part ix - dominant causes of the credit crisis. why taxation may be the key to an economic recovery

8/3/2019 Part IX - Dominant Causes of the Credit Crisis. Why Taxation may be the Key to an Economic Recovery

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Part IX - The Dominant Causes of the Credit

Crisis. Why Taxation may be the Key to a

Recovery

By David Collett

The Relationship between GDP growth and changes to

Top Marginal Tax Rates

Strong correlation between changes in Tax Rates andchanges in Income Inequality

Let us acknowledge the obvious any thought of higher taxes

causes an automatic impulse of revulsion in most people. Aflurry of emotion befalls us. It is not a subject where objectivity

is the norm. If any argument can be raised against higher taxes

the vast majority of entrepreneurs would do so with vigour

because resistance to giving away money we have earned is in

our veins. Secondly, we dont need studies to convince us that

the lowering taxes must have some stimulatory effect on the

economy. If you lower taxes you increase disposable income,

some of which will flow through to demand. That in turn will

drive growth higher, at least in the short term.

However, things are not always what it seems. Not only did the

significant lowering of taxes, especially lowering of the top

marginal tax rates, preceded The Great Depression (1930s)

and The Great Recession (2008) but it also correlates positively

with time periods that underperformed in terms of GDP growth.

An objective analysis of historical data for the United Statescontradicts the conventional wisdom that lower taxes lead to

higher GDP growth over time and vice versa. This is somewhat

of a mystery that can only be solved by looking at it from a

wider perspective. But lets start by looking at the facts.

The Relationship between GDP growth and changes to

Top Marginal Tax Rates


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In Chart T1 below, we compare the real US GDP growth for each

decade (ending 31/12/X9) with the average top marginal tax

rate for the same period. With the exception of the thirties, the

strong positive correlation between changes in top marginal tax

rates and GDP growth is puzzling. One would rather expect a

strong negative correlation between GDP growth and changes

in tax rates. Although the data on chart T1 does not prove that

higher GDP growth was causally linked to higher top marginal

tax rates, it certainly shows that higher tax rates were more

closely associated with higher GDP growth than with lower

growth and vice versa. There is certainly no evidence where

lower top marginal tax rates caused stronger growth over any

sustained period.

The lower GDP growth reflected in the above chart for the

thirties-decade is somewhat misleading for the following

reasons:

1. The end of 1929 was used as the starting point tocalculate the GDP growth for the thirties-decade. GDP
http://www.nvcc.edu/home/elanthier/methods/correlation.htmhttp://www.nvcc.edu/home/elanthier/methods/correlation.htm


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growth moved upwards until the stock markets crashed

late in 1929. The subsequent drop in GDP growth was

only reflected in the period from 1930 to1933.

2. The top marginal tax rate dropped from 73% to 25% in

the first half of the 1920s and remained at that low

level until 1932 when the marginal top tax rate was

moved up to 63%.

3. The thirties-decade in the chart above therefore reflects

the consequences of the 1929 crash, namely the steep

drop in GDP that occurred mainly in 1930 and 1931

when the low rate of 25% still applied.

Chart T2 below shows a more accurate picture of the positive

correlation between changes in tax rates and GDP growth for

the twenties and thirties. The period from end of 1917 to the

end of 1938 was divided in three periods of seven years in

order to compare the seven year period (end of 1924-1931),

when the top marginal rate was at the relative low level of

25%, with the seven year period before (end of 1917-1924)

and after (end of 1931-1938).


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The results show that GDP grew only 1% over the seven year

period that the top marginal tax rate was at its lowest,

compared to the 31% for the previous 7-year period and 19%

for the subsequent 7-year period, the latter two periods havingsubstantially higher top marginal rates. Once again the data

shows that GDP growth was higher in times of high tax rates

and lower in times of lower tax rates.

Chart T3 below, analyse the data in more detail. It shows that a

substantial tax reduction to the relative low rate of 25% (1925)

preceded the 1929 stock market crash and The Great

Depression that shows up in the GDP numbers of the period

from 1930 to 1933. It further shows that although the low tax

rate of 25% prevailed until 1932, the GDP growth continued to

slide downwards. There is no indication that the higher

marginal tax rates that came into effect in 1932 and 1936,

prevented GDP growth from recovery. The GDP growth rate for

the period 1934 to 1937 is also substantially higher than

comparative growth in the twenties when the marginal tax rate

was 25%.


