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Part IX - The Dominant Causes of the Credit Crisis. Why Taxation may be the Key to a Recovery
By David Collett

The Relationship between GDP growth and changes to Top Marginal Tax Rates Strong correlation between changes in Tax Rates and changes in Income Inequality Let us acknowledge the obvious any thought of higher taxes causes an automatic impulse of revulsion in most people. A flurry of emotion befalls us. It is not a subject where objectivity is the norm. If any argument can be raised against higher taxes the vast majority of entrepreneurs would do so with vigour because resistance to giving away money we have earned is in our veins. Secondly, we dont need studies to convince us that the lowering taxes must have some stimulatory effect on the economy. If you lower taxes you increase disposable income, some of which will flow through to demand. That in turn will drive growth higher, at least in the short term. However, things are not always what it seems. Not only did the significant lowering of taxes, especially lowering of the top marginal tax rates, preceded The Great Depression (1930s) and The Great Recession (2008) but it also correlates positively with time periods that underperformed in terms of GDP growth. An objective analysis of historical data for the United States contradicts the conventional wisdom that lower taxes lead to higher GDP growth over time and vice versa. This is somewhat of a mystery that can only be solved by looking at it from a wider perspective. But lets start by looking at the facts.

The Relationship between GDP growth and changes to Top Marginal Tax Rates

In Chart T1 below, we compare the real US GDP growth for each decade (ending 31/12/X9) with the average top marginal tax rate for the same period. With the exception of the thirties, the strong positive correlation between changes in top marginal tax rates and GDP growth is puzzling. One would rather expect a strong negative correlation between GDP growth and changes in tax rates. Although the data on chart T1 does not prove that higher GDP growth was causally linked to higher top marginal tax rates, it certainly shows that higher tax rates were more closely associated with higher GDP growth than with lower growth and vice versa. There is certainly no evidence where lower top marginal tax rates caused stronger growth over any sustained period.

The lower GDP growth reflected in the above chart for the thirties-decade is somewhat misleading for the following reasons:
1.

The end of 1929 was used as the starting point to calculate the GDP growth for the thirties-decade. GDP

growth moved upwards until the stock markets crashed late in 1929. The subsequent drop in GDP growth was only reflected in the period from 1930 to1933.
2.

The top marginal tax rate dropped from 73% to 25% in the first half of the 1920s and remained at that low level until 1932 when the marginal top tax rate was moved up to 63%.

3.

The thirties-decade in the chart above therefore reflects the consequences of the 1929 crash, namely the steep drop in GDP that occurred mainly in 1930 and 1931 when the low rate of 25% still applied.

Chart T2 below shows a more accurate picture of the positive correlation between changes in tax rates and GDP growth for the twenties and thirties. The period from end of 1917 to the end of 1938 was divided in three periods of seven years in order to compare the seven year period (end of 1924-1931), when the top marginal rate was at the relative low level of 25%, with the seven year period before (end of 1917-1924) and after (end of 1931-1938).

The results show that GDP grew only 1% over the seven year period that the top marginal tax rate was at its lowest, compared to the 31% for the previous 7-year period and 19% for the subsequent 7-year period, the latter two periods having substantially higher top marginal rates. Once again the data shows that GDP growth was higher in times of high tax rates and lower in times of lower tax rates. Chart T3 below, analyse the data in more detail. It shows that a substantial tax reduction to the relative low rate of 25% (1925) preceded the 1929 stock market crash and The Great Depression that shows up in the GDP numbers of the period from 1930 to 1933. It further shows that although the low tax rate of 25% prevailed until 1932, the GDP growth continued to slide downwards. There is no indication that the higher marginal tax rates that came into effect in 1932 and 1936, prevented GDP growth from recovery. The GDP growth rate for the period 1934 to 1937 is also substantially higher than comparative growth in the twenties when the marginal tax rate was 25%.

