moreover, "Wives in all age groups are
quite sensitive to wages and income."13 In other words,
as after-tax income falls, so does the incentive to work.
Two other economists estimated that
"wives' labor supply will increase by 3.8 percent" in response to a
reduction in the marriage penalty.14
A comprehensive study in The
Journal of Human Resources found that taxes reduce married
males' hours of work by 2.6 percent and married females' by between
10 percent and 30 percent.15
According to a statistical study in
Econometrica, yearly hours of work for white married women
increase by 2.3 percent for every one percent increase in after-tax
While husbands are not as sensitive
to taxes as wives, the impact of taxes on their behavior is
nonetheless dramatic. One study found that they work eight percent
less than they would in the absence of taxes.17 This
indicates a loss in economic output of at least $1,000 per
All studies acknowledge that higher
after-tax incomes increase incentives to work by increasing the
"price" of leisure, but some assume this effect is offset because
lower taxes allow workers to achieve a certain level of income by
working fewer hours. While this trade-off is relevant when looking
at individual choices, two economists note that "the generalization
of the individual analysis to the economy as a whole is invalid"
because "It will be impossible for all individuals to consume both
more goods and more leisure as the individual work-leisure analysis
implies."19 The actual economy-wide response to changes
in tax rates will be higher than almost all studies
One econometric model found that a
one percent reduction in tax rates increased work effort for
lower-income workers by 0.1 percent, for middle and
upper-middle-income workers by 0.25 percent, and for upper-income
workers by more than 2.0 percent.21
Taxes Reduce Savings and Investment
In a book on taxes and capital
formation, Norman B. Ture and B. Kenneth Sanden noted, "The bias
against saving in the present tax system results from the fact
that, with few exceptions, taxes are imposed both on the amount of
current saving and on the future returns to such saving, whereas
the tax falls only once on income used for
Economist John Shoven estimates that
a reduction of 20 percent in the top rate for capital gains would
cause the stock market to rise by 3 percent.23
Undersecretary of the Treasury
Lawrence H. Summers has written that "increases in the real
after-tax rate of return received by savers would lead to
substantial increases in long-run capital accumulation." Further,
"bequests may account for a large fraction of national capital
formation," which strengthens the argument that taxes influence
A study in The American Political
Science Review noted that "Nations... where the extractive
[tax] capacity of government did not significantly increase,
relative to the economic product, have, in a sense, opted for... an
increasing rate of private capital accumulation."25
Analyzing the decline in savings, a
study by three experts concluded that Social Security and other
transfer programs have led to a "decline in U.S.
Two other economists also concluded
that Social Security reduces savings because workers no longer
worry as much about retirement.27
Econometric results, according to a
study published in the Journal of Public Economics, "suggest
that dividend taxes have important effects on investment decisions"
and that "an increase of 10 percent in the stock market would raise
the investment rate by about 15 percent."28
Writing in the National Tax
Journal, three economists found "significant effects for the
after-tax return on saving, after-tax cost of borrowing, or both."
The Reagan tax cuts "had a major impact on U.S. economic
Growth Is Weaker When Government Penalizes Economic
A 1983 World Bank study of 20
countries found that low-tax nations experience faster growth,
generate more investment, and enjoy more rapid increases in
productivity and standards of living than high-tax
The tax system imposes between 22
cents and 54 cents of losses for every dollar raised, according to
a labor-supply economist. For working wives, the losses are even
higher: more than 58 cents for very dollar of tax
Another study found that each 1.0
percent increase in the federal tax burden reduces economic growth
by 1.8 percent and lowers national employment by 1.14
According to a statistical study
published in the American Economic Review, for every dollar
paid to the federal government in taxes, 33.2 cents is lost to the
The increased tax burden between
1965 and 1980 drove an estimated 1.9 million people out of the U.S.
