We can get back to an economy where most people think the country is on track if the easiest way to build after tax wealth is to run businesses that serve others. Wealth can be built tax free or tax deferred within such a business. This productive tax avoidance is rocket fuel for growth. Before I show how and why a high top marginal tax rate is part of such a pro-growth system let’s put the GDP number that was released this morning into context.
In the second quarter GDP grew at an annualized rate of 6.5% which is the 1.6% increase for the quarter in the quantity of goods and services produced compounded over four quarters.
The US produced more goods and services this quarter than ever before. So GDP has had a full recovery and is in expansion mode. After decades of watching business cycles I’ve come to expect jobs to recover slower. We have recovered about two thirds of the jobs lost in the Covid recession with about 6.8 million more needed for full recovery.
I’m always amused to see how people take an economic release and put it in a context to suit their purpose. If you want to make growth look strong over the last year you could tout the year over year rate (growth from red point to blue point on chart) of 12.2%. If you want to claim growth was weak, use the annual rate of 1.6% showing growth to the average of the last four quarters (underlined in blue) from the average of the previous four (underlined in red).
Growth in 2021 is on track for an annual pace of 6.1%. That would be the fourth fastest year of growth since 1944. Let’s not get too excited. It’s a wild fluctuation of one extreme following another. Moving on to the main point of the impact of the top tax rate on long term growth, we’re going to look at the very long term and since population growth varies dramatically we’ll get a clearer picture by using the growth rate per-capita. When you take out the population change we’re on track for 5.8% growth this year.
Below is the growth rate per person for each year from 1950 through our estimate for 2021 along with the top marginal tax rate.
I love scatter plots like the one on the left side of the chart above because they give me a good sense of what kind of relationship one data-series has with another.
Do you remember from the first blog post last week where I said single year growth rates hide the relationship? They’re kind of like not seeing the forest for the trees. This scatter plot is basically a cloud of dots. While the best fit line slopes slightly upward it is not statistically significant.
The graph on the right side uses the same data as the one on the left, but in a time-series format. For me the more ways I look at data the better I understand it. The scale for the top tax rate on the right (in green) is based on the best fit line in the scatter plot; its narrow range is another way of showing no significant relationship between growth and the tax rate using annual data points.
This graph supports the economists who claim the top tax rate does not influence the growth rate. It weakens the case of low tax advocates that cutting the top tax rate strengthens growth.
Before I put the hammer down on the low tax advocates about the top tax rate let me explain where I agree with them. Economic growth and workers benefit from low marginal tax rates on income up through at least three times the average workers pay. Growth also benefits when the first five to ten brackets in a personal income tax schedule allow a low enough average tax rate on a large enough amount of income that it’s very worthwhile for our wealthy and talented to run businesses and be productive.
We disagree on the marginal rate on business owners. Low tax advocates claim a high tax rate punishes success. I believe it encourages plowing a larger share of business revenue into growing a business and creating more wealth in the long term for capitalists along with substantially more wealth for workers.
Did you glaze over when I talked about the average tax rate and marginal rate? Most people I know, including successful executives and people who prepare their own tax returns, are hard pressed to explain the difference.
I remember the first time I calculated my average income tax rate about twenty years ago. I got my tax return and to get the average rate I took the amount of income tax I paid and divided it by adjusted gross income. I was pretty shocked that the average rate was about half of the marginal rate.
People with high income pay tax at all the rates from zero to the top rate of 37 percent. The next chart shows the average tax rate and marginal rate for a couple filing jointly and using the standard deduction on ordinary income from less than a thousand up to a billion dollars of income.
Because of the standard deduction the first $25,100 are tax free. Taxable income begins after that and the next several thousand dollars of income are taxed at the marginal rate of 10 percent. Then the 12 percent bracket kicks in and so on. At $117 thousand dollars of income they would have an average tax rate of 10 percent and be in the 22 percent marginal bracket so they would pay 22 cents on their last dollar of income and on an additional dollar of income. At $388 thousand they have a 20 percent average rate and a 32 percent marginal rate. At $1.04 million the respective rates are 30 and 37 percent. At $155 million their average rate rounds up to the top rate.
Personally I think the 22 percent bracket is too big a jump. If a 15 or 16 percent rate kicked in at that level it might encourage a bit more work. Now this is one of those opinions I don’t really have data to back up, but it sounds reasonable. Cutting that bracket to 16 percent would definitely lower the average tax rate for successful business owners.
As mentioned above a modest average tax rate on business owners is important for prosperity. Now that you understand marginal rates it probably makes sense that the marginal tax rate on a business owner taxes the decision to pull an additional dollar of business revenue out as personal income. The higher that marginal tax rate the bigger the after tax bang of creating wealth by plowing the marginal dollar of revenue into the deductible expenditures that grow a business like wages, equipment and research.
With that in mind here is the data from the last chart shown in forty year periods.
As the forty year average of the top tax rate drops from 76 percent to 39 percent the 40 year growth rate per person drops from around 2.4 percent to around 1.6%. Unlike the single year correlation, statistical significance here is at the 99.99 percent level.
At a 2.4 percent growth rate real income per person would double every 30 years, versus every 44 years at a 1.6 percent rate. Capitalists take a wider slice of the pie with a lower top tax rate, but in the long run they would end up with more if they took a narrower slice of a faster growing pie.
We all need to remember correlation doesn’t prove causation. I’ve made some costly mistakes confusing correlation with causation or influence. When in doubt I always look for more data.
Currently official annual GDP data only goes back to 1929. A couple of economists, Louise Johnson and Samuel Williamson at MeasuringWorth.com estimate GDP back to the first US Census in 1790 using what at some point in time had been official data.
I had been using their data for a year or so and then saw a chart of GDP from the Congressional Budget Office (“CBO”) going back almost as far and quite similar, but not an exact match. For a bit I thought, wow I found official data prior to 1929. After a few tries I got a hold of an economist at the CBO on the phone. He wouldn’t vouch for the data and suggested talking to the Bureau of Economic Analysis. The economist there said the MeasuringWorth.com data was probably the best estimate for GDP prior to 1929.
So using that data here is the 40 year growth rate per person from 1790.
In the 122 years before there was an income tax growth averaged 1.4%. In effect a zero percent top tax rate had 122 years of subpar growth results. The best growth came with the highest average top tax rate.
To me this means all the low tax advocates and economists arguing we want tax policy with the least distortion of incentive are barking up the wrong tree. I want tax policy to shift incentive big time toward plowing more business revenue into growing businesses and the economy.
The larger the share of business revenue that stays in businesses the larger the share of the pie goes to workers and the more stable society becomes. The low marginal rates we have probably means capitalists are pulling around $2 trillion more income out of businesses than they would with higher marginal rates. This squeezes workers. Having a hundred million people one missed paycheck away from financial hardship is a dangerous place for society.
From my reading of history, an income tax schedule that has low marginal tax rates on working people, modest average tax rates on business owners and a series of marginal tax rates that reaches toward the top of the income spectrum should realign the short term interest of capitalists with their own long term interest and also with the interest of workers and everyone else.
I think the top bracket should be around $500 million with a marginal rate somewhere in the 65 to 85 percent range. President Reagan had great results following the five years he had a top tax rate of 50 percent, including 1984 which had the best growth since 1950. I think the growth optimizing bracket for that tax rate would be around $2 million.
I don’t want wealthy people to pay more tax. I want them to take less income, pay less tax and grow their wealth faster within businesses that serve others. Let’s get to Win, Win, Win. To do your part: like, share, comment and follow me here and on my other platforms.