Do Taxes Matter?

Elsewhere, I’ve written about the long-run negative consequences of taxes, and the possibility that the top of the Laffer Curve is not so far off. Karl Smith takes exception to these arguments, when looking at this graph:

The supply of working-age people into the labor market seems to be largely driven by changes in monetary policy, rather than changes in taxes. For Karl, this seems to imply that the choice to enter or exit the workforce is largely pre-determined, and responsiveness to to taxes must be pretty low (he has another recent post that makes the same argument; though it is only shows up in my Google Reader).

I’m pretty skeptical of this line of analysis. Rather than eyeball aggregate data like this, I’d rather look at evidence that spans different countries over time, carefully calibrated analyses of specific tax cuts, or modeling based on economic data. All three methods seem to suggest that the responsiveness of people to taxes is pretty high. Even Saez, who recently won a MacArthur genius award and is generally regarded as being on the left on these issues, has a recent paper that argues the impact of taxes can be sizable, especially for those that itemize deductions and higher-income folks (his paper also suggests that the impact of taxes is taking place through channels other than simple labor supply). I think this is all evidence we should take seriously, regardless of what aggregate data suggest.

But none of this directly answers his chart. Well, here are a few more charts:

This one shows the average federal tax/GDP ratio of the American economy going back a few decades. Across a wide variety of tax regimes that have drastically changed average and marginal tax rates, the average tax/GDP ratio has stayed within a fairly tight band. It seems to be driven far more by changes in the business cycle (especially the stock market) than changes in statutory tax rates.

I wouldn’t subscribe to this interpretation entirely: but one plausible reading is that the long-run Laffer curve maxes out for a pretty low value. Successive tax cuts from the high rates of the ‘50s have been accompanied by economic expansion. Tax hikes from the ‘80s have been accompanied by economic slowdown. A tax/GDP ratio of 18% is, if not optimal, close to a maximum of what can be obtained without seriously affecting work incentives. European countries get higher tax/GDP ratios primarily by lowering GDP, not through higher tax revenue.

Here’s another graph in support of that interpretation:

Somewhat surprisingly, America gets about the same tax income per capita as Western European countries with far higher tax rates. That’s because America’s lower tax rates balance out Europe’s lower income almost exactly. I don’t like generalizing about “Europe”, which contains a variety of different systems, including the low-tax, high economic freedom Switzerland. But a simple reading of this graph would reinforce the conclusion that higher tax rates primarily lower economic output, rather than raising tax revenue.

Back to Karl's original graph — note that labor force participation rates are lower than Europe, at least normally. This was not the case several decades ago, which suggests that “culture” is not the reason. The culprit, depending on the country, seems to be a combination of rather high rates of taxation, high rates of people on disability, and the disincentives of social security provision.

I’ll add finally that this debate plays into whether or not we have a sustainable fiscal future. If you look at this CBO graph:

You’ll see that they project rapidly rising entitlement spending, driven primarily by Medicare and to a lesser extent by Social Security. You’ll also see that they project a rapidly rising tax/GDP ratio under the "baseline scenario", which will increase tax/GDP ratios far above historical norms (though this scenario would call for a full repeal of all of the Bush tax cuts, and so is not probably the path we will take). If the CBO is right, we can easily achieve massive increases in tax revenue without seriously affecting work incentives. If this story above is right (and, again, I’m not sure I’d agree with it entirely), a sharp rise in taxes/GDP would not be accompanied by large rises in tax revenue, but rather by stagnant growth in GDP.

The point here isn’t that we can raise tons of tax revenue by cutting taxes — I think the opposite is true. Also, I suspect labor force participation is pretty fixed for a large chunk of the population. But I think the aggregate data cut both ways, and the best evidence we have suggests that taxes have pretty bad effects.

To make a petty partisan point, I’ll also add that though the Republican plan for dealing with deficits in their Pledge has gotten a lot of flack, I don’t quite see how the Democrats are targeting this issue either. After slamming Bush for a decade for his irresponsible tax cuts, they now plan to extend almost all of them — except for those that may actually grow the economy, as the CBO suggests. Meanwhile, they are rolling out new expansions of healthcare entitlements and plan to hold the line on Medicaid, state and local spending, and Social Security. Conflict efforts in Afghanistan will ensure that large military cuts are not forthcoming either. How exactly is this supposed to be affordable? I really hope Karl is right on this one.