Statistical research published in
Lloyd's Bank Review has found that in the U.K. each one
percent rise in payroll taxes causes hiring to fall by
approximately 1.4 percent. The same study estimated that each $1 of
additional tax revenue costs $3 in lost economic
A study printed in the American
Sociological Review concluded that "Increases of one percent in
the tax burden relative to household income are directly associated
with a 2.8 percent decline in economic growth over three years, or
just under one percent annually."36
An American Economic Review
study found that every dollar of taxes could impose as much as $4
of lost output on the economy, with the probable harm ranging
between $1.32 and $1.47.37
A 1981 analysis of the Swedish
economy in the Journal of Political Economy found "The
estimated long-run effects [of high marginal tax rates] are
sufficient to explain up to 75 percent of the recent decline in the
measured growth of the Swedish GNP."38
According to a former Treasury
Department official, between 75 percent and 80 percent of the
additional wealth generated by increased savings and investment
goes to workers.39
Another study in the Journal of
Political Economy estimated that the corporate income tax costs
more in lost output than it raises for the government. The "excess
burden" is "123 percent of revenue."40
A 1984 study in the American
Economic Review estimated "20.7 cents of welfare loss per
additional dollar of tax revenue."41
A study of U.S. taxes at the state
level found that low-tax states grew 35 percent faster than
high-tax states between 1970 and 1980.42 The
relationship between growth and taxes among the states has been
shown in literally dozens of studies.43
Another economist was able to
illustrate a very strong inverse relation between average per
capita growth rates and average tax rates on income and profits in
According to an article in the
Journal of Political Economy, based on worldwide data,
increasing the tax burden by ten percentage points will reduce
annual growth by two percentage points.45
In a paper presented at the World
Bank, two economists uncovered an "impressive negative relation
between the rate of growth and the ratio of tax revenue to GDP" as
well as a "negative association between growth and... the
'marginal' income tax rate."46
Of the explosive growth of Hong
Kong, Taiwan, Singapore, and South Korea, Hoover economist Alvin
Rabushka has written that
The four Asian tigers adopted supply-side tax policies
decades before the Reagan and Thatcher revolutions. Finance
ministers oversaw systems of taxation that featured low rates
and/or low levels of direct taxation of individuals and businesses,
the absence of or very light charges on capital income (interest,
dividends, capital gains), and a smorgasbord of inducements for
domestic and foreign enterprises to invest and reinvest in each
Other studies have found that the
economy is harmed when government spends tax revenue:
A National Bureau of Economic
Research study, using worldwide data, found that an increase "in
government spending and taxation of 10 percentage points was
predicted to decrease long-term growth rates by 1.4 percentage
According to Daniel Landau, "The
results of this study [published in the Southern Economic
Journal] suggest a negative relationship exists between the
share of government consumption expenditure in GDP and the rate of
growth of per capita GDP."49
Two economists found that increases
in U.S. government outlays for social programs "are associated with
reductions in the growth rate."50
U.S. Bureau of the Census Current
Population Reports: Series P60-189, "Income, Poverty, and Valuation
of Non-Cash Benefits: 1994," (Washington, D.C.: U.S. Government
Printing Office, 1996).
This moral argument is less
stringent if the debt was incurred to win a war or for some other
purpose which presumably yields benefits to future
Paul A. Samuelson and William D.
Nordhaus, Economics, 12th Edition (New York: McGraw-Hill,
Inc., 1985), p. 789.
Depreciation refers to the amount of
capital that is used up or wears out during each period. For
instance, a machine may have a life expectancy of five years. In
order to measure increases in the capital stock accurately,
increases in investment should be adjusted to reflect
"Tax Policy and the Macroeconomy:
Stabilization, Growth, and Income Distribution," Joint Committee on
Taxation report for House Committee on Ways and Means, December 12,
1991, p. 21.
Craig Elwell, "The Goal of Economic
Growth: Lessons from Japan, West Germany and the United States,"
Congressional Research Service, July 17, 1989.
For a complete discussion of the
scholarly research on deficits and interest rates, see "Government
Deficit Spending and Its Effects on Prices of Financial Assets,"
Department of the Treasury, May 1983.
Aldona Robins, Gary Robins, and Paul
Craig Roberts, "The Relative Impact of Taxation and Interest Rates
on the Cost of Capital," in Dale Jorgenson and Ralph Landau, eds.,
Technology and Economic Policy (Cambridge, Mass.: Bellinger
Barry J. Seldon and Roy G. Boyd,
"The Economic Effects of a Flat Tax (Draft)," National Center for
Policy Analysis, Dallas, Texas (forthcoming).
