Mind Games 2.0

Bloggin' 'bout science and life

What is the relationship between economic performance and the highest income tax rate?

I am a scientist.  The fundamental basis of science is empirically testing the assumptions, hypotheses and theories for how one thinks something works.  Given the debates about taxes, economic growth and the countries’ debt and deficit over the past 10 years, I decided to do a scientific test of one major premise.  Does having a lower top marginal tax rate (i.e., the tax rate on those with the highest incomes) correspond to a better economy?

Doing science is actually very simple.  (1) You propose an hypothesis for how you think something works.  (2) From that hypothesis you devise a prediction of what should happen when you do something (i.e., you design an experiment that will test the hypothesis), or what types of correlations you should see in observational data you gather (i.e., you gather data to test your hypothesis).  If your prediction is upheld, at least you are not demonstrably wrong, and you may be right.  You are not assured of being right because many different hypotheses may make the same prediction, so at least the hypothesis you tested is still in the running of possible right answers.

As a scientist, I am always interested in the empirical evidence that supports the policy decisions of our political class.  One of the major policy platforms espoused today by almost every Republican politician is that a higher top income tax rate stifles the economy.  This certainly seems to be the primary hypothesis for their fiscal policy today.

From this hypothesis, one can derive a very simple prediction: the economy should perform better when the highest income tax rate is lower.  One way to test this prediction would be to consider the relationship between various metrics of economic performance and the top income tax rate.  One often cited measure of economic performance is the rate of change in the Gross Domestic Product (GDP).  Thus, the change in the GDP should be negatively correlated with the top income tax rate.  In other words, as the top income tax rate increases, GDP should decrease.

These data are publicly available for the USA, and so I compiled them in about 2 minutes of searching on the web.  I obtained the change in US GDP (1930-2010) from the Bureau of Economic Analysis, and data on US federal income tax rates from the Tax Foundation.

figure of the GDP vs Top Tax Rate

This figure shows the relationship between the USA GDP and the highest income tax rate for data from 1930-2010.

This is a plot of these data for 1930-2010.  For the full data set of 1930-2010, the regression line for GDP vs. Highest Income Tax Rate (the black line in the figure) has a statistically significant and positive slope (for those who are interested, the regression equation is GDP = 0.054 * Highest Tax Rate – 0.057, and the slope is significantly different from zero based on a standard t-test [t=2.24, P<0.027]).  Thus, in the full data set, GDP and the highest income tax rate for the USA are positively correlated, which is not consistent with the prediction of the hypothesis.

I also did separate analyses for three different periods in the data. Data for these three different periods are identified by different symbols and colors in the plot.  During the period 1930-1945 (i.e., the Great Depression & WWII – blue circles and blue line), the relationship between GDP and the highest income tax rate was strongly positive (GDP = 0.27 * Highest Tax Rate – 14.57  [test for slope different from zero, t=2.77, P<0.016]).  During the period 1946-1963 (brown triangles, the highest tax rate only varied by 2% from 90-92%, and so a regression analysis was not warranted.  And during 1964-2010 (red diamonds and red regression line), the relationship was not significant (test for slope different from zero, t=1.52, P>0.13).

Thus, based on these data, the hypothesis that a low top tax rate spurs economic growth must be rejected.  In none of the major historical periods of the past century was GDP negatively related to the tax rate on the wealthiest Americans.

Perhaps GDP is not the appropriate variable to evaluate economic growth. However, if it is not, I would like to see similar analyses of what others think are the appropriate metrics of the economy to justify their policies.  If one is to justify policies, one must support them with facts.

Dogma and faith are no basis for deciding government policy.

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3 Comments

  1. Jean

    Nicely done! Now if only politicians would learn basic scientific principles…

  2. BRUCE CAMPBELL

    SEEMS THAT THE DATA FOR 1930 TO 2010 IS HIGHLY INFLUENCED BY THE 1930 TO 1945 DATA. GDP IS ALSO CORRELATED TO GOVERNMENT SPENDING WHICH HAS CERTAINLY INCREASED THANKS TO DEFICIT SPENDING, RIGHT NOW ABOUT 10% OF GDP IS BORROWED. I ASSUME THIS SHOWS INCREASING TAXES LEADS TO INCREASING GOVERNMENT SPENDING WHICH INCREASES GDP

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