Bartlett: Low Taxes Not Enough for Growth
Bruce Bartlett writes:
When Republicans talk about economic growth, they tend to talk as if there is only one factor that affects it: tax rates. Thus, last week former Minnesota Gov. Tim Pawlenty, a candidate for the Republican presidential nomination, put forward an economic plan that he said would raise growth rate of the real gross domestic product to 5 percent per year from its historical level of about half that. His only specific proposal for achieving this ambitious goal was to slash tax rates on the wealthy.
Pawlenty would cut the top individual income tax rate from 35 percent to 25 percent, cut the corporate rate from 35 percent to 15 percent, and eliminate completely all taxation of capital gains, interest and dividends – the principal sources of income for the wealthy. Implausibly, Pawlenty asserted that despite reducing revenues by some $8 trillion over the next 10 years – from the lowest level of federal revenues as a share of GDP in 60 years – that his plan would balance the budget. I could find no data or analysis of how Pawlenty’s plan would actually achieve this goal.
My purpose today is not to criticize the particulars of Pawlenty’s plan, which is very much in the Republican mainstream, but rather to talk about the nature of economic growth and how one-dimensional the GOP view is. The truth is that economists know a lot about what causes growth and what policies will raise the growth rate, and tax rates have a far smaller role than most people and all Republicans believe.
To present the textbook view of what determines long-term economic growth, I turned to an actual textbook by Harvard economist Gregory Mankiw, who served as chairman of the Council of Economic Advisers for George W. Bush.
Mankiw begins by noting that economic growth is essentially a function of productivity – output per man-hour. How much a worker can produce is a function of several things: physical capital (machines, equipment, public infrastructure), human capital (education and training), natural resources (energy, land), and scientific and technological knowledge.
The key determinant of the amount of capital available to workers is saving – foregone consumption from current production. In general, more saving will lead to more investment, and more investment will raise productivity and growth.
Economists have spent many years trying to figure out how to increase the rate of saving, without much success. Insofar as individuals are concerned, their saving is largely determined by the need to save for retirement, get the down payment on a house, pay for their children’s education, and have a financial cushion for unforeseen circumstances. These are all things people would have to save for even if they got no return on their savings at all. Consequently, reducing the tax rate on saving is very unlikely to raise the personal savings rate. Research on the impact of tax-favored savings accounts, such as Individual Retirement Accounts and 401(k) plans, shows that people mostly shift their saving and don’t increase the total amount. Of vastly more importance, economically, is saving and investment by businesses and governments.
What matters for business investment is not the corporate tax rate, but the ultimate tax rate on capital including the tax on the corporation’s owners, the shareholders. In 2003, that was almost 58 percent – 35 percent at the corporate level and as much as 35 percent at the individual level. Now, that combined rate is at most 45 percent because in 2003 the tax rate on dividends was reduced to a maximum of 15 percent.
Unfortunately, there’s no evidence that the 2003 tax cut did anything to stimulate corporate investment. Indeed, according to the Federal Reserve, nonfinancial corporations have increased their holdings of liquid assets to $1.8 trillion from $1.2 trillion since 2003. Thus it’s implausible that a further reduction in the corporate rate, as Pawlenty and other Republicans favor, would do much to raise investment.
What is holding back business investment is not taxes, but poor economic prospects. For some time, members of the National Federation of Independent Business have listed “poor sales” as their number one problem. Businesses are not going to invest, no matter how low the tax rate is, if there is no demand for their output.
