Going for growth

Alan Reynolds
Posted: Mar 23, 2006 12:05 AM

Try to guess who said this: "High taxes on earned income discourage labor supply and reduce the returns from entrepreneurship and higher education. Growth, innovation and human capital development are all harmed as a result."

You might think that remark came from some Reaganite supply-sider, such as Art Laffer or Larry Kudlow. Actually, it came from a major study, "Going for Growth 2005," by the Organization for Economic Cooperation and Development (OECD) in Paris, an group generally regarded as a paragon of economic orthodoxy.

Guess who said this: "Taxes on labor income and consumption expenditures encourage households to substitute away from the legal market sector in favor of untaxed activities -- leisure, household production and the shadow economy."

You might think that came from another Reaganite supply-sider, such as Jack Kemp, Steve Entin or me. Actually, it came from Steven J. Davis of the University of Chicago and Magnus Henrekson of the Stockholm School of Economics. Their multi-country evidence in the 2005 anthology "Labor Supply and Incentives to Work in Europe" "supports the view that tax rate differences among rich countries are a major reason for large international differences in market work time."

Davis and Henrekson estimate that a tax hike of 12.8 percentage points -- regardless of whether that tax is on what we earn (an income tax) or what we spend (a value-added tax) -- would shrink the employment-population ratio by 4.9 percentage points, cut hours worked by 122 per year among those left working in the taxable economy and boost the size of the tax-free underground economy by 3.8 percent of GDP.

Taxes matter -- a lot. We don't need astute economists from France and Sweden to prove it. I mentioned some U.S. studies in an August 2002 column, "Supply-Side Goes to Harvard," including one by Ed Prescott, who later won the Nobel Prize. A half-dozen other Nobel laureates have done related research on the nefarious ways high tax rates distort incentives.

This is a congressional election year, however, so politicians and pundits would much rather talk about federal spending as a blessing than a burden. They are trying hard to change the subject to budget deficits. But describing the issue in terms of how much the government borrows, rather than how much it spends, makes it appear as though higher tax rates are a realistic solution, rather than an ominous threat.

To focus on budget deficits is to pretend the burden of government spending would magically disappear if only it could be financed entirely from current tax revenue, rather than having a small portion (2.6 percent of GDP) financed by selling bonds. This is a dangerous delusion.

If the government had never borrowed a dime (which makes no more sense for governments than it would for homeowners and corporations), all that could have saved is the interest on the debt. But interest on the debt was only 1.5 percent of GDP over the last four years -- the lowest since 1977 and lower than when the budget was in surplus.

Aside from interest, government spending is either for transfer payments (entitlements) or purchases. Transfer payments and purchases impose an immediate burden on the private economy, regardless of how they're financed. Transfer payments typically involve taking money from taxpayers who've earned it and giving it to other people on the condition that recipients promise not to work too hard, save too much or plant too many crops. If work is allowed at all, it is sternly punished. Those who keep working past age 65 pay a penalty income tax on most of their Social Security benefits, while also paying Social Security tax for some lazier person's tax-free benefits.

Government purchases of buildings, equipment, material and land reduce the availability of those resources for private business and raise their cost. When the government hires more bureaucrats or soldiers, that raises the cost of labor for private business.

For the next three years, unfortunately, we are sure to be cursed with many irrelevant suggestions about how to "fix the deficit" by raising tax rates on the richest 10 percent. That would soon prove counterproductive, for reasons explained by the OECD and Davis-Henrekson. Even as a policy of spiteful egalitarianism, it won't work.

It is not as though the United States never experimented with tax rates of 50 percent or more on high incomes. We did that as recently as 1986. But trying to impose high tax rates on high incomes just left us short of rich folks to tax. If the tax on dividends were put back up to 35 percent, for example, I would quickly stop holding dividend-paying stocks in a taxable account. Instead of collecting 15 percent of something, the IRS would then get 35 percent of nothing.

The Congressional Budget Office estimates that the total effective tax rate on the top 1 percent of households rose from 25.5 percent in 1986 (when the top tax rate was 50 percent) to 31.4 percent in 2003 (when the top rate was 35 percent on salaries, and 15 percent on capital gains and dividends). Their total tax includes Social Security and excise taxes.

In stark contrast, the bottom 20 percent saw their overall federal tax burden cut in half -- from 9.6 percent in 1986 to 4.8 percent in 2003. The next highest 20 percent saw their burden drop from 14.8 percent to 9.8 percent. And the middle fifth paid only 13.6 percent of their income in federal taxes in 2003, down from 18 percent in 1986.

Ever since the highest tax rates were sharply reduced on salaries, dividends and capital gains, there have been many more rich Americans paying much more in taxes, allowing unprecedented tax cuts for everyone else. If anyone was foolish enough to try putting that history into reverse, by raising tax rates on high incomes and dividends, a smaller group of people with high incomes would soon pay much less in taxes, as they did before. And everyone else would pay more.

Federal spending is a large and growing problem. Trying to patch over that problem with high tax rates on high incomes would do nothing to reduce the economic burden of federal spending. But it would create many other nasty problems.