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In chart T4 we look at the second half of the 20 th century and

first decade of 21st century. It shows how the downward slide in

the top marginal tax rates was accompanied by a similar

downward trend in GDP growth.


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The nineties-decade seems to deviate slightly from the trend. A

closer examination of the late eighties and nineties is shown inChart T5 below. It confirms the strong positive correlation

between higher taxes and higher GDP growth and vice versa.


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The first decade of the 21st century had the lowest growth since

The Great Depression and chart T6 below reflects the same

trends as shown in other charts above.


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The above charts show that GDP growth and tax rate changestracked each other (positive correlation) in trending up or down

instead of moving in opposite directions (negative correlation).This contradicts conventional wisdom and the logicalconsequences of decreases in tax rates as argued in ourintroduction, both of which suggest a strong negativecorrelation between changes in marginal tax rates and GDPgrowth.

The above data is however, subject to the following caveats:

1. Although the tax rates for both the top and bottomincome brackets generally moved in the same directionfor the relevant period, the tax rate movements for thetop income brackets were relatively larger in anyupward or downward movements. The top incomegroups disposable incomes were therefore moreimpacted by the movements. On the downward movesin top marginal income tax rates one could surmise thatthe major part of the increases in disposable income

that flowed to top earners was saved rather than spent.When the tax rates went up, the opposite can besurmised in that it impacted the lower earners lesswhile higher earners consumption expenditure werenot significantly affected. However, although the abovemay explain why tax reductions did not spur economicgrowth as much as one would have expected ordecreased growth as much when taxes went up, it doesnot explain the conundrum as to why economic growth

tends to move up with tax increases and down withdeclining marginal tax rates.

2. Increases or decreases in top marginal tax rates can bemisleading if the values of top income brackets (onlyincome over a certain limit or bracket-value issubjected to the top marginal tax rate) are changed tosuch an extent as to negate much of the impact ofhigher or lower tax rates. The increase in tax rates in

the thirties was to some extent negated by the largeincreases in the value of the top income brackets and


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the same happened in the early twenties when the topincome bracket was lowered at the same time aslowering the marginal tax rates. The same goes forchanges in allowable deductions which might have had

a material impact on tax payable from time to time.

3. World War II added extra growth to the GDP growth in

the forties as the United States became the main

supplier of arms to the Allied Forces. The forties GDP

growth as reflected on chart T1 above may therefore

include a war premium (10% - 25%) that was

unrelated to any changes in taxation.

4. Since the late sixties, payroll taxes moved in theopposite direction to top marginal tax rates. Theincreases in payroll taxes had much less impact on topearners (top 1%) than on lower income earners. Payrolltaxes therefore had a more direct impact on demand asit decreased the disposable income of those earnerswho would most likely have spent it. It may well haveplayed some part in the lower economic growth overthe last four decades.

5. Capital gains taxes also trended downwards since themiddle of the 20th century and had a great influence onthe effective tax rate that some income earners paid,especially in the first decade of 21st century.

None of the above however, explains the conundrum of astrong positive correlation between changes in top marginalrates and GDP growth instead of the expected negative

(inverse) correlation. The solution to this puzzle must be soughtelsewhere.

Changes in Income Inequality are the link betweenTaxes and GDP growth.

Changes in the dispersion of income between the bottom 99%and top 1% of income earners are the missing link thatconnects GDP growth with changes in topmarginal tax

rates.


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The evidence below will show that higher marginal tax ratesfor the top 1%, strongly correlated with an improvement inincome inequality (bigger share of income dispersed tobottom 99%). Part VIII of The Dominant Causes of the Credit

Crisis explains how growing income inequality (smallershare of income to bottom 99%) strongly correlates withperiods of lower GDP growth and vice versa.

Simply put when top marginal tax rates go up, marketsand/or employers react and distribute a bigger share of theincome to the bottom 99% - improving income inequality.

This causes an increase in demand for goods and serviceswhich in turn leads to higher GDP growth. When top marginal

tax rates decrease, the opposite happens - leading to higherincome inequality (smaller share to 99%), lower demand andlower GDP growth. The strong positive correlation betweenchanges in top marginal tax rates and GDP growth istherefore due to changes in the dispersion of income (incomeinequality) between the top 1% and bottom 99%.

