The Heritage Foundation

Executive Summary #2095 on Taxes

February 25, 2008

February 25, 2008 | Executive Summary on Taxes

Executive Summary: Tax Hikes, Economic Clouds, and Silver Linings: A Review of Deficits and the Economy

Taxes harm the economy. Traditionally, those with a bias toward bigger government argue that the injury is minor and worth the societal benefits from increased spending or lower deficits. Those inclined toward smaller government argue that the injury is generally greater. In contrast, a new silver lining argument suggests that higher taxes may be benign and possibly even beneficial to economic growth. As with most fads, this too will pass.

Beyond the year-in, year-out wrestling over the annual federal budget, the pending calamity in Social Security and Medicare finances has made the economic effects of taxes a topic of great concern. These entitlement programs are vital to America's seniors but are unaffordable and unsustainable in their current forms. The options are limited: Con­gress must pare benefit growth, raise taxes, or enact some combination of the two--all in large amounts. Liberals commonly propose solving the shortfalls by raising taxes, but higher taxes would signifi­cantly shrink the economy and force American tax­payers to pay twice to close the funding gap--once in higher taxes and again through lower wages from a weaker economy.

Empirical evidence strongly supports the tradi­tional view that higher taxes are bad for the econ­omy. Yet taxes affect economic activity through many channels, and some evidence suggests that higher taxes can help the economy very modestly through one channel that relates higher taxes to lower interest rates and ultimately to higher invest­ment levels. Advocates of higher taxes sometimes emphasize this silver lining, ignoring the many bad effects of taxation.

This paper considers the relationship between taxation and the economy from three perspectives: the historical record, the economic and revenue feedback effect, and the silver lining theory.

The Dark Clouds. In a recent study, Christina Romer and David Romer, professors of economics at the University of California at Berkeley, examined significant tax changes and the ensuing economic performances during the postwar period and found strong evidence that higher taxes tend to diminish economic activity. A study by Greg Mankiw and Matthew Weinzierl of Harvard University sheds additional light on the question. They found that reducing taxes on labor significantly improved eco­nomic performance, and reducing taxes on capital had an even stronger beneficial effect.

These two studies confirm the conventional wis­dom that higher taxes diminish economic vitality, and they arrived at their common conclusion from very different approaches.

The Silver Lining Theory of Higher Taxes. The opposing argument is that higher taxes lead to an increase in national saving, which in turn puts downward pressure on real interest rates, leading to higher levels of national investment and output. This narrow yet plausible argument rests on a chain of testable economic relationships:

The argument's strength is that only one link-- increased national saving leads to lower real interest rates--is controversial, but every link must be valid for the narrow argument to hold. The links must also be robust for the theory to be relevant. Other­wise, the broader range of negative effects from taxes would overwhelm the narrow positive effect from higher taxes. Advocates naturally focus on the possible silver lining, ignoring the dark clouds of negative economic effects.

Eric Engin of the National Bureau of Economic Research and Glenn Hubbard, Dean of the Colum­bia Business School, recently examined the histori­cal record of government debt and interest rates. Using a theoretical framework relating government debt, investment levels, and real interest rates, Engin and Hubbard found a slight positive relation­ship between federal debt and interest rates. An increase in federal government debt of 1 percent of gross domestic product (GDP) would increase the long-term real interest rate by only about 3 basis points, or 0.03 percentage points.

A study by Thomas Laubach at the Federal Reserve found a similar result by looking at the effects of projected fiscal policies on longer-horizon interest rates rather than current levels of long-term interest rates. Laubach found that a 1 percentage point increase in the projected debt-to-GDP ratio would be expected to raise future interest rates by about 4 to 5 basis points.

Together, the two studies suggest a developing consensus that deficit reduction has a very slight effect on real interest rates and therefore would not appreciably affect the level of economic activity.

Tax changes affect the economy through many channels. The silver lining theory emphasizes the effects of deficit reduction on investment, but taxes also distort economic decision making by reducing the amount of investment that businesses are will­ing to undertake and the amount of labor that workers are willing to supply. Taxes also distort the allocation of resources in the economy. The accu­mulated negative effects of these various distortions more than offset any beneficial effect associated with the silver lining theory.

Conclusion. On balance, clear and compelling evidence shows that higher taxes reduce economic output. The silver lining theory argues that higher taxes could lead indirectly to a stronger economy through a chain of effects, but the evidence suggests that the effect is extremely weak and easily over­whelmed by the negative direct effects of raising taxes. In short, the evidence supports the view that tax increases harm economic performance.

As a first priority, federal, state, and local policy­makers should eschew tax increases. As the tax burden in the United States continues to rise, policymakers at all levels of government should pursue tax relief to preserve and enhance a strong economy.

J. D. Foster, Ph.D., is Norman B. Ture Senior Fel­low in the Economics of Fiscal Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

J.D. Foster, Ph.D. Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
Thomas A. Roe Institute for Economic Policy Studies