In chart T4 we look at the second half of the 20th century and first decade of 21st century. It shows how the downward slide in the top marginal tax rates was accompanied by a similar downward trend in GDP growth.

The nineties-decade seems to deviate slightly from the trend. A closer examination of the late eighties and nineties is shown in Chart T5 below. It confirms the strong positive correlation between higher taxes and higher GDP growth and vice versa.

The first decade of the 21st century had the lowest growth since The Great Depression and chart T6 below reflects the same trends as shown in other charts above.

The above charts show that GDP growth and tax rate changes tracked each other (positive correlation) in trending up or down instead of moving in opposite directions (negative correlation). This contradicts conventional wisdom and the logical consequences of decreases in tax rates as argued in our introduction, both of which suggest a strong negative correlation between changes in marginal tax rates and GDP growth. The above data is however, subject to the following caveats:
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Although the tax rates for both the top and bottom income brackets generally moved in the same direction for the relevant period, the tax rate movements for the top income brackets were relatively larger in any upward or downward movements. The top income groups disposable incomes were therefore more impacted by the movements. On the downward moves in top marginal income tax rates one could surmise that the major part of the increases in disposable income that flowed to top earners was saved rather than spent. When the tax rates went up, the opposite can be surmised in that it impacted the lower earners less while higher earners consumption expenditure were not significantly affected. However, although the above may explain why tax reductions did not spur economic growth as much as one would have expected or decreased growth as much when taxes went up, it does not explain the conundrum as to why economic growth tends to move up with tax increases and down with declining marginal tax rates. Increases or decreases in top marginal tax rates can be misleading if the values of top income brackets (only income over a certain limit or bracket-value is subjected to the top marginal tax rate) are changed to such an extent as to negate much of the impact of higher or lower tax rates. The increase in tax rates in the thirties was to some extent negated by the large increases in the value of the top income brackets and

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the same happened in the early twenties when the top income bracket was lowered at the same time as lowering the marginal tax rates. The same goes for changes in allowable deductions which might have had a material impact on tax payable from time to time.
3.

World War II added extra growth to the GDP growth in the forties as the United States became the main supplier of arms to the Allied Forces. The forties GDP growth as reflected on chart T1 above may therefore include a war premium (10% - 25%) that was unrelated to any changes in taxation. Since the late sixties, payroll taxes moved in the opposite direction to top marginal tax rates. The increases in payroll taxes had much less impact on top earners (top 1%) than on lower income earners. Payroll taxes therefore had a more direct impact on demand as it decreased the disposable income of those earners who would most likely have spent it. It may well have played some part in the lower economic growth over the last four decades. Capital gains taxes also trended downwards since the middle of the 20th century and had a great influence on the effective tax rate that some income earners paid, especially in the first decade of 21st century.

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None of the above however, explains the conundrum of a strong positive correlation between changes in top marginal rates and GDP growth instead of the expected negative (inverse) correlation. The solution to this puzzle must be sought elsewhere. Changes in Income Inequality are the link between Taxes and GDP growth. Changes in the dispersion of income between the bottom 99% and top 1% of income earners are the missing link that connects GDP growth with changes in top marginal tax rates.

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The evidence below will show that higher marginal tax rates for the top 1%, strongly correlated with an improvement in income inequality (bigger share of income dispersed to bottom 99%). Part VIII of The Dominant Causes of the Credit Crisis explains how growing income inequality (smaller share of income to bottom 99%) strongly correlates with periods of lower GDP growth and vice versa. Simply put when top marginal tax rates go up, markets and/or employers react and distribute a bigger share of the income to the bottom 99% - improving income inequality. This causes an increase in demand for goods and services which in turn leads to higher GDP growth. When top marginal tax rates decrease, the opposite happens - leading to higher income inequality (smaller share to 99%), lower demand and lower GDP growth. The strong positive correlation between changes in top marginal tax rates and GDP growth is therefore due to changes in the dispersion of income (income inequality) between the top 1% and bottom 99%. Strong correlation between changes in Tax Rates and changes in Income Inequality The charts below will show how closely changes in US income dispersion between the top 1% and bottom 99% were linked to changes in top marginal tax rates. It further illustrates how changes in top US marginal tax rates preceded or coincided with decreases in the top 1%s share of income and vice versa. Simply put when the top marginal tax rates moved up, the top 1% got less of the total income cake and when marginal rates moved down, the top 1% got less of the income cake. It is also important to take note that all income refers to gross personal income or income before tax and not disposable (after tax) income. In other words; increases to the bottom 99%s income did not come from the higher taxes paid by the top 1%, but from increased salaries and wages. Higher top marginal tax rates would therefore not necessarily lead to bigger tax collections by governments, because the top 1% would pay tax on a relatively smaller income and the bottom 99% would pay tax on a relatively larger income.

