Sep 20, 2008

Do we really need lower taxes?

It may be impossible to get elected in the US these days without promising tax cuts. Obama, the more fiscally responsible (or, more accurately, less irresponsible) of the two major-party presidential candidates, has promised not to increase the taxes of anyone earning less than $250,000 a year. I understand that low- and average-income people are hurting, but are families with incomes in the low 6-digits really that burdened with taxes that they can't pay more?

The usual response to this question is that higher taxes, and higher marginal taxes in particular - that is, higher rate of tax on the next dollar earned - reduce incentives to work and save, and thus reduce output and capital formation and slow down economic growth. Neoclassical economic models "prove" that low taxes are good for the economy (as long as government spending is also low, a detail often ignored by the passionate tax-cutters). But historical evidence hardly supports that theory.

People with good incomes faced higher marginal tax rates in the 1950s and 1960s, yet the economy was strong and growing fast, people worked just as hard as today, and saved more. As an example of a well-to-do, but not rich, families, I chose those whose income equaled the Congressional salary in each year. The blue line in the graph below shows the marginal tax rate (popularly known as the "tax bracket") that such a family, with two children and no itemized deductions, faced from 1955 to 2008.

Additionally, the orange line shows the tax bracket of a family earning twice the Congressional salary - a family just wealthy enough that its taxes would increase under Obama's plan. From a historical perspective, those people have paid ridiculously low taxes in the last two decades. And we are not even talking about multi-million-earning CEOs, who might have been in the 90% bracket during the Eisenhower administration.

So why would anyone think that a big tax hike on the well-to-do would kill the economy?

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