Strong correlation between changes in Tax Rates and

changes in Income Inequality

The charts below will show how closely changes in US incomedispersion between the top 1% and bottom 99% were linked tochanges in top marginal tax rates. It further illustrates howchanges in top US marginal tax rates preceded or coincidedwith decreases in the top 1%s share of income and vice versa.

Simply put when the top marginal tax rates moved up, the top1% got less of the total income cake and when marginal ratesmoved down, the top 1% got less of the income cake. It is alsoimportant to take note that all income refers to gross personalincome or income before tax and not disposable (after tax)income. In other words; increases to the bottom 99%s incomedid not come from the higher taxes paid by the top 1%, butfrom increased salaries and wages. Higher top marginal taxrates would therefore not necessarily lead to bigger taxcollections by governments, because the top 1% would pay taxon a relatively smaller income and the bottom 99% would paytax on a relatively larger income.
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Chart T7 below compares the changes in top marginal tax rateswith changes in the top 1%s share in total personal income onan annual basis from 1916 to 1928 when the top 1% share in

total personal income grew to a record 19.6% (capital gainsexcluded) or 23.9% (capital gains included), one year beforethe 1929 stock market crash and the onset of The GreatDepression.

The negative (inverse) correlation between changes in topmarginal tax rates and changes in the top 1%s share of income

is clearly visible from the chart. When tax rates went up in1917, the top 1%s share of income dropped. Soon after the taxrates decreased to lower levels in the early twenties, the top1%s share quickly increased to the all-time record level of19.6% (23.9% with capital gains) for the 20th century.

In the aftermath of the 1929 crash the top 1%s share inincome came down a little in subsequent years, which is fairlycommon in years subsequent to major stock market crashes

(smaller bonuses, losses on investments etc.). It however,remained relatively high untill 1941, despite substantial


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increases in the top marginal tax rates. Chart T8 below,confirms that the top 1%s share of total income did not reactsignificantly to the first tax rate increase in 1932 and very littleto the second tax rate increase in 1936. However, from 1942

onwards the top 1%s share of total income decreased at amore rapid pace .

The above chart confirms that the correlation betweenchanging tax rates and changes in income inequality was notas strong for the period from 1933 to 1941 as it was for

subsequent and prior periods. There is however, an explanationas to why a change to the top 1%s share was not so sensitiveto increases in the top marginal tax rates in the relevantperiod. At the same time that the top marginal tax rates wereraised, the top income brackets values were simultaneouslyincreased too, which had the effect that only income above thetop income bracket values was subjected to the higher topmarginal tax rate. The top income bracket went up from$100,000 to $1million in 1932 when the top marginal tax rate

was raised from 25% to 63%. In todays money value the$1million amounts to a value in excess of $10million. In 1936


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the top income bracket was once again raised to $5millionwhich in todays money value would easily exceed $50million.

The effect was that the increases in marginal tax rates weresubstantially negated by the increase in the top income

brackets values which may explain why the top 1%s share ofincome bucked the trend to some extent for the relevantperiod.

In 1942 though, the top income bracket was dropped to$200,000. It had the effect that all personal income in excess of$200,000 was taxed at the top marginal rate and not onlyincome in excess of $5million. The effective tax rates for topearners therefore increased substantially in 1942. This effective

increase in tax payable by top income earners was followed bya significant drop in the top 1%s share of income in 1942; atrend that continued into the seventies albeit at a slower pace.In chart T9 below, the relationship between changes in topmarginal tax rates, top income brackets and the top 1%s shareof total income is clearly demonstrated.


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The top marginal tax rates were lowered to +-70% (with someexceptions) from the second half of the sixties, but they alsoreduced the value of the top income bracket in 1965, whichnegated some of the effects of a lower top marginal rate.

As shown in chart T-10 below, a major drop in top marginal taxrates in 1982 and especially 1987 were accompanied by a newrising trend in the top 1%s share of total income. Althoughvalues of top income brackets also changed, it was ratherminiscule compare to the huge changes of the thirties andforties. The biggest change to the top income bracket, relativeto other changes in the last three decades, was in 1994 when itwas lifted from $89,000 to $250,000, negating some of the

impact of the higher marginal rates (31% to 39.6%). The top1%s share decreased a little after the Dotcom-bubble in 2001but soon renewed its upward trend to new highs after anotherreduction in the top marginal tax rate to 35%.