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Chart T7 below compares the changes in top marginal tax rates with changes in the top 1%s share in total personal income on an annual basis from 1916 to 1928 when the top 1% share in total personal income grew to a record 19.6% (capital gains excluded) or 23.9% (capital gains included), one year before the 1929 stock market crash and the onset of The Great Depression.

The negative (inverse) correlation between changes in top marginal tax rates and changes in the top 1%s share of income is clearly visible from the chart. When tax rates went up in 1917, the top 1%s share of income dropped. Soon after the tax rates decreased to lower levels in the early twenties, the top 1%s share quickly increased to the all-time record level of 19.6% (23.9% with capital gains) for the 20th century. In the aftermath of the 1929 crash the top 1%s share in income came down a little in subsequent years, which is fairly common in years subsequent to major stock market crashes (smaller bonuses, losses on investments etc.). It however, remained relatively high untill 1941, despite substantial

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increases in the top marginal tax rates. Chart T8 below, confirms that the top 1%s share of total income did not react significantly to the first tax rate increase in 1932 and very little to the second tax rate increase in 1936. However, from 1942 onwards the top 1%s share of total income decreased at a more rapid pace .

The above chart confirms that the correlation between changing tax rates and changes in income inequality was not as strong for the period from 1933 to 1941 as it was for subsequent and prior periods. There is however, an explanation as to why a change to the top 1%s share was not so sensitive to increases in the top marginal tax rates in the relevant period. At the same time that the top marginal tax rates were raised, the top income brackets values were simultaneously increased too, which had the effect that only income above the top income bracket values was subjected to the higher top marginal tax rate. The top income bracket went up from $100,000 to $1million in 1932 when the top marginal tax rate was raised from 25% to 63%. In todays money value the $1million amounts to a value in excess of $10million. In 1936

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the top income bracket was once again raised to $5million which in todays money value would easily exceed $50million. The effect was that the increases in marginal tax rates were substantially negated by the increase in the top income brackets values which may explain why the top 1%s share of income bucked the trend to some extent for the relevant period. In 1942 though, the top income bracket was dropped to $200,000. It had the effect that all personal income in excess of $200,000 was taxed at the top marginal rate and not only income in excess of $5million. The effective tax rates for top earners therefore increased substantially in 1942. This effective increase in tax payable by top income earners was followed by a significant drop in the top 1%s share of income in 1942; a trend that continued into the seventies albeit at a slower pace. In chart T9 below, the relationship between changes in top marginal tax rates, top income brackets and the top 1%s share of total income is clearly demonstrated.

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The top marginal tax rates were lowered to +-70% (with some exceptions) from the second half of the sixties, but they also reduced the value of the top income bracket in 1965, which negated some of the effects of a lower top marginal rate. As shown in chart T-10 below, a major drop in top marginal tax rates in 1982 and especially 1987 were accompanied by a new rising trend in the top 1%s share of total income. Although values of top income brackets also changed, it was rather miniscule compare to the huge changes of the thirties and forties. The biggest change to the top income bracket, relative to other changes in the last three decades, was in 1994 when it was lifted from $89,000 to $250,000, negating some of the impact of the higher marginal rates (31% to 39.6%). The top 1%s share decreased a little after the Dotcom-bubble in 2001 but soon renewed its upward trend to new highs after another reduction in the top marginal tax rate to 35%.

