Tax Rate Cuts Would Raise Long-Term Growth

Tax rate cuts would raise long-term growth...cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.

In a recent NBER study, Taxation and Economic Growth (NBER Working Paper No. 5826) Eric Engen and Jonathan Skinner conclude that a major tax reform -- on the order of scaling back average tax rates to those last seen in the Eisenhower Administration -- would increase economic growth by at most 0.2 to 0.3 percentage points. The authors caution, however, that while the growth effects of tax reform may be small in the short-term, their impact is much larger over a longer horizon. If an inefficient tax system had retarded economic growth by 0.2 percent since 1960, then GDP in 1996 would be 7.5 percent smaller, for a net reduction in output of $500 billion. To put this in perspective, that level of annual output reduction is nearly ten times this year's federal government budget deficit. Since per capita GDP growth during the past decade has been only 1.3 percent, the lower tax rates would raise real per capita growth by about one-fifth of its recent value.

Discerning how taxes affect economic growth is not easy, the authors note, because there are typically many other things going on that can easily mask the tax effects on growth. For example, Engen and Skinner show that in the United States, the half-decade with the most rapid growth in GDP is also the half-decade with the most rapid growth in tax rates: World War II. Even in the post-war era, the aggregate data paint a confused picture; growth rates fell in the 1970s as marginal tax rates rose, but in the most recent decade (through 1995) marginal tax rates have fallen while growth has declined.

Engen and Skinner take two different approaches to discerning how taxes affect growth. First, they look at cross-country experiences. Over the past few decades, Engen and Skinner point out, some countries have increased taxation dramatically while others have kept it relatively constant. A number of studies of these countries by other authors have found that cutting marginal tax rates increases economic growth. Based on these cross-country studies, Engen and Skinner conclude that cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.

Second, Engen and Skinner turn to others' research on the effect that changes in tax rates have had on the capital stock, labor supply, and R and D in the United States. They use the results of these studies to estimate the likely effect of cuts in tax rates. A hypothetical 5-percentage point cut in marginal tax rates, they conclude, would cause long-run economic growth to increase by 0.2 percentage points.

Both sets of studies suggest about the same answer: a 0.2 to 0.3 percentage point increase in growth rates in response to a major change in the tax structure, defined here as a decline in the average tax burden of 2.5 percent of GDP or a 5 percentage point marginal tax cut (for example, from a 15 percent marginal tax rate to a 10 percent marginal tax rate).