The tendency to take a greater share of income in the form ofcapital gains increased in popularity among top income earnersover the last three decades. Chart T-11 below shows that the

same inverse trend as shown in the above charts, existed


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between changes in capital gains tax rates and changes in thetop 1%s share in total income that included capital gains.

The strong negative correlation between changes in marginaltax rates and the top 1%s share of income, as portrayed in theabove chart, is compelling. The direct and near immediateimpact of changes in the abovementioned tax rates on the top1%s share of income is undeniable.

These trends are not unique to the United States. Many of the

advance economies have experienced a rise in incomeconcentration over the last two to three decades against ageneral trend of lower taxes on the higher income groups.Switzerland, which was not subjected to the major changes intax rates as the US and other develop countries were over thepast century, shows relatively little change in incomedistribution over the comparative period. This lends support tothe argument that major changes in marginal tax rates have amajor impact on income inequality.
http://247wallst.com/2011/12/06/taxing-the-rich-one-state-at-a-time/http://247wallst.com/2011/12/06/taxing-the-rich-one-state-at-a-time/http://www.econlib.org/library/Enc/MarginalTaxRates.htmlhttp://247wallst.com/2011/12/06/taxing-the-rich-one-state-at-a-time/http://247wallst.com/2011/12/06/taxing-the-rich-one-state-at-a-time/http://www.econlib.org/library/Enc/MarginalTaxRates.html


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Why is there such a strong correlation between changesin Tax Rates and changes in Income Inequality?

The answer to the above question is a tricky one. One can

approach the question from two angles; one being the effect onafter-tax income dispersion and its influence on future incomeand the other one being the before-tax income dispersion, thefocus of this article.

Lower tax rates may lead to lower personal tax collection (as a% of GDP) by governments and vice versa. For example, theUnited States collection of personal income taxes (payroll taxexcluded) dropped in the last decade due to substantially lower

effective tax rates. Changes in taxation may therefore enablegovernments to increase or decrease transfers to lower incomegroups, thereby creating a more equal net distribution ofincome benefits. Some economists question the effectivenessof these transfers but there are countries like some of theScandinavian countries where it was implemented with somedegree of success. This topic, however, have very little to dowith the changes in income dispersion as referred to in thecharts above because it does not impact before-tax income

dispersions at least not directly.

The before-tax changes in income dispersion are a gamebreaker in any major changes in income inequality whereas theredistribution of higher taxes actually paid generally has lessimpact. As said before, the above charts depict the before-taxdistribution of gross personal income (salaries, wages, bonuses,rent, fees, interest, dividends etc.). Changes in tax policy(higher or lower top marginal tax rates) preceded most of thechanges. The distribution in gross personal income thereforedid not change because of the taxes actually paid, but changedbecause of the taxes that were to be paid by the 1%. Why didthis happen?

There is no simple answer to this important question. It wouldprobably be best to try and interpret the trends and relateddata in the most logical way possible.

One explanation that has been proposed before is that a lowerdisposable (after-tax) income for the top 1% cause them to dig


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into their savings; leaving increasingly less savings to earnfuture returns causing a downward trend in income for the top1%. If true, a decrease in the top 1%s share of disposableincome (due to higher taxes) would imply that gross personal

income would grow slower in subsequent years. One wouldtherefore expect lower growth in total personal income inperiods where the top 1%s share of personal income decreasesand higher growth in periods where the top 1%s share ofpersonal income increases. But as clearly demonstrated in PartVIII ofThe Dominant Causes of the Credit Crisis, exactly theopposite happened as personal income grew substantiallyfaster in the sixties (top 1%s share decreased) than anysubsequent decade (80s; 90s & 2000s) in which the top 1%s

share increased. The fastest increases in the top 1%s share ofincome occurred in a decade (eighties) with the 2nd lowestgrowth in real personal income. Only the last decade (2000s)has a poorer rate of growth for real personal income. Anotherproblem with the above argument is that it fails to explain whymajor changes in top marginal rates had such a decisive andnear immediate impact on the top 1%s share of income asshown in the above charts. Although the above proposition maybe a contributory factor over the longer term, it is certainly not

the complete answer.

