Lazear on taxes and growth

Ed Lazear has an article in the Wall Street Journal decrying Obama’s plan for a discretionary spending freeze (again, it would have been nice if people like him has been saying things like this back when Republicans wanted it).  Anyway, he’s correct that it’s in no way a serious effort to cut the long term budget deficit.  However, the article also includes this interesting bit

My analysis of data from 1950 to the present shows that periods with high tax-to-GDP ratios exhibit much slower economic growth than lower tax ratio periods. The GDP growth in high tax years (defined as years during which the ratio of tax-to-GDP was above 18%, the 60-year average) was about 1.5 percentage points lower than the growth rate in low-tax years.

High taxes are clearly bad for the U.S. economy. For example, were we to tax above the 18% tax-to-GDP ratio over the next 25 years, GDP per capita in 2035 would be about 50% less than if we were to tax below the 18% ratio. A 50% per capita GDP differential is about as large as the difference between the U.S. and Greece today.

Is this true?  Is there really such a large difference in growth rates when the tax-to-GDP rate is slightly above the historical average compared to when it’s slightly below the historical average?  This would be somewhat odd, as it suggests something magical about the 18% tax-to-GDP ratio.  After all, it isn’t as if the tax rate oscillates between 3% and 33% to get an 18% average.  Since 1950, federal tax rates have typically stayed between 15% and 20%.  So what explains this?  Posted below, I have a graph that shows historical federal tax rates (along with state and local taxes, which would be interesting to look at as well, but ignore them for now).

It’s hard to tell exactly where the 18% threshold is, but it actually shouldn’t matter too much.  What matters are the patterns.  The black lines here are where I marked years of negative or near negative growth.  Basically, these are years of recession.   There are two areas where we have two lines pretty close to one another, 1974-75 and 1980-82.  We should count these as part of the same episode, so mainly just pay attention to the second line in each set.

Anyway, a pretty clear pattern emerges.  Prior to most of these episodes, taxes look to be pretty comfortably above the historical average.  Then the recession hits, and in the next year or two tax receipts start falling as incomes fall and the government engages in counter-cyclical fiscal policy by lowering tax rates.  In about the third year, tax revenue begins to increase again as incomes return to their pre-recession levels and fiscal policy is phased out.

At the bottom of this post is a chart of what growth rates looked like during these episodes.  I have included the growth rates in the year of the recession (year t) and growth rates in the two years following the recession (years t+1 and t+2).  As you can see, growth is negative in the first year, and often very aggressive over the next two years.  However, because we are still closing the output gap and fiscal policy is still in effect, tax receipts are lower than normal during the two years after the initial slump. After these years, tax revenues begin to climb again but growth rates fall back to their historical average.   In other words, for most of these recessions, we’re counting the first year of negative growth as being in the high tax-to-GDP ratio camp, and the next two years of aggressive growth as part of the low tax-to-GDP ratio camp, when in reality the tax-to-GDP ratio seems to be much more a reflection of GDP growth than vice-versa.

This explains the magical jump in GDP growth when tax rates are below normal compared to when they are above normal.  What the data is really saying is “When GDP growth falls, tax revenue tends to as well, even faster than GDP (due to counter-cyclical fiscal policy and a progressive tax system).  On the eve of a recession, the economy is typically experiencing good growth, and thus tax-to-GDP ratios are above normal.  Slightly higher taxes than what are historically normal should not lead to a 50% difference in per capita income over the next 25 years.

. Episode Growth (t) Growth (t+1) Growth (t+2)
. 1954 -0.6 7.2 2
. 1958 -0.9 7.2 2
. 1970 0.2 3.4 5.3
. 1975 -0.2 5.4 4.6
. 1982 -1.9 4.5 7.2
. 1991 -0.2 3.4 2.9
. 2001 1.1 1.8 2.5

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