Tax Rates Impact Economic Performance, but other Policies also Matter

I’m a big fan of fundamental tax reform, in part because I believe in fairness and want to reduce corruption.

But I also think the flat tax will boost the economy’s performance, largely because lower tax rates are the key to good tax policy.

There are four basic reasons that I cite when explaining why lower rates improve growth.

1. They lower the price of work and production compared to leisure.
2. They lower the price of saving and investment relative to consumption.
3. They increase the incentive to use resources efficiently rather than seek out loopholes.
4. They attract jobs and investment from other nations.

As you can see, there’s nothing surprising or unusual on my list. Just basic microeconomic analysis.

Yet some people argue that lower tax rates don’t make a difference. And if lower tax rates don’t help an economy, then presumably there is no downside if Obama’s class-warfare tax policy is implemented.

Many of these people are citing David Leonhardt’s column in Saturday’s New York Times. The basic argument is that Bush cut tax rates, but the economy stunk, while Clinton increased tax rates and the economy did well.

The defining economic policy of the last decade, of course, was the Bush tax cuts. President George W. Bush and Congress, 

including Mr. Ryan, passed a large tax cut in 2001, sped up its implementation in 2003 and predicted that prosperity would follow. The economic growth that actually followed — indeed, the whole history of the last 20 years — offers one of the most serious challenges to modern conservatism. Bill Clinton and the elder George Bush both raised taxes in the early 1990s, and conservatives predicted disaster. Instead, the economy boomed, and incomes grew at their fastest pace since the 1960s. Then came the younger Mr. Bush, the tax cuts, the disappointing expansion and the worst downturn since the Depression. Today, Mitt Romney and Mr. Ryan are promising another cut in tax rates and again predicting that good times will follow. …Mr. Romney and Mr. Ryan would do voters a service by explaining why a cut in tax rates would work better this time than last time.

While I’ll explain below why I think he’s wrong, Leonhardt’s column is reasonably fair. He gives some space to both Glenn Hubbard and Phil Swagel, both of whom make good points.

“To me, the Bush tax cuts get too much attention,” said R. Glenn Hubbard, who helped design them as the chairman of Mr. Bush’s Council of Economic Advisers and is now a Romney adviser. “The pro-growth elements of the tax cuts were fairly modest in size,” he added, because they also included politically minded cuts like the child tax credit. Phillip L. Swagel, another former Bush aide, said that even a tax cut as large as Mr. Bush’s “doesn’t translate quickly into higher growth.” Why not? The main economic argument for tax cuts is simple enough. In the short term, they put money in people’s pockets. Longer term, people will presumably work harder if they keep more of the next dollar they earn. They will work more hours or expand their small business. This argument dominates the political debate.

I hope, by the way, that neither Hubbard nor Swagel made the Keynesian argument that tax cuts are pro-growth because “they put money in people’s pockets.” Leonhardt doesn’t directly attribute that argument to either of them, so I hope they’re only guilty of proximity to flawed thinking.

But that’s besides the point. Several people have asked my reaction to the column, so it’s time to recycle something I wrote back in February. It was about whether a nation should reform its tax system, but the arguments are the same if we replace “a flat tax” with “lower tax rates.”

…even though I’m a big advocate for better tax policy, the lesson from the Economic Freedom of the World Index…is that adopting a flat tax won’t solve a nation’s economic problems if politicians are doing the wrong thing in other areas.

There are five major policy areas, each of which counts for 20 percent of a nation’s grade.

1. Size of government
2. Regulation
3. Monetary Policy
4. Trade
5. Rule of Law/Property Rights

Now let’s pick Ukraine as an example. As a proponent of tax reform, I like that lawmakers have implemented a 15 percent flat tax.

But that doesn’t mean Ukraine is a role model. When looking at the mix of all policies, the country gets a very poor score from Economic Freedom of the World Index, ranking 125 out of 141 nations.

Conversely, Denmark has a very bad tax system, but it has very free market policies in other areas, so it ranks 15 out of 141 countries.

In other words, tax policy isn’t some sort of magical elixir. The “size of government” variable accounts for just one-fifth on a country’s grade, and keep in mind that this also includes key sub-variables such as the burden of government spending.

Yes, lower tax rates are better for economic performance, just as wheels matter for a car’s performance. But if a car doesn’t have an engine, transmission, steering wheel, and brakes, it’s not going to matter how nice the wheels are.

Not let’s shift from theory to reality. Here’s the historical data for the United States from Economic Freedom of the World. As you can see, overall economic policy moved in the right direction during the Clinton years and in the wrong direction during the Bush-Obama years.

To be more specific, the bad policy of higher tax rates in the 1990s was more than offset by good reforms such as lower trade barriers, a lower burden of government spending, and less regulation.

Similarly, the good policy of lower tax rates last decade was more than offset by bad developments such as a doubling of the federal budget, imposition of costly regulations, and adoption of two new health entitlements.

This is why I have repeatedly challenged leftists by stating that I would be willing to go back to Bill Clinton’s tax rates if it meant I could also go back to the much lower levels of spending and regulation that existed when he left office.