Do Low Tax Rates On Rich People Actually Ruin The Economy?

US Income Tax Top BracketUS federal income tax, 1913-2008. Click for more detail.

Photo: National Taxpayers Union

In the past few days, as our dysfunctional government pushes us ever closer to defaulting on our obligations, we’ve taken a look at government spending and historical tax rates.The Republicans are right that today’s level of government spending relative to GDP is higher than it has been in the past 60 years–and probably unsustainably so. So spending does have to be cut.

But another one of the contentions of today’s Republican party is that high income tax rates are always bad for the economy, because they deprive people of an incentive to work hard, thus making us a nation of lazy good-for-nothings.

This argument has been repeated so often and for so long that it is now basically regarded as fact.

But, interestingly, the history of income tax rates in the US actually suggests that it may be b.s.

Some of the most prosperous periods in US history (1950s and 1960s) have come during periods of super-high marginal income tax rates.  And some of the most disastrous periods in US history (1930s, 2010s) have come after periods of super-low income tax rates.

In the good periods, moreover, the middle-class boomed and inequality between the country’s highest earners and everyone else shrank. In the bad periods, meanwhile, inequality soared, and the richest 1% of the population came to earn a staggering amount of the country’s income. (In the past, this inequality was addressed by a massive hiking of tax rates, which we imagine will eventually happen this time, too. See “DEAR RICH FOLKS: A (Tax) Revolution Is Coming To Take Your Money Away.”)

Now, lots of other factors were at play during these “good times” and “bad times,” so we obviously can’t pin all of it on income tax rates.

But it is certainly interesting that the two biggest busts and eras of income inequality in US history in the past century have come right after periods with super-low marginal income tax rates–and that the economy boomed and the middle-class prospered in periods with super-high tax rates.

And these facts raise a reasonable question:

Income inequality hit century-peaks right before the Great Depression and our current malaise. Click the chart for a Paul Krugman presentation on this.

Photo: Joint Economic Comittee

Are low marginal tax rates actually BAD for the economy? Far from encouraging sustainable prosperity and growth, do low income tax rates actually help produce “sugar highs”–brief, unsustainable periods of rapid growth and money-making that are then followed by protracted busts?We don’t have the answer to this question yet, and we’d love your help in figuring it out. We do have a theory for why this might be the case, however.

In the past few days, when we observed that past income tax rates were often radically higher than today’s, many sharp readers quickly pointed out that, thanks to a variety of “tax shelters,” the effective tax rates in those days were much lower than the stated tax rates.  When tax rates were cut radically in the 1980s, our readers continued, lots of the shelters were eliminated, so the effective tax rates actually didn’t change that much.

Now, that’s an important point, one we’d like to do some more research on.  If anyone has any data on the effective tax rates on different tax brackets over the past century, we’d love to see it. (Please send links to [email protected]).

But that point about tax shelters raises another important question:

Were the tax shelters that high-earners were encouraged to set up to shield themselves from high income tax rates actually better for building a sustainable, prosperous economy than the combination of low tax rates and no shelters?

Was there something about these tax shelters that encouraged high earners to invest more sustainably–in businesses, real-estate, and so forth–than the “free market” of low rates does?  And did high income taxes encourage executives to be less piggish and selfish when compensating themselves, thus narrowing the now-spectacular gap in incomes between the average employee at a big company and the most-senior executives?

Because we just saw what happens in the economy when high earners get to keep most of their incomes: They spend it on SUVs, flat-screen TVs, home renovations, vacations, hedge-fund and private-equity fees, and other ephemeral things that don’t add a lot of lasting value to the economy. And they certainly don’t save any of it (because they aren’t encouraged to).

And spending our incomes, along with money we borrow against the appreciating value of our assets, certainly pumps up growth for a while. But, as we’ve just seen, it also leads to a gross mis-allocation of capital, unsustainable growth, and a depletion of savings.

So, could it be that the high income tax + investment-based tax shelters of prior eras were actually a more healthy and sustainable system than the low income tax rates of today?

We don’t know the answer, so we’re eager to hear your thoughts. But history suggests that the question is at least worth asking.

THE TRUTH ABOUT TAX RATES: A Look At History Shows How Low Ours Really Are
DEAR RICH FOLKS: A (Tax) Revolution Is Coming And It’s Going To Take All Your Money Away

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