Does A Prosperous Economy Require Low Taxes?

Even during the uncertain founding of the nation, Benjamin Franklin’s now famous assertion of the inevitability of taxes rang true. Taxation is a key component of the social contract between citizens and the government: that the state provides a certain degree of public goods and services necessary to the functioning of society and the common good. Governments need the revenue to fund essential services, and, without taxes, basic government institutions would cease to function. As such, all contemporary governments must levy some taxes, but deciding who and how much to tax has confounded legislators throughout history. The levels of taxation can have profound effects on an economy’s health and larger downstream impacts on economic activity. Taxes raise the costs and diminish the returns for a taxed activity, so intuitively it makes sense that very high taxation might provide a disincentive for opening new firms or taking financial risks since potential profits are lower. But just how powerful is the relationship between taxation and economic success? Can a high tax economy be prosperous?

Differing justifications and explanations for taxes have been pushed throughout history. In feudal states, taxes were often used to support the aristocracy, raise armies, and fortify defenses. These types of taxation were justified through divine or moral rights, imposed primarily upon the lower classes in society. Modern justifications have moved towards utilitarian and economic arguments. Now, taxes can be levied across individual income, corporate income, capital gains, property, inheritance, and sales, to fund government revenues and implement political ideologies. For example, proponents of progressive taxation argue that higher tax on high-income earners creates a more equitable society. Public goods theorists argue that taxes can be necessary to fill gaps where private markets fail to allocate optimally, for example, in areas of national defense or public safety. Higher taxes can also serve as deterrents to consumption, as is the case in cigarette taxes.

Politicians on the economic left argue that higher taxes will give governments more revenue, which they can use to finance ambitious new public programs. These programs are often targeted towards low-income groups, using taxes as a blunt tool to create a more equitable economic system. Indeed, U.S. Senator Bernie Sanders, a democratic socialist and one of America’s most prominent progressives, justifies his call for a wealth tax on the top 0.1% of income earners by saying that it would raise an estimated $4.35 trillion over the next decade and cut the wealth of billionaires in half over 15 years. He argues this would substantially break up the concentration of wealth and power of this privileged class. This follows a similar approach used by President Franklin D. Roosevelt in the New Deal programs. Through the Revenue Act of 1935, his administration created the progressive system of taxation, which takes larger percentage of income as an earner moves towards high-income, instead of applying the same rate across all citizens. This ideology views taxes as both a necessary source of funds and as a vital instrument to promote equality against entrenched concentrations of economic power.

On the other side of the ideological spectrum, conservatives see excessive taxation as burdensome to businesses, and worry that high taxes might discourage entrepreneurs from taking financial risks. Economists Barry Poulson and Jules Gordon Kaplan find that, between 1964 and 2004, there was a significant negative relationship between a U.S. state’s marginal income tax rate and economic growth (i.e. higher marginal tax rates hurt Gross State Product growth). High tax states performed worse in several key economic indicators. Conservative economists typically support tax cuts, especially for high income earners, believing they will reinvest the extra money into the economy, a process often referred to as ‘trickle-down economics’. The costs of these tax cuts are often offset by government spending cuts. This ideological approach is tied to supply-side economics, a branch of economics that asserts less regulation and tax cuts for corporations and high-income earners will trigger company investment and stimulate employment.

Arthur Laffer, a supply-side economist whose counsel informed the Reagan Administration’s economic policy, popularized the Laffer Curve, which proposes a theoretical relationship between taxation and economic growth such that some specific tax rate between 1% and 99% will maximize government revenue while minimizing the impact to tax-payers. At high tax rates, there is less incentive for entrepreneurs to take risks with their money since potential profits are lower. Because of this, fewer new businesses will be created and the rate of economic growth may be lower. This means that, despite the rate of taxation being high, government revenues may be lower than they would at a more modest rate of taxation due to the incentive-induced economic growth.

The Laffer Curve has been used by conservative politicians as justification for ambitious tax cut plans, which have achieved mixed results with respect to raising revenues. The Reagan administration passed the Economic Recovery and Jobs Act of 1981, a sweeping tax reform package that lowered the top marginal income tax rate from 70% to 28% on the promise that it would catalyze economic growth and ultimately increase government revenue. Growth did increase markedly during the Reagan era, with 3.2% annual GDP growth compared to 2.8% under the previous administration. However, while government tax revenue did increase in absolute terms after the tax cuts were passed, The Treasury Department’s Office of Tax Analysis estimates that revenues dropped 13% relative to what they would have been without the cuts.