Taxation and economic growth

Summary

Abstract - Tax reforms are sometimes touted as having strong macroeconomic growth effects. Using three approaches, we consider the impact of a major tax reform—a 5 percentage point cut in marginal tax rates—on long-term growth rates. The first approach is to examine the historical record of the U.S. economy to evaluate whether tax cuts have been associated with economic growth. The second is to consider the evidence on taxation and growth for a large sample of countries. And finally, we use evidence from microlevel studies of labor supply, investment demand, and productivity growth. Our results suggest modest effects, on the order of 0.2 to 0.3 percentage point differences in growth rates in response to a major tax reform. Nevertheless, even such small effects can have a large cumulative impact on living standards.

INTRODUCTION

By now, a presidential campaign is incomplete without at least one proposal for tax reform. Recent proposals suggested that by reducing marginal tax rates, or by replacing the current federal income tax with a consumptiontype tax, the United States can experience increased work effort, saving, and investment, resulting in faster economic growth. For example, Steve Forbes vaulted briefly into the political limelight based almost solely on his advocacy of a flat tax which cut nearly every person's tax bill, but which was supposed to balance the budget by stimulating economic growth.