There is a strong possibility that changes in top marginal taxrates directly impacted the greed factor. The top earners werethe CEOs, senior executives, board members or owners ofbusinesses who often had the final say on the major part ofcompensation distribution. Although, they might not have setthe compensation levels for all individual pay packages at thelower levels directly, their profit targets and bonus systemswould have taken care of that down the line. When highincome earners realised that for every additional dollar ofincome they would earn in compensation, they would onlyreceive say 20 cents instead of 80 cents after tax, it probablychanged their outlook and perceptions on many fronts,including their approach to compensation for lower incomelevels.

Also, during the forties, fifties and sixties, the spread betweentop marginal tax rates and capital gains tax increased steeply.
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Short term gains were taxed at a much higher rate than longterm gains.

It is likely that both the above factors had the effect that

owners and top executives favoured long term gains aboveshort term gains. Such an approach would have favouredhigher investment in businesses (including employees) and amore prudent view on risk-taking. All of this would have workedin favour of higher compensation for employees at lowerincome levels, more realistic compensation for the top 1% andhence a better distribution of gross personal income.

Although the above explanation as to why higher taxes led to a

more equal distribution of gross personal income amounts toconjecture, there is ample evidence that supports it:

1. Real median incomes moved higher at a much fasterpace in the fifties and sixties (top 1%s sharedecreased) compared to the last three decades (top1%s share increased). Since the middle seventies,growth in real median income trended downwards untilit started to decline in the last decade. Contrary to the

above, the top 1%s personal income increased atrecord pace.

2. During the relevant periods, increases in top marginaltax rates had a near immediate impact on the top 1%sshare (smaller share) without reducing the total incomecake or its growth rate. This was not possible unless thebottom 99% share of personal gross income increasedby a similar or bigger amount.

3. During the last three decades, top marginal tax ratescontinued to drop and the spread between it and capitalgains tax narrowed considerably. This was followed bysubstantial increases in the top 1%s share of grosspersonal income and excessive risk taking - often withthe aim to maximise short term profits to justify theenormous increases in bonuses and other forms ofcompensation paid to some of the top income earners.


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Conclusion

There are of course other factors that might have had animpact on changes in income inequality. Bringing forward the

realisation of capital gains (to benefit from lower capital gainstax rates) may have had a sizeable impact on top 1%s grossincome over the last three decades. Outsourcing, off-shoring,mechanisation, globalisation and improving technology were allfactors that impacted wages of lower earners and growingincome inequality. Also, in the last three decades CEOs andtheir boards came up with new incentives schemes (shareoptions, cash bonuses, etc.) that caused the remunerationpackages of top executives to skyrocket. It created a new

culture of corporate elitism which has gone viral globally. All ofthese factors have a momentum of their own and it may not bepossible to turn it around until a calamitous event destroysmuch of the economy.

However, no individual factor has shown itself more influentialor closely linked to changes in the dispersion of gross personalincome (and consequently GDP growth) than changes in taxrates and tax policies. It has a proven record over time and is

probably still the best and most reliable tool to stop furtherincome concentration in the top 1%s hands and to turn thetide more in favour of the bottom 99% - giving demand a muchneeded boost.

The argument that lower taxes will enable the top 1% to createmore jobs is without substance. During the first decade of the21st century, the top 1% enjoyed the lowest top tax rates inmore than eighty years, yet it resulted in the lowest job growthdecade. Notwithstanding the aforementioned, the argument forlower taxes on the top 1%s income is propagated as the HolyGrail of job creation.

The debate on using higher taxes to remedy incomeconcentration should not be about taking away from one groupto give to another but rather to focus at the best solution to pullthe economy back from the brink and put it on the road ofrobust growth. For that to happen you need a growing economywhich in turn depends to a great degree on the more equaldistribution of income. That will not happen while the top 1% in
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the United States takes home nearly a quarter of the incomepie. Furthermore, debts can only be repaid to the top 1% (or itsinvestment vehicles) when the debtors have the ability to doso. Higher taxes and a more equal distribution of income will

greatly enhance the debtors ability to repay these debts.Failure to achieve that may well lead to huge debt write-offsand a much smaller income and wealth pie. The quarter shareof the top 1% may end up having much less value than asmaller share of a much bigger income pie.

In our next article we will look at China and its impact on theglobal financial crisis and future growth.

Copyright David Collett 2012.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its author, David Collett;

nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability,

accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any

liability for the consequences of any reliance placed on opinions expressed or any other information contained in the

above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is

intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If

you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party

involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.
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part ix - dominant causes of the credit crisis. why taxation may be the key to an economic recovery

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