John B. Shoven, "Alternative Tax
Policies to Lower the U.S. Cost of Capital," in Business Taxes,
Capital Costs and Competitiveness, American Council for Capital
Formation Center for Policy Research, July 1990, p. 3.
Mark Showalter and Norman K.
Thurston, "Taxes and Labor Supply of High-Income Physicians,"
unpublished manuscript, October 21, 1994.
Nada Eissa, "Taxation and Labor
Supply of Married Women: The Tax Reform Act of 1986 as a Natural
Experiment," unpublished manuscript, September 1994.
Robert E. Hall, "Wages, Income, and
Hours of Work in the U.S. Labor Force," in G. Cain and H. Watts,
eds., Income Maintenance and Labor Supply (Chicago: Markham,
Jerry Hausman and Paul Ruud, "Family
Labor Supply with Taxes," American Economic Review, Vol. 74,
No. 2 (May 1984), pp. 242-248.
Robert K. Triest, "The Effect of
Income Taxation on Labor Supply in the United States," The
Journal of Human Resources, Vol. XXV, No. 3, pp. 491-516.
Harvey S. Rosen, "Taxes in a Labor
Supply Model with Joint Wage-Hours Determination,"
Econometrica, Vol. 44, No. 3 (May 1976), pp. 485-507.
Jerry Hausman, "Labor Supply," in
Henry J. Aaron and Joseph A. Pechman, eds., How Taxes Affect
Economic Behavior (Washington, D.C.: The Brookings Institution,
1981), pp. 27-83.
Robert E. Hall and Alvin Rabushka,
Low Tax, Simple Tax, Flat Tax (New York: McGraw-Hill Book
James Gwartney and Richard Stroup,
"Labor Supply and Tax Rates: A Correction of the Record,"
American Economic Review, Vol. 73, No. 3 (June 1983), pp.
This is confirmed by other
economists. See, for example, Paul Craig Roberts, "The Breakdown of
the Keynesian Model," The Public Interest, No. 52 (Summer
1978), pp. 20-33; Norman B. Ture, "The Economic Effects of Tax
Changes: A Neoclassical Analysis," in Richard H. Fink, ed.,
Supply-Side Economics: A Critical Appraisal (Frederick, Md.:
University Publications of America, 1982); and William G. Laffer,
"Virtues and Deficiencies of Supply-Side Economics Viewed From an
Austrian Perspective," unpublished manuscript, September 28,
Michael K. Evans, "New Developments
in Econometric Modelling: Supply-Side Economics," in Fink,
Supply-Side Economics: A Critical Appraisal.
Norman B. Ture and B. Kenneth
Sanden, The Effects of Tax Policy on Capital Formation
(Washington, D.C.: Institute for Research on the Economics of
Shoven, "Alternative Tax Policies to
Lower the U.S. Cost of Capital."
Lawrence H. Summers, "The After-Tax
Rate of Return Affects Private Savings," American Economic
Review, Vol. 74, No. 2 (May 1984), pp. 249-253.
David Cameron, "The Expansion of the
Public Economy: A Comparative Analysis," The American Political
Science Review, Vol. 72 (1978), pp. 1243-1261.
Jagadeesh Gokhale, Laurence J.
Kotlikoff, and John Sabelhaus, "Understanding the Postwar Decline
in United States Saving: A Cohort Analysis," unpublished
manuscript, November 1994.
Lawrence H. Summers and Chris
Carroll, "Why Is United States National Saving So Low,"
Brookings Papers on Economic Activity, Vol. 2 (1987), pp.
James M. Poterba and Lawrence H.
Summers, "Dividend Taxes, Corporate Investment, and 'Q',"
Journal of Public Economics 22 (1983), pp. 135-167.
Allen Sinai, Andrew Lin, and Russell
Robins, "Taxes, Saving, and Investment: Some Empirical Evidence,"
National Tax Journal, Vol. XXXVI, No. 3 (1983), pp.
