Higher Taxes and Lower Growth: A Few Thoughts

As we write this in September 2010, the debate about stimulating the economy with lower tax rates versus the need to reduce the budget deficit rages on. Unfortunately, in the heat of the arguments, a few facts and thoughts have been missing. We would like to submit for your consideration some experiences and studies. It is readily acknowledged that there may be more facts and studies available and this article is not intended to be an exhaustive study. Time available simply does not permit that. This limited offering is intended to lead to further considerations of the matter. We believe it is in our interests as investors as well as the national interest find ways to stimulate growth in our country. There should be no illusion that there could or would be any rational discussion of the issue by the Administration and Congress, as they are heavily invested in their own political agendas.

Allen Sinai, Chief Global Economist, Strategist and President of Decision Economics, Inc., has just finished a new study, Capital Gains Taxes and the Economy. The American Council for Capital Formation published it, and here are a few of its findings.

The study simulated reductions and increases in capital gains taxes starting in 2011 and extending to 2016 to estimated the effects on economic growth. Admittedly, this is not a study of historical experience and therefore does not qualify as fact. We were careful to entitle this article "A Few Thoughts" least it be considered misleading. Nevertheless, here is what Mr. Sinai's forward-looking study found:

             ►  Hiking capital gains tax rates would cause significant damage to the economy.

             ►  Real GDP would be reduced; unemployment would increase; productivity

                   would decline. The specific findings were:

                         A 20% capital gains rate would cause a loss of 231,000 jobs a year.

                         A 28% capital gains rate would cause a loss of 600,000 jobs a year.

                        A 50% capital gains rate would cause a loss of 1,600,000 jobs a year.

            ►  The damage would be greater than the increased tax collections.

            ►  Lowering the capital gains rate would grow the economy and jobs.
                  The specific findings were:

                        A  5% capital gains rate would increase jobs by 711,000 a year.

                        A  0% capital gains rate would increase jobs by 1,300,000 jobs a year.

Mr. Sinai is careful to present a balanced view. For example, his forward-looking study showed that a 0% capital gains rate would cost the U.S. Treasury about $23 billion in lost tax revenue per year after the positive effects of a stronger economy on personal income, payrolls, productivity, and corporate profits. That works out to a cost of about $18,000 per new job. We think that's considerably less than the cost of a new job under the $787 billion Stimulus Act passed by Congress in 2009. Estimates have varied on that statistic, as we have heard a figure as high as $1,000,000 per new job, assuming that 787,000 jobs have been created since the Stimulus Bill was passed.

Turning now to the experience of the Reagan tax cuts, the Congressional Budget Office, a commonly-viewed independent body, figured that total tax revenue fell from 19.2% of the gross domestic product(GDP) in 1982 to 18.4% of GDP in 1989, the year President Reagan left office. However, that is misleading. Actually, the U.S. economy produced real growth of  34.3%, or 4.3% using an 8 year period (because the Economic Recovery Act of 1981 really took effect starting in 1982). Nevertheless, the CBO statistics do not take into account the extent to which the decrease in interest rates during the Reagan years contributed to economic growth. Rates in October 1981 were in the 15% range and by October 1989 were in the 8.5% range. The decline in interest rates followed the decline in inflation. All told, the CBO's figures do not clearly lend support to the growth-generating capability of a lower tax environment, although one suspects the lower rates had something to do with economic growth. At this point, we have not found concrete proof that the lower tax rates of the 80's were responsible in part for the economic growth of the period.

Perhaps the experience of the Indian and Hong Kong economies will be supportive. Neither country has a dividend tax. India abolished their dividend tax in March 2002. India had a GDP growth rate of 6% during the period from 1988 to 2003. After that, the GDP growth rate increased to 8.5% until the Great Recession. Lower tax rates alone do not account for the better growth in India, however. The Indian IT and service industry's strong growth must be taken into account (http://business.mapsofindia.com). Hong Kong showed growth of 6.3% from 2003 through 2008. Solid proof is again lacking.

Steve Entin and Michael Schuyler, economists with the Institute for Research on the Economics of Taxation, published a study in October 2008 on both the dynamic and static effects of the tax proposals put forth by then Presidential candidates Barack Obama and John McCain. Their conclusion was that taxpayers in the top two tax brackets would respond to the higher marginal rates by working, saving, and investing less. They concluded that Senator Obama's plan would increase corporate tax receipts, after all economic effects, by about $37 billion, but payroll, excise, tariffs and estate tax revenues would fall by about $53 billion. The U.S. economy as a whole would contract by 3.5%. (The research paper can be found at www.iret.org.)

Alan Reynolds in a paper entitled Marginal Tax Rates cites East Asia, Ireland, Russia, and India as a few economies that began expanding impressively after marginal tax rates were sharply reduced. He cites a study entitled Economic Growth by Robert J Barro and Xavier Sala-i-Martin which showed that the world's twenty fastest growth economies had low marginal tax rates to begin with or cut them by 50% or more between 1979 and 2002. He also presents a table of 47 countries showing 32 of them with reduced marginal tax rates from 1990 to 2002. (www.econlib.org/library/Enc/MarginalTaxRates.html)

Unfortunately, we need to leave this brief exploration of a very important topic...higher taxes. The facts we have presented are not conclusive, but they together with studies suggest that higher taxes may have negative effects on economic activity. We are basing our investment decisions on this suggestion and continue to believe that the higher tax policy of the present government, combined with other negative growth policies, indicate a slow-growth economy for an undetermined period.

 
John A. Epeneter, CPA/PFS, CFP®, CFS, CCPS, Master of Science in Financial Planning.  Copyright © September  2010.