The tendency to take a greater share of income in the form of capital gains increased in popularity among top income earners over the last three decades. Chart T-11 below shows that the same inverse trend as shown in the above charts, existed

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between changes in capital gains tax rates and changes in the top 1%s share in total income that included capital gains.

The strong negative correlation between changes in marginal tax rates and the top 1%s share of income, as portrayed in the above chart, is compelling. The direct and near immediate impact of changes in the abovementioned tax rates on the top 1%s share of income is undeniable. These trends are not unique to the United States. Many of the advance economies have experienced a rise in income concentration over the last two to three decades against a general trend of lower taxes on the higher income groups. Switzerland, which was not subjected to the major changes in tax rates as the US and other develop countries were over the past century, shows relatively little change in income distribution over the comparative period. This lends support to the argument that major changes in marginal tax rates have a major impact on income inequality.

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Why is there such a strong correlation between changes in Tax Rates and changes in Income Inequality? The answer to the above question is a tricky one. One can approach the question from two angles; one being the effect on after-tax income dispersion and its influence on future income and the other one being the before-tax income dispersion, the focus of this article. Lower tax rates may lead to lower personal tax collection (as a % of GDP) by governments and vice versa. For example, the United States collection of personal income taxes (payroll tax excluded) dropped in the last decade due to substantially lower effective tax rates. Changes in taxation may therefore enable governments to increase or decrease transfers to lower income groups, thereby creating a more equal net distribution of income benefits. Some economists question the effectiveness of these transfers but there are countries like some of the Scandinavian countries where it was implemented with some degree of success. This topic, however, have very little to do with the changes in income dispersion as referred to in the charts above because it does not impact before-tax income dispersions at least not directly. The before-tax changes in income dispersion are a game breaker in any major changes in income inequality whereas the redistribution of higher taxes actually paid generally has less impact. As said before, the above charts depict the before-tax distribution of gross personal income (salaries, wages, bonuses, rent, fees, interest, dividends etc.). Changes in tax policy (higher or lower top marginal tax rates) preceded most of the changes. The distribution in gross personal income therefore did not change because of the taxes actually paid, but changed because of the taxes that were to be paid by the 1%. Why did this happen? There is no simple answer to this important question. It would probably be best to try and interpret the trends and related data in the most logical way possible. One explanation that has been proposed before is that a lower disposable (after-tax) income for the top 1% cause them to dig

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into their savings; leaving increasingly less savings to earn future returns causing a downward trend in income for the top 1%. If true, a decrease in the top 1%s share of disposable income (due to higher taxes) would imply that gross personal income would grow slower in subsequent years. One would therefore expect lower growth in total personal income in periods where the top 1%s share of personal income decreases and higher growth in periods where the top 1%s share of personal income increases. But as clearly demonstrated in Part VIII of The Dominant Causes of the Credit Crisis, exactly the opposite happened as personal income grew substantially faster in the sixties (top 1%s share decreased) than any subsequent decade (80s; 90s & 2000s) in which the top 1%s share increased. The fastest increases in the top 1%s share of income occurred in a decade (eighties) with the 2nd lowest growth in real personal income. Only the last decade (2000s) has a poorer rate of growth for real personal income. Another problem with the above argument is that it fails to explain why major changes in top marginal rates had such a decisive and near immediate impact on the top 1%s share of income as shown in the above charts. Although the above proposition may be a contributory factor over the longer term, it is certainly not the complete answer. There is a strong possibility that changes in top marginal tax rates directly impacted the greed factor. The top earners were the CEOs, senior executives, board members or owners of businesses who often had the final say on the major part of compensation distribution. Although, they might not have set the compensation levels for all individual pay packages at the lower levels directly, their profit targets and bonus systems would have taken care of that down the line. When high income earners realised that for every additional dollar of income they would earn in compensation, they would only receive say 20 cents instead of 80 cents after tax, it probably changed their outlook and perceptions on many fronts, including their approach to compensation for lower income levels. Also, during the forties, fifties and sixties, the spread between top marginal tax rates and capital gains tax increased steeply.