Keith Marsden, "Links Between Taxes
and Economic Growth: Some Empirical Evidence," World Bank Staff
Working Paper No. 605, 1983.
Hausman, "Labor Supply."
William C. Dunkelberg and John
Skorburg, "How Rising Tax Burdens Can Produce Recession," Cato
Institute Policy Analysis No. 148, February 21, 1991.
C. L. Ballard, J. B. Shoven, and J.
Whalley, "General Equilibrium Computations of the Marginal Welfare
Costs of Taxes in the United States," American Economic
Review, Vol. 75, No. 1 (1985), pp. 128-138.
Otto Eckstein, "Tax Policy and Core
Inflation, A Study Prepared for the Use of the Joint Economic
Committee" (Washington, D.C.: U.S. Government Printing Office,
1980). See also L. Godfrey, "Theoretical and Empirical Aspects of
the Effects of Taxation on the Supply of Labour" (Paris:
Organization for Economic Cooperation and Development, 1975).
Michael Beenstock, "Taxation and
Incentives in the U.K.," Lloyd's Bank Review, No. 134
(October 1979), pp. 1-15.
Roger Friedland and Jimy Sanders,
"The Public Economy and Economic Growth in Western Market
Economies," American Sociological Review, Vol. 50 (August
1985), pp. 421-437.
Edgar K. Browning, "On the Marginal
Welfare Cost of Taxation," American Economic Review, Vol.
77, No. 1 (March 1987), pp. 11-23.
Charles E. Stuart, "Swedish Tax
Rates, Labor Supply, and Tax Revenues," Journal of Political
Economy, Vol. 89, No. 5 (1981), pp. 1020-1038.
Norman B. Ture, "Supply Side
Analysis and Public Policy," in David G. Raboy, ed., Essays in
Supply Side Economics (Washington, D.C.: Institute for Research
on the Economics of Taxation, 1982).
Jane G. Gravelle and Laurence J.
Kotlikoff, "The Incidence and Efficiency Costs of Corporate
Taxation When Corporate and Noncorporate Firms Produce the Same
Good," Journal of Political Economy, Vol. 97, No. 4 (1989),
Charles Stuart, "Welfare Costs per
Dollar of Additional Tax Revenue in the United States," American
Economic Review, Vol. 74, No. 3 (June 1984), pp. 352-362.
Richard K. Vedder, "Rich States,
Poor States: How High Taxes Inhibit Growth," Journal of
Contemporary Studies, Fall 1982, pp. 19-32.
See Bruce Bartlett, "Impact of State
and Local Taxes on Growth: Bibliography," Alexis de Tocqueville
Institution, 1995, and Richard K. Vedder, "Do Tax Increases Harm
Economic Growth and Development?" Arizona Issue Analysis,
Report No. 106, September 20, 1989 (Annotated Bibliography).
Charles Plosser, "The Search for
Growth," unpublished manuscript, August 1992.
Robert G. King and Sergio Rebelo,
"Public Policy and Economic Growth: Developing Neoclassical
Implications," Journal of Political Economy, Vol. 98
(October 1990), pp. S126-S150.
William Easterly and Sergio Rebelo,
"Fiscal Policy and Economic Growth: An Empirical Investigation,"
unpublished manuscript, March 1993.
Alvin Rabushka, "Tax Policy and
Economic Growth in the Four Asian Tigers," Journal of Economic
Growth, Vol. 3, No. 1.
Eric M. Engen and Jonathan Skinner,
"Fiscal Policy and Economic Growth," National Bureau of Economic
Research, Working Paper Series, No. 4223, December
Daniel Landau, "Government
Expenditure and Economic Growth: A Cross-Country Survey,"
Southern Economic Journal, Vol. 49 (January 1983), pp.
John McCallum and Andre Blais,
"Government, Special Interest Groups, and Economic Growth,"
Public Choice, Vol. 54 (1987).
Even assuming the Clinton Administration's forecast for this
year is accurate, the United States economy's performance since
1989 will have been the worst seven-year period since the end of
World War II. Adjusted for inflation, median household income has
declined by 6.6 percent since Ronald Reagan left