Studying a paradox: When higher marginal tax rates helped the economyArticle added by Nicholas Paleveda MBA J.D. LL.M on October 4, 2012
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Bellingham, WA

Joined: March 27, 2012

Higher marginal rates actually helping the economy is a counter-intuitive thought. Generally, it is the thinking of the hoi palloi that lower marginal tax rates lead to prosperity; however the historical data indicates otherwise. This study takes us from1951, where the highest marginal tax rates were 92 percent, until the present, where the highest marginal tax rates are 35 percent.

The study compares the returns of the S&P 500 and its relationship to the highest marginal tax rates during that time period. An abecedarian concept of taxation is to focus on the highest marginal tax rates. This study compares the highest marginal tax rates with the growth in the economy as measured by the S&P 500.

In reviewing the data, the optimal tax rates to keep the economy moving forward falls between 39.6 percent and 50 percent. The call for lower marginal rates or the benighted tea party movement appears only to hurt the people who are supporting the movement. The pledge not to raise taxes appears also as a pledge not to help the economy.

Tax rates 91 percent to 92 percent
Growth 11.8 percent +-

During this time period, the marginal tax rates were a staggering 91 percent to 92 percent. If high tax rates could only hurt the economy, this period cannot be explained, as the S&P 500 grew on an average of 11.92 percent (mean growth), 11.8 percent (median growth). The double-digit growth cannot be explained along with the higher marginal tax rates and especially what happened next.

Tax rates 70 percent to 77 percent
Growth 3.6 percent +-

The first paradox: Marginal tax rates fall and the economy slows down. During this time period, tax rates actually fell from between 91 percent and 92 percent to between 70 percent and 77 percent. At the same time, the economy grew at 3.6 percent (mean growth) or 7.7 percent (median growth). In any event, with lower marginal tax rates, the economy actually did not do as well as when tax rates were between 91 percent and 92 percent.

Tax rates 70 percent
Growth 4.35 percent

The second paradox: Tax rates continue to decrease and the economy still is sluggish. During this time period, marginal tax rates were 70 percent and the economy continued at an anemic pace of 4.35 percent (mean growth), 10.8 percent (median growth). The tax rates remained high, but the economy did not grow rapidly for a decade.

Tax rates 50 percent
Growth 14.8 percent

Finally, tax rates decrease and the economy grows. During this time, the Economic Recovery Tax Act of 1981 (ERTA) was passed during the Regan administration and the economy encountered real growth. The mean growth was 14.88 percent and the median growth was 14.8 percent. Marginal tax rates were lowered to 50 percent, and the economy created double-digit growth.

Tax rates 28 percent to 31 percent
Growth 10.9 percent

The third paradox: Tax rates decrease and the economy slows down. During this time, the Tax Reform Act of 1986 was passed by President Regan, the mean growth was 10.9 percent, and the median 8.45 percent. Even though the marginal tax rates were lowered, the economy actually sputtered compared to the time where marginal tax rates were 50 percent. Hence a paradox, where lower marginal rates actually did not help the economy.
Tax rates 39.6 percent
Growth 15.8 percent

The fourth paradox: Tax rates now rise and the economy has its best years. Another paradox: Tax rates increased and the economy boomed. During the Clinton era, tax rates actually increased but the economy responded on a favorable basis, increasing growth to 15.8 percent (mean) and 19.9 percent (median). In spite of the increase in the marginal tax rate, the economy actually had its best seven years as measured by the S&P 500.

Tax rates 35 percent
Growth 1.69 percent

The fifth paradox: Tax rates are lowered and the economy slows. Once again, taxes were lowered to 35 percent and the economy sputtered to 1.69 percent (mean) and 6.25 percent (median) growth. George Bush passed EGTRRA in 2001, which still remains today as the bulk of the tax law in the United States. Another paradox: When marginal tax rates were lowered, the economy faltered once again.

What is the optimal marginal tax rate?

Is a marginal tax rate of 35 percent an optimal number? To achieve growth of between 14.8 percent and 15.8 percent, the tax rates of between 39.6 percent and 50 percent were optimal rates that existed during this time period. When rates fall to between 28 percent and 31 percent, or to 35 percent, the economic growth also falls to 10.9 percent, or even worse, 1.69 percent.

However, when rates climb to 70 percent, the growth slows to between 3.6 percent and 4.35 percent. This leads the reader to an optimal marginal tax rate which appears to be in the 40 percent to 50 percent range. The tax cognoscenti, of course, can argue that marginal rates make up only a part of overall tax policy and enforcement.
  • When marginal tax rates fall below a range of 40 percent to 50 percent, the economy slows.
  • When marginal tax rates go above a range of 40 percent to 50 percent, the economy also falters. (We will discount for a moment the years 1951–1963, where rates were as high as 92 percent and the economy grew at 11.9 percent.)
  • When the rates fell to 70 percent, the economy slowed to between 3.6 percent and 4.35 percent.
  • In any event, 11.9 percent growth is still not as good as 14.8 percent and 15.8 percent, where the rates were between 39.6 percent and 50 percent.
Why do higher marginal tax rates help the economy?

This is a really good question. One answer is that money is taken out of circulation when tax rates are lowered, as wealthy individuals are able to save more money — money that is not being spent on goods and services. Another answer is that when tax rates fall and the government borrows money to fund the deficit, this creates an economic climate that exists today. Today, an ever-increasing national debt looms over the entire economic base of the United States, which impedes growth. Bottom line is that it's difficult to conclude why higher marginal rates actually help the economy, but historically, it appears the optimal rate is between 39.6 percent and 50 percent.

In fact, wealthy people may be better off with a higher marginal tax rate, as the GNP appears to increase, which actually will increase their wealth since much of their wealth is tied to the S&P 500. If marginal tax rates go up 5 percent but the stock portfolio increases 15 percent, perhaps that is a tax increase that makes sense.
If I had a hammer...

Imagine a village with 100 people. One person in the village has 30 hammers. He worked hard and saved money to purchase hammers, and by hard work he accumulated 30 hammers. Ten people in the village have two hammers. They too worked hard and saved and now have two hammers. Twenty people in the village have one hammer, and they also worked hard to be able to afford a hammer. However, 69 people in the village do not even own a hammer.

Law of redistribution

A law of redistribution was passed that upon the death of an individual, 50 percent of his hammers had to be distributed to people without hammers. The man with 30 hammers did not complain, as he felt his child would be left with 15 hammers, which is a lot of hammers for one person. The persons with two hammers complained; how could they survive with just one hammer? Nevertheless it was the law, and the person with 30 hammers died. Fifteen hammers went to people without a hammer, and these people began to work and produce more homes, roads and buildings. The village did prosper.

Law of communism

Next, a law of communism was passed that stated anyone who built a chair within 30 days would get another hammer, or if you did not build a chair, you would get another hammer within 30 days.

Now some people built a chair and some did not because they would receive a hammer anyway, so why bother to build the chair? Chairs were not produced, and there was nowhere to sit.

Law of capitalism

Finally, a law of capitalism was passed that said you would receive another hammer only if you built a chair. Many chairs were produced, as most people in the village really wanted a chair and upon producing the chair, they received another hammer.

What this simple parable demonstrates is that redistribution is not communism or capitalism. In many cases, these distinctions are confused. Redistribution can create a more robust economy for a group. Communism can disincentivize a group and capitalism can incentivize a group.

Conclusion: The paradox may be difficult to explain by economists and politicians; perhaps we should ask the simple village why it worked for them.
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