The Effects of Tax Rates on Revenue and GDP

A lot of claims are made with regard to the effects of income tax rates and revenue, as well as the economic benefits of low tax rates and the harm of high tax rates. For example, we regularly hear that the Bush tax rates were not paid for and even created the Great Recession, while the economy boomed under the higher Clinton tax rates.

I’d like to examine the issue by comparing revenue from federal income taxes to gross domestic product (GDP). To try and correlate these to tax policy, I’ve grouped the years from 1954 through 2011 by “president’s tax rates.” For example, George W. Bush made significant tax rate changes in the early years of his administration, and those rates remain in effect today, so the Bush Tax Rates go from 2001 through 2011. While Barack Obama has been president since 2009, the current tax rates are the result of Bush’s tax policy and not Obama’s. I use the following periods:

• Truman (D) Tax Rates 1954-1964
• Kennedy (D) Tax Rates 1965-1981
• Reagan (R) Tax Rates 1982-1990
• H.W. Bush (R) Tax Rates 1991-1992
• Clinton (D) Tax Rates1993-2000
• W. Bush (R) Tax Rates 2001-2011

Historical Tax Rates

The following chart summarizes historical tax rates, showing bands between the highest and lowest tax bracket and tracking the average and median tax rate. It is included here simply to provide context.

Click to enlarge

Income Tax Revenue

The tax rates above generated tax revenue as shown in the next chart (data provided by the Tax Policy Center. In terms of raw dollars, there is very little to learn from this chart. In each tax period, revenue rises steadily over time regardless of tax rates. The two largest dips correspond to 1) the Internet recession and terrorist attacks on 9/11/01 at the beginning of the Bush administration and 2) the Great Recession of 2008. Tax rates did not vary significantly across those recessions, so they cannot correctly be associated with Bush’s tax policy.

Gross Domestic Product

In terms of the economic effect of tax policy, the next chart showing GDP from 1954-2011 (data from the Bureau of Economic Analysis) strongly indicates that there is no effect whatsoever. It’s worth noting that during the period of highest tax rates (1954-1964), GDP is at its flattest, but undoubtedly GDP continues a steady rise over time regardless of rates. Like the revenue chart earlier, the 2008 recession shows the most significant dip.

Revenue as a Share of GDP

The two charts above can be blended by calculating income tax revenue as a percentage of GDP. At least with this view we get some meaningful comparisons between presidents and their tax policies.

Truman Tax Rates (20%-91% with a median of 60.5%)    The Truman period shows a flat trend line indicating that higher tax rates don’t necessarily lead to higher tax revenue as a share of GDP. It’s worth noting that this is the end of several decades of high tax rates, so one explanation for the flat trend is that Americans had learned to adjust to higher tax rates.

Kennedy Tax Rates (14%-70% with a median of 45%)    The Kennedy period shows positive revenue growth over time, with a rapid spike immediately following the implementation of the Kennedy tax rates. The Kennedy rates involved significant tax reform and a general lowering of rates. From this positive trend, conservatives tend to draw the lesson that lower tax rates always lead to higher tax revenue.

Reagan Tax Rates (11%-50% with a median of 28%)    After the Reagan tax reforms, revenue fell substantially but otherwise held a flat trend throughout the period. This contradicts the common conservative argument that lower tax rates increased revenue by expanding the tax base. The H.W. Bush years (15%-28% with a median of 21.5%) generally extend the Reagan period, although Bush implemented a tax rate increase and saw a slight decline in revenue relative to GDP.

Clinton Tax Rates (15%-39.6% with a median of 31%)    The Clinton tax rates demonstrate the highest and most persistent revenue growth across all presidents between 1954 and 2011. Unlike the positive trend following the Kennedy rate decreases, Clinton saw higher tax revenue after raising rates. Progressives like to point to the Clinton period as an example of how higher tax rates always lead to higher revenue.

Bush Tax Rates (10%-35% with a median of 26.5%)    Finally, the George W. Bush tax rates show a clear downward trend in revenue, although the results are muddied by the two recessionary periods that occurred in 2001 and 2008. But even discounting those recessionary periods, it’s clear that tax revenue trended downward as a share of GDP.

Lessons for Tax Policy

At this point, the conclusion should be obvious: tax rates alone do not affect economic growth or federal tax revenue. Instead, income tax rates are one factor among many that affect economic growth, and it’s more likely that tax revenue is positively correlated to economic growth than tax rates.  The lessons for policy makers should be similarly obvious: to increase tax revenue, focus on economic growth instead of increasing tax rates.

A second lesson is perhaps less obvious. If tax rates don’t really matter in generating revenue, then tax policy will naturally be driven by other motives. For example, Republicans want “fair” tax policies that are generally low and require most people to pay something into the system, while Democrats want “fair” tax policies that have the rich pay more and shift the burden away from the poor and the middle class.

Both parties have their own ideological agendas, and tax fairness is something that both parties claim to want. Perhaps they should stop pretending that lower or higher tax rates are part of that ideological agenda, and are instead just a tool to accomplish other goals.