Taxes and Growth

The Trump administration has plans to cut taxes. There have been other blogs and articles that have explained that tax cuts do not necessarily increase growth (see Dietrich Volrath, and Brookings  for example). Most of these consider only US economic history, which may be idiosyncratic. Instead, this post will look at recent economic tax policy and economic performance of several OECD countries from 2000 to the present (the data can be found on stats.oecd.org). 

The graph above depicts the average growth rate before and after a tax policy change. The blue lines represent tax cuts and the yellow lines, tax hikes. The darker lines averages the five year average (annualized) growth rate within each country, and the lighter lines average the one year growth rate. The results confirm what has been found in most research, tax cuts have little impact on growth, and tax hikes can lead to higher growth in the long run.

The figure does a nice job of showing this, but numbers may also put it in perspective. The difference between the five year average before and after a tax cut is -0.877 percentage points. For a tax hike the similar number is 1.256 percentage points. In other words the five years after a tax cut have almost 1 percentage points lower GDP than the five years prior, whereas the years after a tax hike have a 1.25 percentage point increase.

Some caveats to this analysis:
1) One might think that a tax cut follows the start of a recession. In this case 4 out of the 15 hikes and 9 of the 37 cuts occurred in 2008 through 2011. Roughly the same percent.
2) Deciding whether there was a tax hike or cut depended upon a change in the marginal income tax rates. Sometimes tax reforms changed both the margins and the rates, making it unclear whether there was a cut or a hike. Those cases were ignored.
3) Finally, the analysis above is crude and one dimensional. It is possible that countries that tend to cut taxes rather than raise them have other characteristics that lead to lower growth.

Even with those caveats in mind, the evidence seems pretty clear. The lower tax rates will not be offset by higher economic growth, certainly not to the extent predicted by the administration or Congressional republicans.