The Wall Street Journal
By Edward Conard | August, 2012
With the prospects for a postrecession economic rebound fading, it has grown increasingly obvious that the United States must eventually raise taxes or cut spending. President Obama claims we can raise taxes on those earning over $250,000, to avoid spending cuts with little, if any, effect on growth because growth was faster in the 1990s and in the 1950s and ’60s when marginal income-tax rates were higher.
The evidence doesn’t support Mr. Obama’s conclusion.
President Clinton raised taxes in the 1990s and the economy grew. So does that mean it would grow today if we did the same thing?
Commercialization of the Internet lifted the Nasdaq from 800 in 1995 to 4,500 in 2000, the largest five-year gain of any major index in American history. Put bluntly, increased payoffs for successful investment and rising equity values simply dwarfed offsetting increases in marginal tax rates. The taxes themselves didn’t increase growth.
The story is similar for the Eisenhower and Kennedy eras, when top marginal rates were high. The economy rebounded from two decades of underinvestment, first from the Great Depression and then from World War II.
Large corporations like General Motors raced to capitalize on markets unleashed from wartime rationing and controls. A postwar increase in college graduates raised productivity and opened new avenues for investment. Dramatic improvements in agricultural productivity lowered the cost of food to 10% of GDP from 25%. Oil was a fraction of today’s price and dollar-an-hour offshore labor was inconsequential. Mass markets were fostered by TV and interstate highways.
Meanwhile, weakened by the war, slow to educate their workforces, and fragmented into smaller markets, Europe and Japan remained weak economic competitors until the 1970s.
No such favorable circumstances lie on the horizon today. Rising real-estate values prior to the 2008 financial crisis accelerated economic activity just as a 30% drop afterward decelerated it. Without a foreseeable rise in asset prices, high taxes and government spending will have a more dampening effect on growth.
Today, federal, state and local spending has reached 38% of GDP. In the late 1990s, it was only 33%. Throughout the 1950s and ’60s, it was only 28%. The notion that the robust economy of the 1950s, ’60s and ’90s proves that historically high government spending and taxes have little, if any, negative effect on growth is naïve.
What does this history really teach us? Expectations of growing wealth drive investment and risk-taking up and down.
Do increased government consumption and higher marginal tax rates on successful investors and risk-takers raise expectations of increased investment and wealth in the future? No. When the government consumes income that would otherwise be invested, it slows growth no matter the tax rate.
Public investment might increase productivity in theory—the GI Bill and investment in the federal highway system, for example, helped make Americans more productive. But today’s endless increases in government spending with no discernible improvement in our infrastructure or educational outcomes makes it painfully obvious that politics and special interests have undercut its benefits.
With unconvincing evidence that additional government spending has been productive, its champions claim that incremental increases in marginal tax rates have only a small impact on private investment and risk-taking. They fail to see that small effects gradually compound into big effects.
Just look at the performance of the U.S. economy relative to Germany and France, where top marginal income tax rates are five points higher and total government spending relative to GDP is five to 14 points higher. Total hours of work since 1991, a true measure of employment, grew 12% in the United States; they grew only 2% in France and declined 4% in Germany, according to the U.S. Bureau of Labor Statistics.
The number of hours worked did not slow because of a shortage of workers. Today, even with 8% unemployment, the hours of work available per working-age adult are 35%-40% greater in the U.S. than they are in Germany and France. Incredibly, the French government even restricts the number of hours one can work to spread around what little work remains.
High marginal tax rates are a disincentive to work longer hours and take risks that might create wealth and jobs. In the U.S., higher payoffs gradually drive talented individuals to work longer hours, take more risk, and earn more income. The success of U.S. entrepreneurs created companies like Google and Facebook that provided talented Americans with more valuable on-the-job training and increased their chances of success.
Success also put equity into the hands of investors more willing to bear the risks needed to innovate. As a result, U.S. productivity growth accelerated to 2% per year after 1990 from 1.2% per year in the two decades prior, according to the University of Pennsylvania’s Center for International Comparisons. At the same time, productivity growth in Germany and France slowed despite access to the same technology and similarly educated workforces.
Higher taxes on the most productive workers to fund increased government spending reduces incentives, and redistributes and consumes income that would otherwise fund private investment. Expectations of lower investment and slower growth lower asset values and slow economic activity. Until circumstances improve, lowering the trajectory of unproductive government spending provides our best opportunity for growing economic activity today.
Mr. Conard, a former managing director of Bain Capital, is the author of “Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong” (Portfolio, 2012).