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: the state provides a certain degree of public goods and services necessary to the functioning of society and the common good. Governments need tax 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 been a major challenge for legislators throughout history. A government’s tax policy can have profound effects on economic growth and health. Many theorists assert that taxes are essential to fill gaps where private markets fail, such as national defense or public safety.  Taxes often do increase expenses and reduce the gains associated with a taxed activity, which governments can use as a tool to discourage consumption, as seen with cigarette taxes. However, many economic theories conclude that excessively high taxation discourages individuals from starting new businesses or taking financial risks, as the potential profits would be 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 early history, feudal states often used taxation to support the aristocracy, raise armies, and fortify defenses. Taxation was justified through divine or moral rights, imposed primarily upon the lower classes in society. As the scope of government spending has expanded, modern justifications have moved toward utilitarian and economic arguments. Now, taxes can be levied across individual income, corporate income, capital gains, property, inheritance, and sales, to fund government operations and programs.  

Taxation and spending are central challenges for legislators, giving rise to political differences and conflicts. In general, politicians on the economic left advocate for higher taxes to enable the government to expand its capacity to address societal issues, particularly inequality. The government can address these challenges through ambitious new progressive tax revenue-funded public programs. Often it is proposed that the funding for these programs come from those most well-off in society and that these programs be targeted towards low-income groups, as a blunt tool to create a more equitable economic system. For example, 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 substantially break up the concentration of wealth and power of this privileged class. This follows a similar approach President Franklin D. Roosevelt used in the New Deal programs. Through the Revenue Act of 1935, his administration created the progressive system of taxation, which takes a larger percentage of income as an earner moves towards high-income, instead of applying the same rate across all citizens. Proponents of progressive taxation argue that higher tax on high-income earners creates a more equitable society. Higher taxes can also discourage the consumption of goods that harm public health or safety, as seen with cigarette taxes. This ideology views taxes as both a necessary source of funds and a vital instrument to promote equality against entrenched concentrations of economic power. 

On the other side of the political spectrum, the economic right argues that excessive taxation burdens consumers and businesses while discouraging entrepreneurial financial risks. All these effects could stifle potential economic growth. Economists Barry Poulson and Jules Gordon Kaplan find that, between 1964 and 2004, a significant negative relationship existed 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 for all income groups, especially for high-income earners, believing they will reinvest the extra money into the economy to foster innovation and stimulate employment, a process often referred to as ‘trickle-down economics’ or supply-side economics.  The costs of these tax cuts are often offset by government spending cuts. These tax policies were championed by former U.S. President Ronald Reagan and former United Kingdom Prime Minister Margaret Thatcher. 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%. This ideology relies more on the market, and not the government, to best account for social and economic challenges.

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 be at a more modest rate of taxation due to the incentive-induced economic growth.

The Laffer Curve has been used by conservative politicians to justify ambitious tax cut plans, which have achieved mixed results in raising revenues. The Reagan administration’s Economic Recovery and Jobs Act of 1981 did increase economic growth 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. More recently in the United States, the 2017 Tax Cuts and Jobs Act reduced the top corporate tax rate and income taxes for most Americans. There is an ongoing debate over whether or not these tax cuts contributed to the rapidly growing federal debt or grew the economy and enabled economic recovery after the COVID-19 pandemic.