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Thursday, December 15, 2011

Tax Rates and Economic Growth

Jane G. Gravelle
Senior Specialist in Economic Policy

Donald J. Marples
Section Research Manager

This report summarizes the evidence on the relationship between tax rates and economic growth, referring in a number of cases to other CRS reports providing more substance and detail. Potentially negative effects of tax rates on economic growth have been an issue in the debates about whether to extend the 2001-2003 income tax cuts, whether to increase taxes to reduce the deficit, and whether to reform taxes by broadening the base and lowering the rate.

Initially, it is important to make a distinction between the effects of policies aimed at short-term stimulation of an underemployed economy and long-run growth. In the short run, both spending increases and tax cuts are projected to increase employment and output in an underemployed economy. These effects operate through the demand side of the economy. In general, the largest effects are from direct government spending and transfers to lower-income individuals, whereas the smallest effects are from cutting taxes of high-income individuals or businesses.

Long-run growth is a supply-side phenomenon. In the long run, the availability of jobs is not an issue as an economy naturally creates jobs. Output can grow through increases in labor participation and hours, increases in capital, and changes such as education and technological advances that enhance the productivity of these inputs.

Historical data on labor participation rates and average hours worked compared to tax rates indicates little relationship with either top marginal rates or average marginal rates on labor income. Relationships between tax rates and savings appear positively correlated (that is, lower savings are consistent with lower, not higher, tax rates), although this relationship may not be causal. Similarly, during historical periods, slower growth periods have generally been associated with higher, not lower, tax rates.

A review of statistical evidence suggests that both labor supply and savings and investment are relatively insensitive to tax rates. Small effects arise in part because of offsetting income and substitution effects (which make the direction of effects uncertain) and in part because each of these individual responses appears small. Institutional constraints may also have an effect. Offsetting income and substitution effects also affect savings. Capital gains taxes are often singled out as determinants of growth, but their effects on the cost of capital are quite small. International capital flows also appear to have a small effect. Most expenditures that affect the productivity of labor and capital inputs (research and development, education, or infrastructure) are already tax favored or provided by the government. Small business taxes are also sometimes emphasized as important to growth, but the evidence suggests a modest and uncertain effect on entrepreneurship.

Claims that the cost of tax reductions are significantly reduced by feedback effects do not appear to be justified by the evidence, where feedback effects are in the range of 3% to 10% and can, in some cases, be negative. Because of the estimated realizations response, capital gains tax cuts have in the past been estimated to have a large revenue offset (about 60%), but more recent empirical estimates suggest one of about 20%. In general, for stand-alone rate reductions the additions to the deficit would cause tax cuts to have a larger cost both because of debt service and because of crowding out of investment which would swamp most behavioral effects.

Date of Report:
December 5, 2011
Number of Pages:
Order Number: R42
Price: $29.95

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