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Short term gains were taxed at a much higher rate than long term gains. It is likely that both the above factors had the effect that owners and top executives favoured long term gains above short term gains. Such an approach would have favoured higher investment in businesses (including employees) and a more prudent view on risk-taking. All of this would have worked in favour of higher compensation for employees at lower income levels, more realistic compensation for the top 1% and hence a better distribution of gross personal income. Although the above explanation as to why higher taxes led to a more equal distribution of gross personal income amounts to conjecture, there is ample evidence that supports it:
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Real median incomes moved higher at a much faster pace in the fifties and sixties (top 1%s share decreased) compared to the last three decades (top 1%s share increased). Since the middle seventies, growth in real median income trended downwards until it started to decline in the last decade. Contrary to the above, the top 1%s personal income increased at record pace. During the relevant periods, increases in top marginal tax rates had a near immediate impact on the top 1%s share (smaller share) without reducing the total income cake or its growth rate. This was not possible unless the bottom 99% share of personal gross income increased by a similar or bigger amount. During the last three decades, top marginal tax rates continued to drop and the spread between it and capital gains tax narrowed considerably. This was followed by substantial increases in the top 1%s share of gross personal income and excessive risk taking - often with the aim to maximise short term profits to justify the enormous increases in bonuses and other forms of compensation paid to some of the top income earners.

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Conclusion There are of course other factors that might have had an impact on changes in income inequality. Bringing forward the realisation of capital gains (to benefit from lower capital gains tax rates) may have had a sizeable impact on top 1%s gross income over the last three decades. Outsourcing, off-shoring, mechanisation, globalisation and improving technology were all factors that impacted wages of lower earners and growing income inequality. Also, in the last three decades CEOs and their boards came up with new incentives schemes (share options, cash bonuses, etc.) that caused the remuneration packages of top executives to skyrocket. It created a new culture of corporate elitism which has gone viral globally. All of these factors have a momentum of their own and it may not be possible to turn it around until a calamitous event destroys much of the economy. However, no individual factor has shown itself more influential or closely linked to changes in the dispersion of gross personal income (and consequently GDP growth) than changes in tax rates and tax policies. It has a proven record over time and is probably still the best and most reliable tool to stop further income concentration in the top 1%s hands and to turn the tide more in favour of the bottom 99% - giving demand a much needed boost. The argument that lower taxes will enable the top 1% to create more jobs is without substance. During the first decade of the 21st century, the top 1% enjoyed the lowest top tax rates in more than eighty years, yet it resulted in the lowest job growth decade. Notwithstanding the aforementioned, the argument for lower taxes on the top 1%s income is propagated as the Holy Grail of job creation. The debate on using higher taxes to remedy income concentration should not be about taking away from one group to give to another but rather to focus at the best solution to pull the economy back from the brink and put it on the road of robust growth. For that to happen you need a growing economy which in turn depends to a great degree on the more equal distribution of income. That will not happen while the top 1% in

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the United States takes home nearly a quarter of the income pie. Furthermore, debts can only be repaid to the top 1% (or its investment vehicles) when the debtors have the ability to do so. Higher taxes and a more equal distribution of income will greatly enhance the debtors ability to repay these debts. Failure to achieve that may well lead to huge debt write-offs and a much smaller income and wealth pie. The quarter share of the top 1% may end up having much less value than a smaller share of a much bigger income pie. In our next article we will look at China and its impact on the global financial crisis and future growth.

Copyright David Collett 2012.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability, accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any liability for the consequences of any reliance placed on opinions expressed or any other information contained in the above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.