From the February 2012 issue of Research Magazine • Subscribe!

February 1, 2012

Tax Hike Needed

Contrary to conventional wisdom, higher tax rates would spur growth.

We’re conditioned to regard taxation as bad for the economy. Politicians typically either advocate tax cuts or defend taxes as a regrettable but necessary evil. The proposition that higher taxes could spur faster economic growth is anathema in our political debate and flies in the face of current economic dogma. Yet it is not such a farfetched idea.

Consider first the conventional wisdom expounded by, among others, the Club for Growth, a premier think tank whose main goal is to promote economic growth in the United States through low-tax policies. The Club for Growth claims that a progressive taxation system, with those in higher income brackets not only paying more in absolute terms but getting taxed at much higher rates, discourages the ambitious and entrepreneurial from working hard and taking risk. As a result, there is less growth, less innovation and less wealth creation.

Historical evidence seems to support this view. In the U.K. in the 1970s, for example, the top marginal income tax rate sometimes reached as high as 98 percent. At such confiscatory rates, with wealthy taxpayers giving the government 98 pence of every extra pound they earned, the incentive to make more money disappeared. It was also a period of economic stagnation, which ended after Margaret Thatcher reduced taxes sharply.

But a very different scenario could also occur. Imposing higher taxes on the most productive members of society should actually make them work far harder in order to escape the egalitarian income levels imposed by progressive taxation.

Tax rates that leave just 2 percent of your latest earnings in your pockets are obviously overkill, but if the top income tax rate goes up from, say, 30 percent to 60 percent, there will be an incentive for those in the top income bracket to earn two dollars for every dollar they previously earned, so as to keep 80 cents rather than 70 cents. That would mean entrepreneurs work harder and provide a boost to the economy.

What is needed is an opportunity to make that extra dollar. Entrepreneurship, risk-taking and innovation depend on overall economic conditions that encourage them, not just on high or low taxation levels. Relatively high taxes have not prevented innovative economies from emerging in the Nordic countries and Israel. Most people in Sweden pay a tax rate of 50-60 percent when central government and municipal taxes are included, and in Israel the top income tax rate is 45 percent. In Russia, on the other hand, where a flat tax rate of 13 percent has been in place for a decade, the economy has shown no sign of becoming more dynamic or entrepreneurial. On the contrary, small and medium-size businesses have been disappearing and businesspeople have been migrating to higher tax jurisdictions in the West.

In the U.S. the information technology revolution began in the second half of the 1970s, when getting rich seemed extremely difficult since the top income tax rate was a whopping 70 percent. Staying rich was even harder, because high inflation was destroying accumulated wealth while the stock market was stagnant. Nevertheless, the fear of eventually giving Uncle Sam more than two thirds of their earnings didn’t keep Steve Jobs and Steve Wozniak from assembling the first Apple computer at a garage, or Bill Gates from founding Microsoft and doggedly fighting to secure for it a near-monopoly on personal computer software.

The info tech revolution reached its peak in the 1990s, before the two rounds of George W. Bush’s tax cuts came into effect. The 20th century’s final years saw high employment, and even a labor shortage, in the U.S., with kids fresh out of college commanding exorbitant salaries. New entrepreneurial fortunes, provided by such companies as eBay, Google and Amazon, began to be built.

As to the Bush tax cuts, which theoretically should have provided a boost to jobs and generated solid economic growth by freeing job creators of their excessive tax burden, they resulted instead in the creation of a massive housing bubble and a huge speculative pyramid in financial markets and commodities.

Useful Adversity

It could be argued, then, that in an entrepreneurial economy higher taxes offer an incentive for entrepreneurs for trying harder, not a job-killing proposition as we’ve been told by our politicians. Higher taxes on the job creators could stimulate their creative juices and entrepreneurial ideas. What doesn’t kill us makes us stronger. By the same logic, cutting taxes on the rich could easily make them lazy. Indeed, we may be seeing a new speculative bubble inflating in financial markets because money managers have not really suffered the bracing discipline of a serious recession in 2008. They got a brief scare, which promptly turned into the bull market of 2009-11, when the Dow nearly doubled in a 24-month period.

A similar story is with U.S. corporations, which have the highest statutory corporate tax rate among leading industrial nations. The combined federal and state corporate tax rate in the U.S. is 39.3 percent, compared to 31.9 percent in other OECD countries and 33.8 percent in the large Group of Seven nations, according to the Tax Foundation. Other nations cut their corporate tax in the first decade of the 21st century, but they have not been able to beat American companies, which continue their global dominance. Among the world’s most valuable brands in 2011, according to the BrandZ classification, U.S. brands hold nine out of the top 10 positions, as well as 17 out of the top 25.

Even in a slow-growth period in the past three years, U.S. corporations have performed strongly, posting robust profits growth and accumulating trillions in cash holdings. Low profits and a lack of cash do not seem to be the key factors holding back job-creating investment.

The only glaring exception has been the auto industry. Detroit Big Three got into trouble back in the 1970s and, uniquely in the history of American business, have not been able to regroup and smash their competitors over a period of 40 years, during which the industry lost billions. Also uniquely, Uncle Sam had to take over a large industrial corporation to save it from bankruptcy. Today even storied Ford no longer appears among the world’s most valuable brands, which in the automotive industry are dominated by Toyota, BMW and even Hyundai.

 Untaxed Industry

It should be noted that the U.S. automotive industry benefits from extremely low taxation. Not of carmakers themselves, but in this case, of gasoline. Americans pay less than half as much at the pump compared to what European and Japanese motorists must shell out. Ironically, even in this globally competitive industry, tax advantages have made American automakers perennially lax, less technologically sophisticated, less cost-conscious and less responsive to changes in consumer preferences.

The U.S. government has introduced new fuel efficiency standards, which are supposed to double miles per gallon for the car fleets sold by automakers in the U.S. to an average of 53 over two decades. This may be a good way to jolt U.S. automakers out of their hibernation, but it is not an optimal solution, because it relies on government regulation and not a market mechanism. Doubling gas prices by gradually raising taxes at the pump would be far more efficient. Consumer preferences would force carmakers to develop more energy-efficient cars while also boosting alternative energy sources and creating those promised green-tech jobs.

Taxes in the U.S. have been falling steadily since the early 1980s and now the tax burden on the average U.S. taxpayer has declined to levels not seen since the early 1950s. Instead of the kind of universal prosperity that the anti-tax economists have been predicting, we have massive budget deficits and economic stagnation — a very different environment from what we had in the 1950s and 1960s, when tax rates were going up, and the 1980s and 1990s, when tax rates were higher than they are now. We are also suffering from a massive federal budget deficit that, unless economic growth returns soon, will inevitably bankrupt the nation. Perhaps we should try raising taxes to spur growth.

 

Alexei Bayer is an economist and author based in New York City.

 

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