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_______________________________

Institute for Workplace Studies----------------- Professor Samuel B. Bacharach

School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies

Cornell University

16 East 34th Street, 4th floor---------------------- Stuart Basefsky

New York, NY 10016 -------------------------------Director, IWS News Bureau

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Congressional Research Service (CRS)

 

Tax Rates and Economic Growth

Jane G. Gravelle, Senior Specialist in Economic Policy

Donald J. Marples, Specialist in Public Finance

January 2, 2014

http://www.fas.org/sgp/crs/misc/R42111.pdf

[full-text, 12 pages]

 

Summary

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 increase taxes to reduce the deficit and whether to reform taxes by broadening

the base to lowering tax rates.

 

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

indicate 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 lower, not higher, 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.

 

Contents

Short-Run Counter-Cyclical Effects Versus Long-Run Growth ...................................................... 1

Historical Comparisons of Tax Rates, Labor Supply, Savings, and Growth Rates .......................... 1

Labor Force Participation .......................................................................................................... 2

Savings and Investment and GDP Growth ................................................................................ 3

Review of Evidence on Factors Affecting Growth .......................................................................... 5

Labor Supply ............................................................................................................................. 6

Savings and Investment Response ............................................................................................. 6

Technological Progress, Innovation, and Small Business ......................................................... 7

Dynamic Revenue Estimating ......................................................................................................... 8

 

Figures

Figure 1. Tax Rates and Labor Force Participation ......................................................................... 2

Figure 2. Tax Rates and Hours Worked ........................................................................................... 3

Figure 3. Tax Rates and Net Savings ............................................................................................... 4

 

Tables

Table 1. Average Top Tax Rates on the Growth Rate of Real GDP and Real Net Fixed Investment, by Time Period ................... 5

Table 2. Average Top Income Tax Rate on the Growth Rate of Real GDP ..................................... 5

 

Contacts

Author Contact Information............................................................................................................. 9

 

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