Econ 101: How Do Tax
Despite the mediaís portrayal, tax cuts
Ďfor the richí arenít bad Ė and they boost the economy.
By Gary Wolfram, Ph.D.
Free Market Project Adviser
Jan. 11, 2006
The recent economic expansion in the United States Ė bolstered by
news of 2 million jobs created in 2005 and an unemployment rate
below 5 percent Ė is in large part due to the 2003 tax reduction.
Tax cuts create economic growth. There is little doubt that this is
the case, both at the national and local levels. Letís look at how
theyíve worked through history.
A Short History: Tax Cuts Work
¬†¬†¬†¬† If we look at the U.S. economy, three historical
examples are the Harding-Coolidge tax cuts of the 1920s, the
Kennedy-Johnson tax cuts of the 1960s, and the Reagan cuts of the
1980s. The U.S. federal income tax, established with the enactment
of the 16th amendment in 1913, began with a top marginal rate of 7
percent. This quickly escalated to 77 percent by 1918. During the
Harding-Coolidge administrations the top marginal rate was reduced
to 25 percent by 1925. Economic output nearly doubled over the
following four years, and unemployment fell sharply.
¬†¬†¬†¬† During the Depression and World War II tax rates rose
steadily, with the top marginal rate reaching 94 percent by the end
of the War and remaining at 90 percent or more well into Kennedy's
term. Kennedy pushed for tax cuts, which were enacted in 1964 after
his assassination. The top marginal tax rate was reduced from 91
percent to 70 percent by 1965. What followed was a major expansion
in the economy. Real gross domestic product rose in the four years
after the tax cut by an average of 5.1 percent per year.
Unemployment averaged 3.9 percent, compared to a 5.8 percent average
in the four years prior to the tax cut.
¬†¬†¬†¬† The Reagan tax cuts of 1981 dropped the top marginal
rate from 70 percent to 50 percent, with additional cuts in the tax
on capital gains. The top marginal rate was further reduced to 28
percent by 1988. The result was again an increase in growth in the
economy. Real GDP grew by .9 percent per year between 1978 and 1982,
and grew by 4.8 percent per year from 1983 to 1986. The unemployment
rate was 9.7 percent in 1982. It fell to 7.0 percent by 1986, and
was 5.3 percent in January of 1989.
Tax Cuts Ďfor the Richí?
¬†¬†¬†¬† This is a history of tax breaks ďfor the richĒ
resulting in economic growth for everyone, especially for the poor.
Just as an example, in 1920, 26 percent of Americans owned
automobiles. The Harding-Coolidge tax cuts were enacted and by 1930,
60 percent of Americans had a car. Electric lighting was in 35
percent of Americansí homes in 1920 and 68 percent by 1930. When the
top marginal tax rate was 91 percent in 1920, only one in five
people lived in a household with a flush toilet. By 1930 more than
half of Americans would have flush toilets.
¬†¬†¬†¬† Why does a reduction in the highest marginal tax rates
improve the living standards of all of us? It does not occur due to
some trickle-down theory that rich people will spend more money on
goods and this will create jobs for the rest of us. There simply
arenít enough rich people for this to make sense. The real answer
lies in an understanding of how markets work.
¬†¬†¬†¬† A market economy is based on voluntary exchange. I
cannot force you to buy something that I produce, and you cannot
force me to produce something for you. The only way you can get rich
in a market economy is to produce something that others want and are
willing to pay for. Since there are not a lot of rich people, you
are more likely to get rich producing something for the poor and
middle class that they will want and at a cost that they can and are
willing to pay.
¬†¬†¬†¬† The marginal tax rate is the one that affects your
incentive to do this. It tells you how much of the next dollar the
government will take and how much of the next dollar you get to
keep. Lowering the marginal tax rates creates a greater incentive
for people to find a way to produce things for the poor. This is
what happens in any market economy, be it the United States or
Estonia (which is growing rapidly after reducing its top marginal
tax rates). It also makes it easier for people who are poor to
become rich, thus increasing their willingness to work hard and risk
their assets to produce what others will want.
¬†¬†¬†¬† If the government taxes away 90 percent of each
additional dollar you earn, there will be little incentive for you
to risk your life's earnings in a new venture that has an uncertain
payoff, and it will be very difficult for you to move from poverty
to wealth. On the other hand, if you get to keep 75 percent of each
dollar that you earn, you will have an incentive to risk your
capital, work hard, and produce goods and services that others want
at a cost they can afford.
¬†¬†¬†¬† Democrats try to chide Republicans for offering ďtax
breaks for the rich.Ē Republicans, unfortunately, seem not to be
willing to claim credit for doing so. It is by creating tax breaks
for the rich that the poor in America become wealthy. Today 60
percent of all poor households in America own their own car. Nearly
half own their own home. This situation has occurred because of the
workings of the market system of voluntary exchange and incentives
that reward those who produce for others. Once the average person
understands how the market system works, attempts to confuse voters
through what Ludwig von Mises called the politics of envy will fail,
and we will be able to maintain economic growth for all.